Trading Insights

7/30/2019 Trading Insights

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The Best of Louise Bedfords Articles

Congratulations on purchasing Trading Insights.

These articles have been compiled from years of writing for Sharesmagazine, Personal Investor, Your Trading Edge and a variety ofother publications.

There are droplets of trading wisdom that you wont find in any of herbooks, all presented with humour and a style that will make theconcepts easy to remember.

The best way to navigate around the articles is to use the list ofhyperlinks shown in the Index to go directly to your article of choice

(and the Back to Index link at the bottom of each article to return tothe Index).

For more information, about trading, refer towww.tradingsecrets.com.au and www.tradinggame.com.au

Copyright Trading Secrets Pty Ltd

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Index

-Articles on Options and Downtrend Strategies-

1) Getting Started With Options2) Downtrend Doesnt Have to Mean Doom3) Short Selling Strategies4) Cheap and Nasty5) The Option Pricing Puzzle6) 8 Option Traps7) Volatility Trading8) Trading Volatile Markets9) The Naked Truth

-Articles on Trading Psychology-

1) The Art of War2) Temples of Doom3) In Your Dreams4) Know Yourself the Key to Super Profits5) Affirmations6) Avoid Primal Urges

-Articles on Technical Analysis-

1) Relative Strength Comparison2) Failed Signals

-General Articles-

1) 7 Deadly Sins2) Pyramiding House of Cards3) Position Sizing4) The Derivative Kicker

5) Handling a Windfall Profit




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-Articles on Options and Downtrend Strategies-

1) Getting Started With Options

Novices tend to overestimate the returns that they can derive from

the sharemarket, yet underestimate the amount of effort thatbecoming a successful trader will require. Often influenced by a slicksales pitch, many nave hopefuls begin trading options prematurely,to their detriment. Lets have a look at some of the ways that you cansafely begin trading options.

The Covered Call

The covered call is a simple way that you can generate a solidcashflow if you currently own shares in the Top 15. This is when you

own the underlying stock and you write calls over it. If you areexercised (ie you are told to sell your shares at the strike price) andyou have written a call with a strike price (eg $20.00) greater thanyour purchase price, you will realise a capital gain on the share, inaddition to the premium (eg 38 cents) that you received for writingthe call. This is the best way to begin trading in the options market.Only write options against shares that you are willing to sell, or youwill need to take defensive actions to remove yourself from riskbefore being exercised.

Bought options depreciate in value. Once you have sold anothertrader an option (ie written an option), if all other things remainequal, the option will expire worthless. You will have the money inyour bank account and the buyer of the option will be holding aworthless asset at expiry. In fact, up to 85% of people lose moneywhen buying options.

Lets have a look at an example. Imagine you own 5000 BHP shares,and you decide that you would be happy to sell your shares if BHPgoes up to $20.00. You could write a $20.00 call due for expiry at theend of April and receive a premium of 38 cents. 5000 shares x 38

cents = $1900. If the share price stayed below $20.00 by the end ofApril, $1900 would be yours to keep and you would get to hold ontoyour shares. However, if the share price was greater than $20.00 bythe end of April, you would in all likelihood be required to sell yourshares for $20.00 per share, but you would still get to keep the$1900 that you had earned in options premium.

This strategy is suggested for shares that are trending gentlyupwards, moving sideways or trending gently downwards. A sharewith high levels of volatility is not suited to this concept. At all times




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be aware that the premium that you receive by writing calls will notoutweigh the capital loss you will make by holding onto a down-trending share. Set your stop losses and stick to them, even if youhave open written call positions over that particular share.

The other concern is that you may miss out on the additional capitalgain that you could receive if the share trended upwards suddenly.Written calls are rarely exercised prior to expiry (in contrast towritten puts). If your share becomes very bullish, it may be best toclose out your call position. Alternatively, a sound re-entry strategyto repurchase your uptrending shares may be required. For thisstrategy, always choose options that are liquid (ie have large openinterest, or many other buyers and sellers). If you do not deal withliquid options, it may be difficult to close out your position if the sharetrends against your initial view. By consistently writing calls overshares that you own, you will receive a cashflow similar to receiving adividend cheque in the mail every month.

Put Option Writing

A put option writer is of the opinion that a share will be trading in asideways band, or bullish in their view. They are under obligation tobuy the shares from a put option taker at the strike price should theybe exercised. You could implement this strategy if you were happy tobuy the share at a certain value below the current market price.

As an example of this strategy, imagine that we wrote an ANZ putoption at $14.00, and the current price was $15.00. We would be ofthe view that ANZ would not go below $14.00 by expiry. If ANZstayed above $14.00, we would keep the premium that the taker hadpaid (eg 20 cents). One contract provides exposure to 1000 shares,so if we wrote 5 contracts, we would receive $1000 in premium,providing exposure to $70,000 of ANZ.

There are defensive actions available if the trade does not trend inthe expected direction, however, as an option writer, technically our

loss is unlimited. It is for this reason that monitoring is an essentialcomponent of trading options, particularly for written put strategies.Never write a put if you have concerns that the share will downtrend,or if you have reason to believe that we are due for a marketcorrection. If you do not have a clear view regarding the direction ofthe share, do not write or buy options. Do not write more puts thanyou can cover if the market suddenly trends downward sharply.

Make sure you have a clear exit strategy in mind before you enterinto any position in the sharemarket. If you have difficulty trading




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shares successfully, it would be foolhardy to move into a leveragedarea such as options, warrants, or the futures market. Forexperienced traders however, options can multiply the availablerewards.

Many traders mistakenly believe that a Utopian Risk-Free tradeexists - and they spend their lives searching for this elusive goal.Options do not represent a shortcut to untold profits. As with anyleveraged instrument, options will escalate your speed of failure ifyou do not fully understand the principles of analysis, strategy anddiscipline.

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2) Downtrend Doesnt Have to Mean Doom

There is no such thing as a born trader. Every principle of trading islearned. It is easy to feel daunted by the jargon involved in thesharemarket, but with effort you can learn how to trade like a

professional. Professionals make money regardless of the marketdirection. Most people know how to make money in a bull market, butfew know how to profit from a bear market. Lets have a look at someof the methods that you can use.

Act on Your Stops

Aldous Huxley stated, "facts do not cease to exist because they areignored". If you recognise that a bear market is in place, the first stepis to review your existing portfolio. Take a close look at where youhave set your stop losses, and make sure that these levels areconsistent with your trading plan. If your stop is hit, exit immediately.Do not hope that your shares will recover. Traders tend to hold ontoshares that are trending down, yet sell shares that are trending upprematurely. This trait will ensure that you will stay amongst themediocre masses, and never fight your way to the top of the class.

Writing Call Options

There are two types of call options a covered call and a naked call.A covered call is where you own the underlying stock. If you areexercised (ie you are told to sell your shares) and you have written acall with an option strike price greater than your share purchaseprice, you will realise a capital gain on the share. This is in addition tothe premium (eg 40 cents a share) that you received for writing thecall. This is the safest way to begin in the options market. Be awarethat you must only write options against shares that you are willingto sell, or you will need to take defensive actions to remove yourselffrom risk before being exercised. By consistently writing calls overshares that you own, you will receive a cashflow similar to receiving adividend cheque in the mail every month.

If you do not own shares, you can write a naked call. Writing a callassumes that you have a sideways or downtrending view on thefuture share price action prior to the expiry date of the option. Aslong as the share price stays below the strike price of the option, thenyou will get to keep the full premium that the option taker paid you.If the share price goes above the option strike price, you are likely tobe exercised, and told to deliver shares to sell to the option taker.Unless you own these shares, you will be required to buy them atmarket value, and then deliver them to the option taker. This




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strategy is best reserved for professional traders, or traders that fullyunderstand the risks involved.

Bought options depreciate in value, right up until a defined expirydate. This is called time decay. Once you have sold another trader an

option, if all other things remain equal, the option will expireworthless. You will have the money in your bank account and thebuyer of the option will be holding a worthless asset. In fact, up to80% of people lose money when buying options.

Buying Put Options

Writing options involves collecting a small fixed premium, yetincurring a theoretically unlimited loss. Buying options has a lowerprobability of success, yet due to the leveraged nature of thisstrategy, the rewards from the 20% of trades that do work, mayoutweigh the losses from the 80% of losing trades.In the options market, as the share price drops, the price of putoptions increase, often very dramatically. If you buy a short datedoption, then time decay will erode your profit. For this reason, it ispreferable to buy an option that expires in at least 4 months or more,and exit before the final month.

Short Selling

Usually when we buy a share, we are hoping to buy it at $5.00 forexample, and sell it at $10.00 at a later date. Short-selling performsthis same process, but in reverse. In effect, you borrow shares thatyou do not own, sell them with the expectation that the share pricewill drop, then buy them back at a later date. Your profit or loss is thedifference between your sell price, and your buy price so if theshare price drops, you make a profit. If the price increases, you willincur a loss. It is actually quite a simple concept, yet less than 1% oftransactions in Australia are executed utilising this method. There areapproximately 300 shares that can be short-sold on the Australianmarket.

In the majority of cases, a leverage of 5:1 applies as brokerage firmsusually require you to lodge 20% of the value of the initial share pricein a cash management account. Be aware that you will be margincalled, and required to place more money into this account if theshare price trends upwards, (against your initial view). Rememberthat these strategies must be used with shares that have sufficientliquidity, or you will have trouble extracting yourself from the positionif the market suddenly turns bullish. This is absolutely essential, asthere is nothing worse than being trapped in a trade due to of lack of




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volume.

The sharemarket will continue to redistribute wealth to the peoplethat are determined to educate themselves. Much of our success isultimately determined by the strategies that we implement, as well as

our discipline and mindset. Your financial future is in your hands.

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3) Short Selling Strategies

Short selling is similar to buying a share, only the buying/sellingorder is reversed. Instead of buying a stock and then selling it, yousell the stock first and then buy it back at a later time. In effect, you

borrow shares that you do not own (your full-service broker willorganise this for you), sell them with the expectation that the shareprice will drop, then buy them back at a later date. Your profit or lossis the difference between your sell price and your buy price so if theshare price drops, you make a profit. If the price increases, you willincur a loss. It is actually quite a simple concept.

A significant benefit with short selling is that unlike the options andwarrants market, there is no time decay issue. (Bought options andwarrants decrease in value as they approach their expiration date).

The US Market

Many of the texts available on short selling originate from the USmarket. There are a few differences between the Australian marketand the US market. The good news is that in many ways, thesedifferences serve to improve our efficiency as traders, rather thandetract. Although you cannot short-sell online in Australia at thisstage, you at least do not have to wait for an uptick in price to shorta share. The uptick rule means that in the US, you have to place anorder one tick above the last sale. US traders are more likely to havethe trade trend against their initial view, prior to it co-operating andultimately dropping in price. It is likely that in the near future, anonline shorting facility will be introduced here, but for now, you mustuse a full-service broker in order to short the market.

Contrary to the views of some journalists, you cannot drive theshare price downward by short selling. You are not legally allowed toshort sell at a price below the previously recorded last sale price. Thisis one of the main execution differences between short selling and theusual method of merely buying a share. It is also one of the likely

reasons why there has been a delay in establishing short selling as anonline facility. Complications such as this tend to delay programming.From my understanding, there is no legal reason as to why an onlinefacility could not be introduced.

Broker Considerations

Some old-fashioned brokers may lead you to believe that you arerequired to pay a daily fee to cover their costs, but this practice islargely being phased out of the industry. Other brokers purport to




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only allow short sold positions to be active for a limited time period,for example 3 days, before they will close your position. This is not anideal situation, and I would question this rule with your broker. It isbecoming more common practice for brokers to enforce deadlines of3 or 6 months. Unless you can be convinced otherwise, it is likely that

time limits are negotiable. Alternatively, you could close out yourinitial position and then reopen it. Unfortunately, you will incuradditional brokerage fees, but if your system suggests that you re-enter your position, you should follow it.

When you place your order with your broker, make sure that youstipulate that you want to short sell. By just asking your broker to

sell, it could appear that you are requesting a sale of an existingshare position.

Not all Australian shares can be short sold. A complete list can beobtained from your broker or from an online broker. There areapproximately 200 shares that can be short sold on the Australianmarket, so the field is wide open for you to make money from adowntrending share. This list varies only to a minor degree on amonth-to-month basis. You cannot short sell any shares involved in atake-over bid and if you are in a current position with a shareinvolved in a take-over, you will probably be instructed to close out.

Especially smaller brokerage firms may have difficulty borrowing thescrip required for you to open a short position, and they are morelikely to enforce a maximum amount of time for the position to beactive. Dealing with one of the larger brokers for this type oftransaction will help you to avoid a multitude of problems thatsmaller brokers are likely to experience. A large brokerage firmshould be able to borrow any scrip on their short sell list to enableyou to perform your transaction and there are fewer limitations onthe minimum position sizing and time limits. Some firms require aminimum position of $10,000 for you to execute a short sold position,although this varies according to company policy and your ownpersonal relationship with your broker.

In the majority of cases, a leverage of 5:1 applies as brokerage firmsusually require you to lodge 20% of the value of the initial share pricein a cash management account. Although when you are starting, it isastute to consider that you have short-sold the entire value of theshare, so that you will not be margin called. Being margin calledmeans that you will be required to place more money into thisaccount if the share price trends upwards (against your initial view)to maintain the original leverage ratio. Convince yourself that you donot have this advantage of leverage and that you are responsible for




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the entire value of your position (ie the total number of shares thatyou have sold, multiplied by their share price). By doing this, it isunlikely that you will run into difficulties with margin calls. It isimportant to know how to trade successfully before you apply anyform of leverage, as leverage will multiply your results, whether they

be positive or negative.

Remember that a short selling strategy must be used with sharesthat have sufficient liquidity, or you will have trouble extricatingyourself from the position if the market suddenly turns bullish. Youwill need to arrive at your own rule for liquidity, but as a guide, youshould not open a position in a share where you are trading morethan 1/5 of the average daily volume over the last 3 months. There isnothing worse than being trapped in a trade due to of lack of volume.

Leveraged Equities

Leveraged Equities have a short sale product called ShortShare. Thisis available through most brokers who short sell. Using this method,there is a slightly reduced list of shares available to short, howeverthe costs and time limitations (if your short sell broker enforcesthem) are reduced. Your broker will charge you their fee, as perusual, and Leveraged Equities will also charge a small one-offestablishment fee. You have up to 12 months in the position withoutfurther fees. There is a minimum position size of $50,000 whichrequires between 15 - 25% of this amount to be lodged in margin. Ifyou are learning how to short sell, I would suggest that a minimumposition size of $50,000 is far too large, regardless of the level ofcapital that you have set aside for trading.

The main advantage of this type of product is that there is noproblem with Leveraged Equities borrowing the scrip (ie shares)required to perform a short sell transaction. They always have thestock available because they are holding it as collateral for otherswho are long in that stock (ie have bought positions). Personally, Iam not certain that this is enough of an advantage to use this

product.

Sometimes the best way to learn about short selling is to try it andsee how you go ideally with a small position size when you begin.This will teach you the lessons that the sharemarket is seeking toreveal to you with amazing clarity. The distance is nothing; it is onlythe first step that is difficult Marie De Vichy-Chamrond (1697 1780).




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Entry Strategies

To some extent, to enter a short position in the market, all you needto do is to reverse the entry signals that you would usually use for along position. This certainly simplifies your search routines. Here are

some of the signals that you could look for:

A share trading below its 30-week moving average that hasjust dropped through support on a bearish black candle.

A gap downwards during an existing downtrend.A top reversal pattern of a temporary uptrend, during anexisting, overall downtrend.

Divergence in a momentum indicator to show a sign ofweakness, prior to entering a short position on a blackcandlestick that has punctured an uptrend line.

A share that bearishly trades below a candlestick bottomreversal pattern, without responding to its potential toreverse the trend, could also trigger an entry.

Consider the sector that the share belongs to. A share thathas been underperforming its sector, in a sector that hasbeen underperforming the All-Ordinaries Index is preferable.

There are many other patterns that assist in a profitable entry into ashort-sold position. The list is only limited by your familiarity withtechnical analysis.

Volume

There is an important difference between my assessment of a highprobability uptrend and a high probability entry into a short soldposition. For an uptrend to commence, I place a significant emphasison the importance of heavy relative volume levels. Contrary to thisview, if other set up signals are present but volume is not increasingduring downticks in share price, I am still likely to short sell theshare. It becomes a higher probability trade if increased volume

levels are evident as the share drops in price, but it is not anessential pre-requisite.

The emotion of fear is much more pervasive than the emotion ofgreed or hope. A ripple of fear will spread very quickly throughout amarket. It only takes one small stone to begin an avalanche. It onlytakes one seller at a price below the current market value to create aselling frenzy.




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Exit Strategies

Consider the term of your view regarding the strength of thedowntrend, prior to determining an effective exit strategy. Traderswith a medium term view can attribute a wider stop to their positions

and be prepared to weather the discomfort of several periods ofcounter-trend reversal. Shorter-term traders may find that their shortsold positions are closed out within just a few days. Stops can be setutilising any of the same methods used to exit a long position, only inreverse. Examples of stops may include:

A break upwards past a resistance level. A top reversal pattern of a temporary uptrend within an

existing downtrend, that fails.

2 or 3 ATR above the point of entry

A technical indicator that has provided a bullish signal

Position Sizing

Position sizing for a short sale can follow the same principles that youapply to your long positions. You will also need to decide whether youare comfortable pyramiding into your position if it continues trendingdownwards. Some traders take full advantage of their leveragedsituation to pyramid very aggressively to short sold positions.

The Implications of Dividends

A good knowledge regarding the implications of dividends while shortselling is essential. Make sure you check the dividend status of thecompany that you are trying to short sell, prior to entering into aposition. Occasionally a brokerage firm will absorb the dividendpayment, especially if they are insisting upon a daily fee to hold theposition open. Most firms will make you pay the dividend out of youraccount, as well as any franking credit benefit that may be derived tocover the tax implication. This can be an unexpected shock for thenewcomer to the shorting market. As a suggestion, when you are

learning to short sell, dont short anything where the underlyingshare is due to pay a dividend, or you may end up being responsiblefor the amount of this dividend, plus any associated franking credits.

One strategy that you could consider is short selling a share that is inan existing downtrend, after it has gone ex-dividend. This will helpyou to avoid any of the consequences of being ultimately responsiblefor the dividend, while capitalising on the additional momentum thatan ex-dividend gap may provide in favour of the existing downtrend.




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For shares in an existing downtrend, a gap downwards may act as atrigger to open a short position. A gap that drops through apreviously well-established level of support is a particularly bearishsignal. Pay particular attention to the trend of the share prior to thepresence of a gap, and trade in line with the direction of the trend.

The lead up to the gap, and whether it is confirmed by subsequenttrading activity must be taken into account if you are to tradeeffectively using this method. With knowledge about how to short themarket - you need never fear a bear market again.

Review

1. Define short selling.

2. Describe a signal that would be likely to trigger your entry into ashort-sold position.

3. How do you plan to exit your short-sale position?

4. How does an ex-dividend situation effect the share price action? Ifthere was a fully franked dividend of 26 cents declared on a share,what would be the likely share price drop when it went ex-dividend?

Answers

1. Short selling is similar to buying a share, only the buying/selling

order is reversed. Instead of buying a stock and then selling it, yousell the stock first and then buy it back at a later time. Your profit orloss is the difference between your sell price, and your buy price soif the share price drops, you make a profit. If the price increases,you will incur a loss.

2. This is a personal decision, but any bearish chart pattern, preferablywithin an existing downtrend could trigger your entry into a short-sold position.

3. Exits can be made on the same basis as the signal required to exit a

long position, only in reverse. For example, you could use a volatilitystop loss, a pattern recognition stop, or a bullish technical indicator.

4. An ex-dividend situation will often create a bearish gap in a chart. Ifa fully franked dividend of 26 cents is declared, the share price islikely to drop approximately 39 cents ie 26 cents + (0.5 x 26c)

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4) Cheap and Nasty

It is an inbuilt instinct for people to hope. Cheap options, just likeTattslotto, feed into this delusion that you could be an overnightmillionaire with no skill required. The slight probability of winning is

overcome by the small amount of money required for a Lotto ticket,and this seems irresistible and worth the gamble.

In the options market, you will not get rich because of some luckybreak. It will take hard work and discipline before those elusiveprofits find their way into your bank account.

Novice buyers of options are particularly attracted to "cheap" options,which ironically have little probability of appreciating. This helpsexplain why a vast majority of option buyers end up net losers in themarket.

In terms of risk/reward and probability, buyers of low-priced optionsmake a trade with a low probability of success, where the rewards arehigh and the risk is minimal.

Why are they cheap?

Traders often buy options that have nominal time to expiry, whichmeans that their bought asset is depreciating like a time bomb. Mostoptions expire worthless and are only ever traded once. People don'tlike to be "wrong". They would rather sweep their bad trade underthe carpet, along with any remaining value that they could claim byclosing out their position, than confess that the trade didn't work.There is no room for this type of ego in trading.

Often, naive traders underestimate the strength of a move requiredto affect the price of the option. These unfortunate souls believe that,even though BHP may have increased by only 10 cents in a month, itcould potentially jump $10 within three days (when their optionexpires). Magically, BHP should recognise the brilliance of the trader

with the deal in play and co-operate!

The concept of delta and gamma becomes extremely important inthis situation - but, rather than learn what these terms mean andhow to use them, overly optimistic traders would rather just placetheir orders and take their chances.

Delta measures the sensitivity of an option price to changes in theshare price. Gamma measures the curvature of delta, so it can act asa precursor indicator when to exit a position. For advanced option




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plays, these two "greeks" or "option sensitivities" can greatly assistyour chances of extracting a substantial profit.

When you next see that amazing bargain option at two cents, askyourself why it is that price. Maybe there is a reason that you haven't

explored. Perhaps you are about to buy an option that is actuallyworth that small amount, not an option that has been mistakenlyunder-priced by market dynamics.

Brokers

Brokers receiving commission based on the number of contracts youbuy - rather than your overall exposure - may urge you to buy cheapoptions with a short time before expiry because they make moremoney. This way, they convert your trading capital to brokerage withlightning precision. Don't rely on your broker to guide you in thisarena. Stand on your own two feet and take responsibility for yourfuture by educating yourself about options, and identifying tradeswith a higher probability of success.

There is much less risk on the part of the broker when dealing inbought positions in comparison to written positions. Written positionscontain contingent liability. This requires careful monitoring by boththe client and the broker to eventuate in a profitable trade.

Alternatively, your trading account can be loaded up with boughtpositions without the need for close monitoring. With bought options,the worst thing that can happen is that you will lose everything youplaced into the trade -you can't lose your house. This is much simplerfor brokers to monitor, and has the side benefit of their not ending upbehind bars for inaccurate suggestions that led to their client'sfinancial collapse.

Buying at or in the money options with two to four months to expirywill often seem like a more expensive trade, but it is much morelikely to eventuate in a profitable trade.

Written positions

When I first started writing naked options on NAB, I reached astartling conclusion. I was presented with two choices. I could chooseto write five close-to-the-money option contracts, where I wouldseemingly take on more risk as the share price could easily breakthrough my strike price, or I could write 28 option contracts thatwere miles out of the money, yet receive the same amount of money




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overall. For a brief moment, I thought I was completely brilliant!

Can you see the problem with writing more contracts but receivingthe same amount of money in total? If you can't see the problem withthis, stop writing options immediately! I have one word that you must

learn about before you progress: EXPOSURE.

By writing many more cheap option contracts, it seems as if yourtrade has a higher probability of success. However, what happens if ahuge announcement is made, or if the share price goes ballistic? Yourexposure is completely blown out of the water! Rather than beingliable for 5000 NAB, I would have become responsible for 28,000 NABif the trade had backfired. Yikes!

When we begin our trading career, we are strong, brave andbulletproof. The market had better not cross us. Unfortunately, thetrading world doesn't work this way, and often the market willprovide a proverbial kick to our soft underbelly to ensure that wedon't repeat our past errors of being too cocky.

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5) The Option Pricing Puzzle

Many factors have an impact on the price of an option or a warrant. Itis crucial to understand these to determine whether theseinstruments represent "fair value" to trade. These factors also affect

the cost and timing of the defensive actions that you may take if thetrade turns against you.

Rather than provide you with a revolting array of mathematicalformulae, we will show you some general principles that affect thepremium value of options and warrants.

Pricing models are available to help calculate the theoretical premiumvalue of these instruments at specific strike prices. Some areavailable online, and require you to enter in a few basic details suchas the strike price, share price and interest rates. A difficulty withthese models is if the derived price is not backed by market support,we have gone to a lot of effort to calculate a figure that is largelyuseless. We prefer to let the market dictate the "fair value" based onthe following concepts:

Degrees of risk

As a rule, the greater the risk, the greater the potential reward. Thisdefinitely holds true when referring to the sharemarket. The closerthe strike price of the option or warrant to the share price, the morethe inherent risk, and the greater the premium price. If you do notunderstand the ramifications of in-, at- and out-of-the-money strikeprices, you need to do more research.

A call option/warrant is in-the-money when the share price is morethan the strike price. A put option/warrant is in-the-money when theshare price is less than the strike price. Option/warrant buyers willpay greater premiums if the option is in-the-money, but this equatesto less risk. If you are intending to write options, this means that youwill receive a greater premium if you write in-the-money or at-the-

money options, but you are exposed to much more risk.

At-the-money options/warrants show the strike at about the sameprice as the share value.




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Options strategies

Conservative Aggressive

WRITEout-of-the-money

calls and putsat- and in-the-money

calls and puts

BUYin-the-moneycalls and puts

at- and out-of-the-moneycalls and puts

Out-of-the money instruments show the reverse of the conditionsrequired for in-the-money positions. If you are an option writer, out-of-the-money options represent a more conservative trade with lessreward, but also less risk. Buyers with an aggressive nature will buyout-of-the-money instruments for a low price and high rewards, butwith less probability of success. Apprentice buyers of

options/warrants are particularly attracted to "cheap" out-of-the-money options, which have very little probability of appreciating.

Buying strategies have a lower probability of success than writingstrategies, yet due to the leveraged nature of bought positions, therewards from the 20 per cent of trades that are profitable mayoutweigh the losses from the 80 per cent of losing trades. A quickreality check, however - only experienced option traders can achievethese results. Despite popular opinion, it is still a tricky proposition toprofitably buy options and warrants. Complete at least one year oftrading shares successfully before you even attempt to trade theseinstruments.

If you want to follow a conservative strategy, buy in-the-moneyoptions/warrants and write out-of-the-money options (see table).

Delta

Delta measures the sensitivity of option price to changes in shareprice. For example, if a call option delta is 0.7, for every one dollar inshare price increase, the option premium will increase by 70 cents.(Put option deltas are expressed as negative figures.) Therefore, if webuy an option that is worth 70 cents, we will approximately doubleour money when the underlying share increases in price by onedollar. The delta approaches one as the instrument becomes deeperin-the-money.

Share volatility

The more volatile the share, the higher the premium price. A simpleway to see the effect of volatility is to have a close look at a share




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chart. The days that have higher volatility or candlestick length arethe days that attract a higher premium. Choppy shares with greaterdistances from the peak to the trough of the share price action aremore volatile and will attract higher premiums. For shares with alower volatility level, the option/warrant premiums will also be lower.

Although this description is simplistic, it can provide you with a basisof understanding why some shares attract vastly different premiumsthan others.

In volatile conditions, options and warrants become more expensive.This information feeds into a calculation called historical volatility. Ifthe market expects future volatility to increase, this affects a statisticcalled implied volatility. The effect of implied volatility was apparentafter the events of September 11. Not even the market makers couldaccurately predict the future, so option and warrant prices wentballistic. This was because the implied volatility spiked in a dramaticway. Uncertainty about future market conditions tends to drive theprices of options and warrants upward.

Volatility strategies can be implemented more effectively in theoptions market than the warrants market, as warrants tend to bewritten at high implied volatility levels. Warrant trades involve adirectional bias, rather than a volatility bias. This actually makes itmore difficult to make money using bought warrants as a vehicle incomparison to a correctly aligned volatility bought option trade.If your understanding of this concept is a bit foggy at this stage, youwill need to educate yourself so that you can trade fairly pricedinstruments based on volatility, not just expected future direction.

Time decay

Option Time Decay

The longer an option has until maturity, the greater the time valuereflected in the price of the premium. For example, a Julyoption/warrant will incur a higher premium than a Juneoption/warrant. Options lose value at an ever-increasing rate as theymove towards the expiry date (when all

else remains equal, such as the price ofthe share, volatility and so on).

The graph at right refers to the entirelife of an option. As is evident, thecloser the option is to expiry, the moresteeply the curve slopes. The timedecay curve is flat at the beginning ofan option's acceleration downwards asit nears the expiry date of the option.

Price

Time




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As a buyer of an option/warrant, it is prudent to buy an option with atleast two to three months' expiry. For writers of options, this timedecay curve provides a greater degree of encouragement to writeshorter-term options so that the buyer will have bought a rapidlydepreciating asset, rather than a less dramatically depreciating asset.

Other influences

There are many other influences to option pricing. Although it isinteresting to consider these influences, when you are starting totrade options it is not essential to analyse them all. It is not evennecessary to understand every definition in order to trade optionseffectively. I find that if I get too sidetracked with details, I missmany trading opportunities.

Other factors affecting option prices are:

Theta - the sensitivity of option price to the passing of time

Gamma - the sensitivity of delta to changes in share price

Vega - the sensitivity of option price to a change in share pricevolatility

Iota - the sensitivity of option price to interest rate changes

Clever young players sometimes try to jump into the deep water oftrading with leverage, without sufficient knowledge about how totrade more conservative instruments successfully. With enoughbravado, even the most stupid of us can convince ourselves that wecan outwit the market. Good luck to you if you hold this attitude. Wewish you the best of luck when the debt collectors start knocking onyour door.

Trading options and warrants is designed to add spice (and additionalreturns) to the lives of experienced traders. Your trading habits and

results will be the best guide to whether you should start tradingoptions and warrants. Successful trading relies on developing yourskills over time, so don't feel pressure to dive headlong into usingleverage if your ability does not match your ego.

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6) 8 Option Traps

Consistent sharemarket winners have a series of strategies for risingmarkets, but they also know how to benefit from a sideways ordowntrending share. If you can make money regardless of the

direction of the market, you have guaranteed yourself an income thatwill last as long as you keep trading. This skill ensures that you willbe able to effectively trade any market around the world, as long asyou know the rules of the stock exchange. Your longevity andsecurity will be assured.

Many naive traders begin trading with leverage prematurely, often totheir detriment. Trading a leveraged instrument will multiply yourresults. But, if you are not already trading proficiently, leverage willonly speed your demise. However, if you are already a skilled trader,then using derivatives and leverage may be worth investigating.Learn about options, warrants, futures and short-selling so you willbe better placed to make money in all market conditions.

A quick review

Options and warrants are very similar tools. There are traders whowrite call or put options, and traders who buy call or put options.Warrant traders can only buy to initiate the trade. Buying options andwarrants has a lower probability of success than writing options, yetdue to the leveraged nature of this strategy, the rewards from the 20per cent of trades that do work, may outweigh the losses from the 80per cent of losing trades. You will need to make your own assessmentregarding which strategy you should engage.

Other forms of leverage include short-selling and futures. Short-selling is similar to buying and selling the physical share, but theorder of the transaction is reversed. Short-sellers look to sell toinitiate the transaction and aim to buy back the share at a lowerprice, locking in a profit. Futures traders deal in standardisedcontracts that do not experience time decay, and can benefit from

upwards as well as downwards movements.

The table below describes the market moves required by traders ofdifferent strategies in order to profit.




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Strategy Market Trending Up Market Trending Down

Buy Shares

Short Sell

Buy Call Optionsand Warrants

Buy Put Optionsand Warrants

Write Call Options

Write Put Options

Trade Futures

Let's have a look at the mistakes that many traders make when usingleverage and derivatives.

1. Not analysing the share price direction

Would you like to make money in the sharemarket beyond your

wildest dreams? Trade in the direction of the overall trend andyou'll be amazed at the results. This sounds obvious, but in realityyou'll probably spend the rest of your trading life trying to achievethis goal.

There are two main rules in the sharemarket - if it is trending up,buy it. If it is trending down, sell it. When you add derivatives intothe picture, this ends up being a little more complicated.If the instrument is trending upwards over the time period thatyou are interested in trading, you can buy a call option/warrant,

write a put option, or buy the physical share. If the instrument istrending downwards, you can buy a put option/warrant, write acall option, or short-sell the share. Futures contracts can be usedwith any of these trends.

All of these leveraged strategies involve trading with the trend. Berule-oriented but maintain a degree of flexibility and adapt tochanging market conditions.




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The nature of the derivatives market means that you will need toget used to "thinking on your feet". Share traders may make adecision each week, but with derivatives, depending on yourtrading style, you may need to make several decisions every day.This adds to the complexity of this style of trading. If you are not

up to the task, there is no harm in refining your skills in sharesand then returning to leveraged instruments when you are ready.The first time you come into contact with any particular tradingscenario, it is likely to make your adrenalin pump at a furiousrate. The key to controlling your emotions is to think about everyconceivable scenario in advance and to plan your actions inmeticulous detail.

2. Underestimating the role of volatility

There are two broad categories of analysts who trade derivatives.There are traders who use volatility to determine the types oftrades that they are likely to enter, and there are traders whofocus on direction. A successful strategy is to combine these twomethods and trade using a hybrid approach. To ignore eitherdirection or volatility will not enhance your profits.

Choppy shares with greater distances from the peak to the troughof the share price action are more volatile and will attract higherderivative premiums. For shares with a lower volatility level, theoption/warrant premiums will also be lower. Although thisdescription is simplistic, it can provide you with a basis ofunderstanding why some shares attract vastly different derivativepremiums than others.Volatility strategies can be implemented more effectively in theoptions market than the warrants market because warrants tendto be written at high implied volatility levels. Warrant tradesinvolve a directional bias, rather than a volatility bias. Thisactually makes it more difficult to make money using boughtwarrants as a vehicle in comparison to a correctly alignedvolatility bought option trade.

If your understanding of this concept is a bit foggy, you will needto educate yourself so you can trade fairly priced instrumentsbased on volatility, not just expected future direction.

3. Only analysing direction when trading derivatives

Trading with leverage can be complicated. So many tradersassume the derivative will behave in the same way as the share.If this is your belief, then your wake-up call may be in the shape




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of massive losses. Trading derivatives relies on a greater level ofskill than that possessed by the average share trader.Most traders only look at "direction", but options require aconsideration of several additional components that share tradersdo not require knowledge about, such as:

Dividend knowledge.

Knowing the correct type of derivative to trade. Understanding the implications of time decay.

Effectively analysing implied and historic volatility. Being aware of the importance of liquidity.

Many traders buy out-of-the-money options/warrants and writein-the-money options. They allow their bought option/warrantpositions to expire worthless and have no idea about how to setan appropriate stop-loss. They write long-dated options and buyshort-dated options/warrants, and have little understanding abouthow to control their risk levels. This is the opposite approach tothat of the professional derivatives trader.

If you are not familiar with these terms, give yourself some timeto learn about the importance of these concepts.

There is no harm in paper trading to establish your foundation ofknowledge, before you jump headlong into some of the morecomplicated methods of trading. It makes sense to bide your timeand invest in your own education.

4. Searching for the totally 'risk-free' trade

Many traders mistakenly believe that a utopian "risk-free" tradeexists - and they spend their lives searching for this elusive goal.No risk means no reward. Derivatives do not represent a short-cutto untold profits. As with any leveraged instrument, options andwarrants will only escalate your speed of failure if you do not fullyunderstand the inherent principles of trading successfully.

5. Dealing in illiquid instruments

If a trade turns against us in a liquid position, we can usually finda market to buy back our option so that we can "close out" ourposition. This is not the case if we deal in illiquid derivatives. Wemay want to escape from the trade, but there may be no marketavailable for us to exit our position. This is a terrifying situation.Save yourself from unnecessary stress by refusing to deal inilliquid instruments.




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6. Using strategies that are too complex

Because derivatives represent a more sophisticated trade, manypeople believe that this will lead to a greater chance of success.Don't delude yourself into thinking that just because something is

complex, it will make you money. Often the simplest ideas andstrategies are the most effective.

7. Letting your losses run

If you do not know how to set a stop-loss, then for goodnesssake, stop trading immediately. An initial stop-loss is designed topreserve your trading capital. A breakeven stop will help lock in ano-loss trade. A trailing stop-loss will assist in preserving yourprofits. Learn how to set a stop and then follow it. If you can keepinvesting in the markets for long enough, you are bound to learnthe secrets about how to succeed. There is no such thing as a"born trader". Every principle of trading can be learned.

Develop a ruthless quality when it comes to taking a loss. Toquote author and chairperson of the US Strategic LearningInstitute Chin-Ning Chu: "The killer instinct is not solely reservedfor the vicious and cunning; it can benefit the virtuous andrighteous as well".

If you lack discipline in being able to take a loss, you may havedifficulty trading in the derivatives market. Trading with leverageis not for everybody. Recognise your own strengths andweaknesses and be prepared to maximise your strengths. If youstruggle with the application of discipline, perhaps stay with toolsthat are not quite as leveraged, such as shares. There is noshame in this.

8. Inadequate money management

Having conducted many courses on trading, I can usually assess

how much experience participants have in the market based onthe questions they ask.

As a trader matures, the questions they ask tend to involvepsychology. Ultimately, traders evolve to conquer the finalfrontier... money management.

I dare you to go boldly where few traders have gone before.Separate yourself from mediocrity. Consider position sizing, stop-loss procedures and capital allocation based on risk. Here are




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some basic guidelines to ensure that you don't get blown up whilefrolicking in the financial jungle.

Commit a maximum of 20 per cent of your total equity to higherrisk sectors of the market as well as derivative trades. As an

example, with a trading float of $100,000, $20,000 can bedevoted to speculative shares and derivatives. This will allow youto maintain a maximum of four to five lower risk positions and upto three to four speculative shares. This will still provide exposureto potential high returns, without the potential to devastate youfinancially if the market does not co-operate with your view.

Before you enter a trade, determine where you will exit if themarket turns against you. If you only permit a loss of a maximumof 2 per cent per position of your capital base, even a string oflosses won't destroy your equity.

Your number one goal in the market must be preservation ofcapital. When traders have learned how to consistently makemore money than they lose, they enter the realm of theprofessional trader.

Successful traders are among the most highly paid professionals inthe world, yet many beginners in the market expect to earn theincome of a brain surgeon without undue planning and effort.Profitable trading does not rely on luck. It demands the highest levelsof skill and discipline.

Your trading habits and results will be the best guide to whether youshould start trading options/warrants, short-selling or trading futures.

Summary of the Eight Trading Traps

1. Not analysing the share price direction2. Underestimating the role of volatility3. Only analysing direction when trading derivatives

4. Searching for the totally 'risk-free' trade5. Dealing in illiquid instruments6. Using strategies that are too complex7. Letting your losses run8. Inadequate money management

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7)Volatility Trading

Amateur traders are a predictable bunch. Most seem obsessed withfinding the magic indicator/software/set-up that will help thembecome a monumental success. In sharp contrast, professional

traders form a view and back that view, using a variety of strategiesmost suited to the markets at that time.

Let's imagine that you have formed a view on News Corp (NCP)shares. You think that, by the end of October (two months from thetime of writing), it will rise by 10 per cent from $10.50. We can usethis view to add specifics to some potentially profitable strategies.

NEWS CORPORATION (NCP)

2002

(Please note that this is a hypothetical example; good traders don'tgive tips and they don't listen to tips.)

After you have completed your analysis, you will need to work out theappropriate strategy to use in order to profit from your findings. Youwill need to decide which vehicle is best to make money from yourobservations - for example, shares or derivatives.

These are some of the strategies you could choose:

Buy the share

Most technical analysts tend to follow a trend. For trend-followers,there are a few simple rules. The first rule is that if a share istrending up, buy it. The second rule is that if it's going down, sell it.




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There are some traders who continually try to trade against theprevailing trend. People who trade against the trend will ultimatelyrun out of money and self-destruct.

Using the above chart, if you purchased NCP at $10.50, for example,

and sold it three months later at $11.55 (10 per cent higher), youwould make 10 per cent return on your initial investment, minusbrokerage costs and such. This equates to an annualised return of 40per cent, which is substantial. When we apply some leveragedstrategies, it is possible to enhance this return even further.

Buy a call option/warrant

Buying options is often similar to a Tattslotto ticket mentality. Novicebuyers of options are particularly attracted to cheap options, whichhave little probability of appreciating. Although the chance of winningTattslotto is minuscule, millions still gamble on it. The slightprobability that you will win is outweighed by the small amount ofmoney needed for a ticket. This reasoning helps explain why the vastmajority of option buyers end up net losers in the market. Buyers oflow-priced options enter a trade with a low probability of successwhere the rewards are potentially high.

If the call option buyer's view is correct, however, and the shareincreases in value, they can either sell the option at a profit, or if theychoose, exercise their rights. They have the right to purchase thewriter's shares at the strike price (which will represent a lower-than-current market value). Most players in the options market do notexercise their rights. They sell their options if their position has co-operated to experience a capital gain. The bulk of options are onlyever traded once and then left to expire worthless.

Strategies

Strategy Pros Cons

Buy Shares

Easy to execute

Easy to understand Lack of coverage

Buy a CallOption/Warrant

Terrific for strong movesExcellent income potential

Confusing to novices

Write a Put OptionHigh probability ofsuccessful trade

Limited income butunlimited liability




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If you are looking to buy an option there are a few simple rules tofollow:

Buy an option with a significant time until expiry. This willhelp minimise the negative effects of time decay.

Always exit your bought position before the final stages ofexpiry. An option close to expiry will incur exponential timedecay, sweeping away your capital at an alarming rate.

Buy an option that is in the money, which by definition willnot be the cheapest option available. Betting that NCP willgo up by $10 within two weeks is not a high-probabilitytrade.

Buy an option that gives the share a bit of room to move,just in case it does not co-operate immediately. If you donot fully understand the implications of in, at and out-of-the-money options, do not buy them.

Do not buy options if you do not understand the impact ofdelta and volatility on option prices.

Bought option positions work well as a short-term trade. Ifthis perception matches your view, but this time horizondoes not suit your trading style, do not buy options.

Only buy (or write) options that have sufficient levels ofliquidity.

Using our hypothetical example of NCP rising 10 per cent in threemonths, you could choose to buy a $10 November call option for$1.29. This is slightly in the money, and provides you with reasonablerelative open interest and a suitable delta of 0.61 (at the time ofwriting). The implied volatility is relatively low, which suggests thatthe option is undervalued and would be suitable for an option-buyingstrategy. So, by buying a November $10 call option, you wouldexpect, based on this delta, that the option would be worth $1.93 byexpiry - an option price increase of 64 cents. In reality, you wouldprobably close out your position by the end of October to avoid thelast month of dramatic time decay. This represents a 49.6 per centreturn on investment in three months, or an annualised return of

198.4 per cent.

Although it is unlikely that you will achieve these terrific returnsconsistently, the occasional extremely profitable trade can beessential to a professional trader's survival.

Another strategy that you could consider either separately, or inaddition to buying a call, is to write a put option.




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Write a put option

A put option writer either thinks that a share will be trading in asideways band, or is bullish. They are under obligation to buy theshares from a put option taker at the strike price, should they be

exercised. You could implement this strategy if you were happy tobuy the share at a certain value below the current market price. Youcould also write a put if you were of the view that NCP would notpenetrate a certain price within a certain period. Most writtenpositions are taken out with three to six weeks before expiry, so youcould use this strategy at least twice within our three-month view.

Trading Terms

Implied volatility - This is the value that you would derive after plugging all of thevariables into an option pricing model (underlying price, days to expiration, interest

rates, and the difference between the option's strike price and the price of theunderlying security).

Historic volatility - This describes volatility observed in a stock over a given period oftime. It is the standard deviation of share price changes over a particular time periodwhich will match the time until expiry of your option.

Delta - Measures the sensitivity of the option price to changes in share price.

Option pricing factors - Effective option trading requires a consideration of severaladditional components that share traders do not require knowledge about. Factors thatcan influence the price of an option include direction, type of option, time decay,volatility and strike price.

As an example of this strategy, imagine that you wrote an NCP putoption at $9.00, and the current price was $10.50. You would be ofthe view that NCP would not go below $9.00 by expiry (within fiveweeks). If NCP stayed above $9.00, you would keep the premiumthat the taker had paid. In this case, using the option pricing currentfor this period, you would be paid 40 cents from the option buyer.Assuming you repeated this trade in the subsequent month andearned a similar premium, you would earn 80 cents in total per shareper contract that you wrote.

Do not write more puts than you can cover if the market suddenlytrends downward sharply. For example, in the NCP exampledescribed, if your contingent liability is $100,000 (that is, 11contracts), it would be prudent to have enough cash or shares athand available to cover this level of exposure.

So in keeping with your view that you expected a 10 per cent rise inNCP in the short term, you could choose to buy the share, buy anappropriate call option, and/or write a put option. Each strategy has




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unique advantages and drawbacks that you need to evaluate beforeentering a position. There are also many defensive strategies thatyou could implement if the share did not co-operate with your initialview.

As well as knowing appropriate strategies, it is also essential tounderstand which strategies would not be effective, given a bullishview. These include writing a call option, buying a put option, or shortselling the share. Each of these strategies would be trading counter toyour view of the potential trend, and they are unlikely to be effectiveif the market moves in this bullish direction.

Even though these strategy examples provide some ideas about howto make money by backing your view, the trading world is not soclear-cut. Unfortunately we are not given crystal balls as soon as wedecide to become share traders.

Successful technical traders have a defined set of rules to enter ashare, and to exit from the market promptly at the first sign of adowntrend, or to preserve their capital after the share or derivativehas retraced in value. They maximise their profit potential throughdedication to the principles of money and risk management.

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8) Trading Volatile Markets

I have a challenge for you. Call up any three share charts at random.Take a few minutes and write down your observations. I can almostguarantee that you will spot an over-riding similarity. (Yes, Ive been

practicing my skills with amateur clairvoyance).

I can bet you that each of the three random charts, have one majorthing in common. In the current market (late 2002), almost withoutexception, share charts seem to be displaying vast levels of volatility.Peak to trough drawdowns are entering the extreme danger area.

Many traders have found that they have been getting stopped out oftheir long positions, as well as their short positions prematurely,despite the share continuing in the expected direction after they haveexited. Previously easy to read charts which showed ripples of calmdirectional activity have erupted into tidal waves of undisciplinedviolent share price action.

If youve been getting stopped out regardless of the direction youvebeen attempting to trade youre probably ready to jump off theproverbial cliff, especially if you have any grain of emotionalattachment to your bank balance. Take heart. Help is on its way.Here is how to survive and thrive in the current trading environment.

1. Set Stops Carefully

The golden rule of trading is: Keep your losses small and let yourprofits run. Stop losses provide a sign that it is time to exit yourposition, as the trade is no longer co-operating with your initialview. Every successful trader has pre-meditated the point of exit,prior to entering the trade.

You may remember that there are several methods available toset a stop loss. Volatility and pattern-based systems tend to workwell for short-selling, or trading shares. Hard dollar stops are

terrific for option/warrants and futures positions.

Pattern based stops are a very popular way to set a stop loss.When the share is no longer trending upwards, exit your position.An appropriate exit can be made if the shares price closes belowa trendline or below a support/resistance line.

Volatility is a measure of movement, not a measure of direction.Shares can be heading in an overall direction upwards, ordownwards, but this general direction is characterised by dramatic




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peak to trough drawdowns. This is typically characteristic of thecurrent market that we are experiencing.

Volatility based stops imply that you should to exit your positionwhen the volatility of the instrument increases dramatically, or

beyond a pre-defined level. To assist in this goal, an indicatorcalled Average True Range (ATR) can be utilised. For an exactdefinition of the ATR indicator, refer to the glossary in the FAQsat www.tradingsecrets.com.au.

A simple definition of ATR is the move in cents that a share couldreasonably be expected to make during a particular period. On adaily chart, it shows how much the share price is likely to go up ordown in a day. It typically shows a figure compiled from the last15 20 days price activity. You may choose to exit if the sharegoes up (for short positions), or down (for long positions) bygreater than a multiple of 3 or 4 times ATR. For example, if theATR is 10 cents, and the share goes up by 30 cents, you couldexit your short position. A drop in share price of 30 cents, wouldsuggest that you should exit your long position.

During volatile periods, set a wider stop loss. Otherwise you willexit your position only to see the share continue in the expecteddirection, without your involvement.

A hard-dollar stop can be effectively utilised for boughtoptions/warrants, or futures. For example, when youve lost amaximum of 2% of your allocated trading equity in any particulartrade, exit that position immediately. You may decide to exit whenyour position has a drawdown of $1000, for example.Alternatively, for a trailing stop, you could exit when the optionhas pulled back your equity $500 from the maximum profit peakthat you had attained in that position at any time. This is aneffective method of controlling your losses, and letting your profitsrun. A wide initial stop, but a tighter trailing stop tends to be thebest strategy in the present market conditions.

2. Learn How To Trade Long and Short

I moderate a trading forum for traders where members can asktrading questions and receive answers (located atwww.tradinggame.com.au ). Recently I was asked a questionregarding searches. A particular trader was wondering whether heshould loosen up his search parameters as he could not find anyshares to buy that fitted his criterion. Previously, he had identifiednumerous opportunities. However, in the current market he was


http://www.tradingsecrets.com.au/http://www.tradinggame.com.au/http://www.tradinggame.com.au/http://www.tradingsecrets.com.au/


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struggling to find two or three potential positions per month.Obviously he was frustrated.

Can you see the problem with applying more liberal searchesduring periods of volatility? By changing our trading system to

supposedly more accurately reflect market conditions, sometimeswe just end up kidding ourselves about the calibre of opportunityavailable.

If your trading system is telling you to buy shares youshould buy them. If your system is suggesting that it would bemore effective for you to sit on the sidelines and not trade due toinsufficient opportunities in the market, ignore this advice at yourown peril.

Alternatively, learn how to recognise a downtrend. Reverse theparameters of your usual searches. Use an option or short soldposition to capitalise on your observations.

3. Use Margin Wisely

I recently had lunch with a trader who could be characterised as abit of a cowboy, but had managed to generate a good tradingplan and consistent profits without the benefit of margin. Fromthe first few minutes of the conversation, I knew that he had aproblem. He excitedly explained to me about a new online systemthat he had discovered that allowed him to trade long and short,using minimal margin to open substantial positions. Theconversation went something like this:

They only want to take 20% margin from my account to openany position. Oh my gosh do you realise what this means I canleverage myself up to the hilt! I can open up as many positions asI want. My $100,000 will allow me to trade up to $500,000 worthof shares! Im going to be rich!!

Now, at risk of bursting his bubble, I decided to curb hisenthusiasm, (lest he couldnt afford to pay for his own coffee the next time we wanted to meet).

Too many traders decide to position size based on the margin thatthey are requested to deposit, instead of the total exposure oftheir position. If you do not immediately recognise the drawbacksof this rationale, you owe it to yourself to work through thisexample.




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Lets say that your system suggests that you can short sell$15,000 of a particular share, but your broker only requests a20% margin. The logical thing to do would be to reserve $15,000in your equity account, and give your broker $3000 in margin to

open your position. (Brokers require a margin in order to openshort sold positions and written option positions). Imagine thatyou had identified a $4 share that you wanted to short sell. Thismeans that you could short sell 3750 shares at $4, which equatesto a total position size of $15,000 (even though the broker is onlygoing to take $3000 in margin).

If the share did not co-operate, then at least you would have theremaining $12,000 of liability available at a moments notice toanswer any potential margin calls. This is a conservativeapproach. It works. It means that you wont end up losing yourhouse if the market ricochets upwards against your position withmeteoric speed.

On the other hand, you could consider the $15,000 that you haveavailable for this trade to be the margin. Rather than only selling$15,000 of the share, now you could short sell a position size of$75,000! Yikes!! Instead of short selling 3750 shares at $4, youwould now short sell 18750 shares! Think of the implications ofthis move. It is five times the exposure of your originalcalculation. It leaves no room for error, and opens you up to thethreat of a very nasty margin call that you are unlikely to be ableto cover.

The current market chews up and spits out non-conservativetraders with ruthless efficiency. Position size based on the positionitself, not the margin required to open your position. Only useleverage when you have developed your skills as a trader. If youinsist on doing otherwise, your career as a trader will be short-lived, but spectacular.

4. Limit Contingent Liability Positions

Writing naked options involves collecting a small fixed premium,yet incurring a theoretically unlimited loss. This is the meaning ofcontingent liability. Written naked option can surprise novices withtheir effectiveness to deplete trading equity.

Many traders are attracted to this concept because the chances ofsuccess of this strategy are high. Approximately 80% of optionsare only traded once and never exercised. On the surface, this




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sounds like a great chance to make money. When you look at therisks involved however, which contain contingent liability, thisstrategy should be left to sophisticated traders.With any position that has the ability to wipe out your bankaccount within one foul swoop, apply caution, limit the number of

this type of position, as well as limit position sizes.

To trade spreads in options, it is essential to understand bothsides of the transaction both buying and writing options. Byspending some time learning about these types of strategies, youcan work out creative ways to minimise your risk and maximiseyour profit.

Trading during volatile times can multiply your rewards. Takeadvantage of this trading environment, but remember to usecaution and common sense.

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9) The Naked Truth

Novice traders often take on incredible levels of risk without realisingthe consequences of their actions. This can lead to a short career inthe sharemarket. Professional traders tend to quantify the risk

involved in any strategy, weigh up the rewards and make aninformed decision as whether to engage the market.

One of the most common questions asked is whether a trader shouldwrite naked options. Naked options involve a high probability ofreceiving a limited reward in return for an unlimited level of risk.They imply that you are selling to initiate an option position whereyou do not own the underlying entity. In the right circumstances,writing naked options can be the ideal strategy. However, if you get itwrong, the consequences can be dire. There are several factors toconsider. Let's review ways you can limit your risk.

Pricing factors

Many factors have a large impact on the price of an option. It iscritical to come to an understanding of these factors to determinewhether these instruments represent fair value to trade. Thesefactors also have an impact on the cost and timing of the tradingtactics you may consider implementing if the trade turns against you.

Some of the main factors determining the price of an option are:

The level of risk - the greater the risk, the greater thepotential reward. The closer the strike price of the option isto the share price, the more the inherent risk, and thegreater the price of the premium.

The level of volatility - in general terms, the more volatilethe share, the higher the premium price. Choppy shareswith greater distances from the peak to the trough of theshare price action will attract higher premiums. For shareswith a lower volatility level, the option/warrant premiums

will also be lower. This information feeds into a calculation called historical

volatility. If the market expects future volatility to increase,this affects a statistic called implied volatility.

The time to expiry - the longer an option has until maturity,the greater the time value reflected in the price of thepremium.

Other factors such as delta, gamma and interest ratefluctuations also have an impact.




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If the naked option trade I am considering does not provide an idealcombination of all of these factors, I walk away from using this as astrategy for that particular instrument. There is no point in enteringinto an option trade that contains unlimited risk unless the set-up isideal. The risk must justify the rewards.

The perfect combination that would encourage me to write a nakedoption rather than employ an alternative strategy would be where theoption had a limited time to expiry in a highly liquid share and optionseries. Ideally, the volatility set-up would suggest that the option isover-priced and likely to decrease in value. Comparing the impliedand historical volatility levels will assist you in this quest. Beforeplunging into writing a naked option, also consider the expectedstrength of the move.

If a strong move downward is expected, writing a call does not oftenrepresent significant profit potential. It will result in a small fixedprofit, regardless of the strength of the ensuing move in the expecteddirection. Another choice would be to buy a put option or short sell.

If a strong move upwards is expected, then writing an unprotectedput position will not capitalise on this. Alternatives would includebuying the share or buying a call option or warrant.

Alternatives

There are several other methods you can implement that do notinvolve writing naked options.

Covered calls

One way to learn about the options market is to write "covered" calloptions over shares you own. When you write options, you receive asmall, fixed amount of money because you are selling to initiate thetransaction.

The risk with written covered call options is that if the share increasesdramatically in price, beyond the strike price of your written option(the level at which you wrote the option), it is likely your shares willbe "called away". When you write a call option, you are underobligation to sell your shares to the option buyer, which is usuallyenacted if the share price exceeds the strike price.

If you are exercised and the strike price is above the initial price youpaid for the share, you will experience capital gain of the share aswell as keeping the premium from selling the option. By writing these




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covered calls, you are making your portfolio work hard. Writing a callwill bring in some regular income in particular circumstances.

Many traders have found that by implementing this strategy, theirreturns have safely increased, and that the additional cashflow has

been a welcome contrast to awaiting dividend payments. If you wantyour blue-chip portfolio to return an extra 5 to 15 per cent per year,this may be the strategy for you.

Credit spreads

The concept behind some of the most effective credit spreads is thatyou limit your downside risk by "covering" your written position insome way with a bought option position. Written straddles andstrangles also fall under the banner of credit spreads, but we willsave the discussion of these concepts for another time.

An excellent text to enhance your knowledge of these types ofstrategies is Chris Tate's Option Trader Home Study Course,available through www.tradinggame.com.au

A call bear spread involves writing a lower strike price call andbuying a higher strike price call with the same expiry date. This isusually written out of the money, above the share price action. It isprofitable if the share stays at the same level or drops in price.

Some people think of the bought position as being a form ofinsurance against a catastrophic loss. Any potential loss isquantifiable and known in advance, so provides a degree ofconsolation to the trader.

The payoff diagram in Fig 1.1 shows the construction of this optionspread. A call is sold at A and a call is bought at B.

Fig 1.1 Call Bear Spread


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The reward is limited to the credit received, so it is probably not theideal strategy if you expect an explosive move to the downside. Forexplosive moves you could short sell, or buy a put option. Thisstrategy will not benefit from a change in volatility either, becauseyou have both a written and a bought option position.

If the share price moves up, this will damage the position, so you canuse an effective stop loss in order to recoup some of your investment.This is often a more effective alternative than letting both positionsexpire.

A put bull spread is where you sell a put option, and then buy a putoption with the same expiry date, at a lower strike price. This isusually written out of the money, below the share price action. Shareprice action that moves sideways or upwards will lead to profit in thissituation. This strategy yields a credit and limits your downside riskby capping your potential loss.The payoff diagram in Fig 1.2 shows the construction of this optionspread. A put is sold at A and a put is bought at B.

Fig 1.2 Put Bull Spread

Both this strategy and the call bear spread benefit from a rapid lossin time value. Traders who implement these strategies will benefit

from a gradual progression in price, rather than dramatic or volatiledirectional price movement.

Call bear spreads and put bull spreads are of advantage to newoption players because they give them a capacity to write options butwith a risk management component built in. Along with covered calls,they represent a great learning ground so that you can learn thebasics without exposure to unlimited downside potential.




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Index options

When trading some instruments, such as index options, sometimes itseems almost impossible to avoid the possibility of writing naked

positions. In order to limit your risk in this situation, remember toemploy an effective stop-loss procedure, and to use a spread tomitigate potential disaster.

Some of the spreads that you could implement involve a call bearspread or a put bull spread as shown in the pay-off diagrams.

It would be foolhardy to write puts under an index without some formof protection such as a put bull spread. Any severe drop in the indexwould involve an unlimited potential for disaster. Several traderstotally eradicated their last five years' worth of profit by ignoring thisrisk before the September 11, 2001 index corrections around theworld. By building a put bull spread, they could have limited theirdownside risk, yet still backed their view.As James Rogers states in Market Wizards by Jack Schwager: "Bevery selective. Never trade for trading's sake. Have the patience to siton your money until the high probability trade sets up exactly right."

This attitude will ensure your longevity in the markets and give you achance to develop profitable strategies.

Back to Index




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-Articles on Trading Psychology-

1) The Art of War

Sun Tzu was a military genius who wrote a classic treatise entitled

The Art of War. The principles in this ancient text are relevantwhether you are planning a military coup, aiming for success in theboardroom, or desire to excel as a trader. The fact that his ideaswere expressed approximately 2500 years ago ensures that theseconcepts have stood the test of time. Lets have a look at some of hiskey concepts and apply these to assist our trading results.

1. Possessing the ability to calculate the difficulties and danger is abasic requirement for a good general"

Your number one goal in the market must be preservation of capital.If you have not evaluated the risks involved, you should not take thetrade. Effective money management skills allow you to quantify theworst-case scenario before engaging the market.

2. To be prepared beforehand for any contingency is the greatest ofvirtues. The degree of success depends upon the extent ofplanning for the anticipated victory"

Meticulous planning Before engaging in battle, you havealready won the war.

Careless planning Before engaging in battle, you mayhave already lost the war.

No planning Your defeat is certain.

Traders who work to a written trading plan stack the odds in theirfavour. The market is a more efficient, bigger and scarier opponentthan you have ever faced in your life. You cannot defeat it unless you

out-think and out-plan it.

3. You need to strengthen yourself and prepare yourself mentally tobe the target of attack. "Know the enemy and know yourself andin a hundred battles, you will never be in peril"

The more knowledge that you can muster about the market, themore likely you will be to succeed. Trading favours the strong ofmind.




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4. Those who carefully calculate their strategies will be led tovictory. Those who carelessly calculate their strategies will be ledto defeat

One of the key trading strategies is to let your profits run, and cut

your losses. Unfortunately, the majority of traders have this rulearound the wrong way. They become risk-seeking when faced with aloss, yet risk-averse when a trade is profitable. Sometimes the oldwives tale of you'll never go broke taking a profit or leave something on the table for the next person comes into play, and they exitthe trade pre-emptively. It is difficult for traders to obey the rules oftrading because their own psychology often defeats them.

5. Within the universe, there are no eternal conquerors

You are only as good as your last trade, so the killing you made inthe tech boom is no longer relevant. Even the bravest among us havelearned that Out of orderliness comes chaos. Out of courage comescowardice. Out of strength comes weakness. You cannot afford to letyour guard down, or you will suffer the consequences.

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