Trading & Investing in Stocks & Options
Department of Social Science & Policy Studies
Worcester Polytechnic Institute
Michael J. Radzicki, Ph.D.
http://www.michaeljosephradzicki.com/
New York Stock Exchange – 4 August 2006
Outline Of My TalkOutline Of My Talk
Hierarchy of Stock & Options Price Movement
Some Basic Macroeconomics
Inter-Market Analysis
Sector Rotation
Market Breadth
Trading & Investing
Options
New York Stock Exchange – 4 August 2006
Hierarchy of Stock & Options Price Movement
Hierarchy of Stock & Options Price Movement
Economy
– Actions of central bank(s)– Fiscal policy
Markets
– Currency Markets– Commodity Markets– Bond Market– Stock Market
Sectors
Industry Groups
Individual Stock Prices
Individual Stock Option Prices
New York Stock Exchange – 4 August 2006
Some Basic MacroeconomicsSome Basic Macroeconomics
Gurus: John Maynard Keynes, Hyman Minsky, Abba Lerner, Warren Mosler & L. Randall Wray
New York Stock Exchange – 4 August 2006
Capitalist economies have a trend & a cycle(s)
Some Basic MacroeconomicsSome Basic Macroeconomics
New York Stock Exchange – 4 August 2006
Trend due to self-reinforcing processes:
– Supply Side
• Population Growth
• Technological Innovation & Ideas
• Capital Accumulation
– Demand Side
• Fiscal Policy
Some Basic MacroeconomicsSome Basic Macroeconomics
New York Stock Exchange – 4 August 2006
Cycle (primarily) due to:
– Consumption Spending
• Since 1980, due to consumer credit
– Investment and the dynamics of its financing
• Which includes speculation (a self-reinforcing process)
– Countercyclical Government Spending
Some Basic MacroeconomicsSome Basic Macroeconomics
New York Stock Exchange – 4 August 2006
Inflation/deflation and involuntary unemployment are the traditional evils that policymakers try to combat
– Other evils exist too
Capitalist economies are often “demand constrained”
– Which results in unused production capacity
– In both the long and short runs
Some Basic MacroeconomicsSome Basic Macroeconomics
New York Stock Exchange – 4 August 2006
Minsky’s Theory of the Cycle
– Investment spending & its financing is the key
– Hedge Firms/Sectors
– Speculative Firms/Sectors
– Ponzi Firms/Sectors
Some Basic MacroeconomicsSome Basic Macroeconomics
New York Stock Exchange – 4 August 2006
Central banks in capitalist economies are said to (implicitly) follow a Taylor Rule:
It = Inft* + rt* + a*(Inft- Inft*) + b*(yt – yt*)
It = Target Federal Funds Rate Inft = Rate of inflation (measured by GDP deflator) Inft* = Desired rate of inflation rt* = Real interest rate consistent with full employment (usually
thought to be 2%) yt = Real GDP yt* = Potential real GDP
Some Basic MacroeconomicsSome Basic Macroeconomics
New York Stock Exchange – 4 August 2006
Some Basic MacroeconomicsSome Basic Macroeconomics
Economy of the Rest of the
World
U.S. EconomyPrivate Sector Balance
Gov’t Budget
Current Account
Federal Reserve System Open
Market Committee
Fed Funds Target Rate; Bond
Purchases & Sales
Taylor Rule, Current Account
& Exchange Rates
New York Stock Exchange – 4 August 2006
During the expansion phase of the cycle (fearing inflation) the Fed starts to raise the Federal Funds rate target
– The term structure of interest rates responds
Generally speaking, rising interest rates & fear of inflation:
– Drives bond yields up and thus bond prices down
– Slows the housing market & thus household sector spending
– Slows the economy (and thus slows earnings growth) [maybe]
– Drives stock prices down
– Drives commodity prices up
– Can strengthen (or weaken) the dollar
Some Basic MacroeconomicsSome Basic Macroeconomics
New York Stock Exchange – 4 August 2006
S&P 500 PE Ratio Moves Opposite of the Federal Funds Rate
S&P 500 PE Ratio Moves Opposite of the Federal Funds Rate
New York Stock Exchange – 4 August 2006
But fiscal policy cannot be ignored!
Actually, the quantity of money in the economy is determined by fiscal policy
“Monetary policy” simply consists of setting the federal funds rate
Lerner-Mosler-Wray story
Some Basic MacroeconomicsSome Basic Macroeconomics
New York Stock Exchange – 4 August 2006
Levy-Kalecki Profits Equation:
Gross After Tax Profits (Includes Interest, Rent & Dividends) =
Investment Spending + Consumption Out of Profits - Saving Out of Wages +
[Gov’t Spending – Gov’t Tax Revenue] +
[Exports - Imports]
Some Basic MacroeconomicsSome Basic Macroeconomics
New York Stock Exchange – 4 August 2006
Thus:
[Gross After Tax Profits – Investment Spending – Consumption Out of Profits
+ Saving Out of Wages] -
[Gov’t Spending – Gov’t Tax Revenue] -
[Exports - Imports] = 0
Some Basic MacroeconomicsSome Basic Macroeconomics
New York Stock Exchange – 4 August 2006
That is:
[Saving Out of Profits + Saving Out of Wages] -
[Budget Deficit/Surplus] -
[Trade Deficit/Surplus] = 0
Some Basic MacroeconomicsSome Basic Macroeconomics
New York Stock Exchange – 4 August 2006
That is:
[Private Sector Balance] -
[Current Account Balance] =
[Government Sector Balance]
Some Basic MacroeconomicsSome Basic Macroeconomics
New York Stock Exchange – 4 August 2006
Currently:
Private Sector Balance (+2% of DPI) -
Current Account Balance (-6% of DPI) =
Government Sector Balance (4% of DPI)
Some Basic MacroeconomicsSome Basic Macroeconomics
New York Stock Exchange – 4 August 2006
Other Levy-Kalecki Profits Equation Relationships :
– The Unemployment Rate closely tracks the Private Sector Balance
• When the private sector goes into deficit it reduces the unemployment rate but also accumulates debt
– The Value of the Dollar closely tracks the Government Sector Balance
• As the budget deficit increases, the value of the dollar falls
Some Basic MacroeconomicsSome Basic Macroeconomics
New York Stock Exchange – 4 August 2006
Thus, any private sector surplus (i.e., any accumulation of wealth by the private sector) coupled with any current account deficit must be offset by a government sector deficit and vice versa!
So, how loud should we applaud the federal budget surpluses during the late 1990s?
Government surpluses are deflationary and directly associated with the loss of private sector wealth
– Which is bad for stock prices
– Which decouples the relationship between stock & bond prices
Some Basic MacroeconomicsSome Basic Macroeconomics
New York Stock Exchange – 4 August 2006
Inter-Market AnalysisInter-Market Analysis
Guru is John Murphy
– http://stockcharts.com/charts/performance/Intermarket.html
– 2004. Intermarket Analysis: Profiting from Global Market Relationships. Hoboken, NJ: John Wiley & Sons, Inc.
– 1991. Intermarket Technical Analysis: Trading Strategies for the Global Stock, Bond, Commodity, and Currency Markets. Hoboken, NJ: John Wiley & Sons, Inc.
New York Stock Exchange – 4 August 2006
Inter-Market AnalysisInter-Market Analysis
Three key relationships:
– U.S. Dollar & Commodities => Negative
– Commodities & Bonds => Negative
– Bonds & Stocks => Positive (Unless Deflation)
• Bond market typically leads stock market by 6-8 months
New York Stock Exchange – 4 August 2006
Source: StockCharts.com
Inter-Market AnalysisInter-Market Analysis
New York Stock Exchange – 4 August 2006
Source: StockCharts.com
Inter-Market AnalysisInter-Market Analysis
New York Stock Exchange – 4 August 2006
Source: StockCharts.com
Inter-Market AnalysisInter-Market Analysis
New York Stock Exchange – 4 August 2006
Source: StockCharts.com
Inter-Market AnalysisInter-Market Analysis
New York Stock Exchange – 4 August 2006
Inter-Market AnalysisInter-Market Analysis
Main idea:
– If you’re going to successfully trade stocks and stock options, you have to pay attention to the bond, commodities and currency markets
– Therefore, you also have to pay attention to the economy, fiscal & monetary policy, and to world events
New York Stock Exchange – 4 August 2006
Sector RotationSector Rotation
Guru is Sam Stovall of Standard & Poor’s
– http://www.businessweek.com/investor/list/stovall_toc01.htm
– 1996. Sector Investing. McGraw-Hill.
– 1995. Standard & Poor’s Guide to Sector Investing. McGraw-Hill.
Murphy & Cramer are into it too!
New York Stock Exchange – 4 August 2006
Sector RotationSector Rotation
Source: StockCharts.com
New York Stock Exchange – 4 August 2006
Sector RotationSector Rotation
Over the macroeconomic cycle, institutions move money out of certain sectors and into other sectors
Thus, a good investing/trading strategy is to follow the institutional money to the hot sectors
http://stockcharts.com/charts/Carpet/
New York Stock Exchange – 4 August 2006
Sector Rotation – Relative Strength
Sector Rotation – Relative Strength
Source: StockCharts.com
New York Stock Exchange – 4 August 2006
Sector Rotation – Relative Strength
Sector Rotation – Relative Strength
Source: StockCharts.com
New York Stock Exchange – 4 August 2006
Gurus are Greg Morris & John Murphy
Morris, Gregory L. 2006. The Complete Guide to Market Breadth Indicators. New York: The McGraw-Hill Companies.
Market BreadthMarket Breadth
New York Stock Exchange – 4 August 2006
Advance/Decline Indicators
New High/New Low Indicators
Up Volume/Down Volume Indicators
McClellan Indicators
Vix
Technical analysis applied to the main indices
Market BreadthMarket Breadth
New York Stock Exchange – 4 August 2006
Not every close of the S&P 500 below its 200 day EMA signals a bear market, however every bear market starts with a close of the S&P 500 below its 200 day EMA.
If the 50 day EMA of the S&P 500 crosses below its 200 day EMA the odds of a bear market increases
– Called a “death cross”
– Opposite is called a “golden cross”
Market BreadthMarket Breadth
New York Stock Exchange – 4 August 2006
Market BreadthMarket Breadth
50 Day EMA
200 Day EMA
New York Stock Exchange – 4 August 2006
Weekly Moving Average Cross-Over System (from John Murphy)
13 Week EMA & 34 Week EMA
Works best on S&P 500
– S&P crossed briefly & then recovered
– NASDAQ has crossed
Market BreadthMarket Breadth
New York Stock Exchange – 4 August 2006
Market BreadthMarket Breadth
False Signal
(Quickly Corrected
) Bull
Bear
13 Week EMA
34 Week EMA
See Next Slide
New York Stock Exchange – 4 August 2006
Market BreadthMarket Breadth
Convergence But No
Cross
Small Cross & Recovery
New York Stock Exchange – 4 August 2006
S&P 500 100 Day (20 Week) & 400 Day (20 Month) Exponential Moving Averages
– Closing below the 100 Day EMA is a minor sell signal (bearish)
– Closing below the 400 Day EMA is a major sell signal (bearish)
– 400 Day EMA is major area of support
Market BreadthMarket Breadth
New York Stock Exchange – 4 August 2006
Market BreadthMarket Breadth
Minor Bearis
h
Bullish
Major Bearish
100 Day EMA
400 Day EMA
400 Day EMA
ProvidesSuppo
rt
New York Stock Exchange – 4 August 2006
Market BreadthMarket Breadth
Bullish
Bullish
Bearish
400 Day EMA
Bollinger Bands +-
2
New York Stock Exchange – 4 August 2006
Generally speaking, it’s better not to trade against the market
Bull market: Buy stocks & call options
Bear market: Sell stocks short & buy put options
Trading & InvestingTrading & Investing
New York Stock Exchange – 4 August 2006
Select Your Style:
– Scalping
– Day Trading
– Swing Trading
– Intermediate Position Trading
– Long Term Position Trading
– Investing
Trading Vs InvestingTrading Vs Investing
As you move from micro scalping to investing, you hold your positions longer (thus tying-up your capital longer) & can earn more $ on each trade. But you must also know more about why a stock is moving [Financial Economy (news, earnings, splits, fundamentals, etc.) & Real Economy (FDA approval, new products, mergers & acquisitions, etc.)].
Pattern Day
Trading Rule
Applies
New York Stock Exchange – 4 August 2006
Three Tools Required for Trading & Investing:
– A method for finding stocks & options to buy & sell
– A trading platform for timing entries to, and exits from, trades
– A method & strategy for executing trades
• Broker
• Trading Plan
Trading & InvestingTrading & Investing
New York Stock Exchange – 4 August 2006
Stock Shepherding
Stock Screeners
– Business Week (Free)
• http://prosearch.businessweek.com/businessweek/general_free_search.html?mode=advanced
– Short Term Stock Selector (Free & Cost)
• http://home.flash.net/~hesler/
• Neural net picks stocks to swing trade
– HotScans (Cost)
• http://www.marketgauge.com/
Market Carpets & Heat Maps
– http://www.smartmoney.com/MARKETMAP/
– http://screening.nasdaq.com/heatmaps/heatmap_pmi.asp
– http://www.spdrindex.com/sectortracker/
Top Ten Lists
News: e.g., CNBC & Bloomberg
Pundits: e.g., Cramer (Boo-Yah)
Value & Growth Investing
Finding Stocks & Options to TradeFinding Stocks & Options to Trade
New York Stock Exchange – 4 August 2006
Technical trading is nothing more than support & resistance!
– http://www.stockconsultant.com/
Need a charting program to identify support & resistance levels & thus to time entries & exits
– http://www.marketbrowser.com/mbzzzq2.asp (Free)
– http://www.bigcharts.com/ (Free)
– http://www.tradestation.com/ (My Personal Choice)
Trading PlatformsTrading Platforms
New York Stock Exchange – 4 August 2006
Like the economy, individual stock prices have a trend & a cycle
Up-Trend: Higher highs & higher lows
– Bullish: Buy stocks; Buy call options
Down-Trend: Lower highs & lower lows
– Bearish: Sell stocks short, Buy put options
No Trend: Price just oscillates
– Neutral: Sell call options on stocks you own
Trading PlatformsTrading Platforms
New York Stock Exchange – 4 August 2006
Must identify up-trend, down-trend, or no trend
Plotting stock price data
– Line plots
– Western bar plots
– Japanese candle sticks
Trading PlatformsTrading Platforms
New York Stock Exchange – 4 August 2006
Apply Well-Known Technical Indicators to the Stock Price Data
– Moving Averages & Trend Lines
• Shows changes in trends
– ADX – Average Directional Index
• Shows the strength of a trend
– Oscillators
• E.g., RSI & Fast & Slow Stochastics
• Shows over-bought & over-sold conditions – i.e., when a stock price will reverse
– An Indicator that Utilizes Elements of Both the Trend & the Cycle
• MACD – Moving Average Convergence Divergence
Trading PlatformsTrading Platforms
New York Stock Exchange – 4 August 2006
Fundamental InvestingFundamental Investing
Growth Investing
– Guru is Cramer (among many others)
– http://www.thestreet.com/
– http://www.cramerwatch.org/
– Main Idea:
P/E = [Price ($/Share) / Earnings ($/Share)]
New York Stock Exchange – 4 August 2006
Fundamental InvestingFundamental Investing
P/E = “Multiple” = M
M * E = P
Find stocks that have a lower M and a higher historical growth rate of E than the average firm in the S&P 500
PEG useful
New York Stock Exchange – 4 August 2006
Fundamental InvestingFundamental Investing
But:
M * Expected Future (E) = Expected Future (P)
So, should try to predict future earnings growth too
– Conference calls– Analysts– New product introductions– Small debt– Better sales & margins, & lower costs than rivals– Secular or cyclical stock?
New York Stock Exchange – 4 August 2006
Fundamental InvestingFundamental Investing
Value Investing
– Guru is Warren Buffet
– http://www.coattailinvestor.com/
– Main Idea: Analyze a company & determine its intrinsic value. When its share price drops below that value => buy.
– Bible is Security Analysis by Graham & Dodd
– Must know basic accounting
New York Stock Exchange – 4 August 2006
Method & Strategy for Executing Trades
Method & Strategy for Executing Trades
Broker
– Keys to selecting a good broker
– Cash & margin accounts
Trading Plan
– Money management
• Risk-Reward Ratios
• Order entry & exit strategies
– Order types
– Setting stops
New York Stock Exchange – 4 August 2006
ExampleExample
http://scansstaging.marketgauge.com/login.asp?reason=denied_empty&script_name=/Scans/OpeningRange.asp&path_info=/Scans/OpeningRange.asp&fid=8969
Paper Trading:
– http://simulator.investopedia.com/
New York Stock Exchange – 4 August 2006
OptionsOptions
Derivative markets are exploding!
Options provide leverage (a small percentage move in the underlying asset means a large percentage move in the value of the corresponding option) & a way to manage risk
Options require a smaller outlay of capital
Many options strategies are quite simple; some are complex
New York Stock Exchange – 4 August 2006
OptionsOptions
Some options strategies only work if the underlying asset moves in a particular direction
Some options strategies only work if the underlying asset moves in either direction
Some options strategies only work if the underlying asset doesn’t move
New York Stock Exchange – 4 August 2006
OptionsOptions
An option is a contract that gives the owner the right, but not the obligation, to buy/sell an underlying asset (e.g., 100 shares of stock) at a particular price (the strike price) by a particular date (the expiration date).
– It’s an asset
Two types of option contracts:
– Calls & Puts
Two styles of options contracts:
– American style & European style
New York Stock Exchange – 4 August 2006
OptionsOptions
The writer of an option has the obligation (a liability) to buy/sell an underlying asset (e.g., 100 shares of stock) at a particular price (the strike price) by a particular date (the expiration date).
– This obligation will not need to be fulfilled unless the strike price is passed
New York Stock Exchange – 4 August 2006
OptionsOptions
A contract has two parties: a buyer & a seller
Call Put
BuyBullishMax risk limited to premium paidMax reward unlimited
BearishMax risk limited to premium paidMax reward = strike price – premium paid
Write
BearishMax reward limited to premium receivedMax risk unlimited
BullishMax reward limited to premium receivedMax risk = strike price – premium received
New York Stock Exchange – 4 August 2006
OptionsOptions
Time decay
– Ice cube melting on a sidewalk
Options Valuation
– Time value
– Intrinsic value
• ITM, ATM, OTM
• Volatility
• Other factors
New York Stock Exchange – 4 August 2006
OptionsOptions
Simple strategies
– Buy a call instead of the underlying stock
– Buy a put instead of shorting the underlying stock
– Buy/Write or Rent Your Stock
– Write a (naked) put to purchase a stock you feel is currently over valued
New York Stock Exchange – 4 August 2006
OptionsOptions
Free information on options:
– http://www.888options.com/
– http://biz.yahoo.com/opt/education.html