Entries - example 1 - conclusion

Of course I'm going to show you that our trade hit it's target - I'm an optimist!!  But, if it would have gone against me and hit one of my stops, I would have quickly and gladly taken that loss.

Here's what happened:

Looking toward the middle of the chart, you'll see the green circle where we entered our bullish trade on 4/8/09.  You'll also see the blue line where we put one of our stops.  The purple line was our target line of $36.00.  On June 1st, 2009, our target was hit and that would be the date where we would sell our option and collect any profit.

Here's what the sale of the trade looked like:

Look at the left middle section of the screen where the yellow highlighted prices are.  You could sell your June 29 call option back to the market for $7.20.

You bought the call option for $4.10 back on 4/8/09 and once it hit your target on 6/1/09, you sold it back for $7.20.  This was over a 75% profit in under 2 months, making you $3.10 per option you bought and sold back.  Not bad.

Entries - position management

Once you have entered a trade, you then need to manage it.  This basically means that you want to watch it every day to see if you need to either get out of the trade, or stay in it.

You would exit the trade for 2 reasons:

1.  The trade hits your target, or

2.  The trade hits your stop

The target exit is simple - the stock price went where you thought it would - mission accomplished.

The trade hitting your stop is the opposite - the stock price did NOT go where you thought it would.  It either went against you, or just traded more sideways and did not hit your target.

Let's talk about STOPS.  

Stops are basically the line in the sand that if the price crosses it, then you realize your trade is incorrect, and you take your loss and get out.  Human nature would want you to stay in the trade and just HOPE that it will turn around in your favor - this has been the doom of many many traders.  HOPE has hurt me many times in the past.  Being strict with your stops will save your account from taking a huge financial loss.

Think of the stop as your friend.  It protects you from further loss and allows your trading account to live another day.  It has been said that the best traders take their losses quickly.

Now, we have to address where to place your STOP.  Look at the chart below:

At the far right you will see the higher low that formed, which is represented by a black candle.  You'll see the next white candle that closed above the high of that black candle (i.e. higher low day).  So, we want our stop just below the low of that black candle.  Personally, I take the lowest price of that black candle and subtract $0.25 from it and that becomes my stop (here represented by a blue line on the chart).  I think as long as you place your stop below that low somewhere, then you are good to go.

The stop is placed below that low because that is where the buyers came in and drove up the price.  If price trades back down to that low and goes lower, this means that either the buyers are no longer there, or that the sellers are stronger than the buyers and the direction of the trend MAY be changing from bullish to either sideways or bearish.

So, now in our trade example that we entered, we have:

1.  The Target = $36.00

2.  The Stop = $30.92 (low = $31.17 - $0.25 = $30.92)

There is one other Stop I usually have active when dealing with options, which is IN ADDITION to the price stop above.  First, remember that options involve time.  And as we get closer to the option expiration date, the more time decay is affecting the option price and is making that part of the option price cheaper.  (again, if you have not gone to other websites for education on this part, then please do it now so you understand this concept).  

So, if we are going more sideways than up toward our target and it's taking a long time, then we don't want our option price going to zero and thereby losing our entire trade.  To combat this, I use a 50% stop on the price of the option I purchased.  So, if the price of the option drops by 50%, then I'm getting out and will cut my losses at that point.

In our example, the initial price of the option was $4.10.

50% of $4.10 = $2.05

Now we have 2 different stops on our trade:

1.  If the price of the STOCK hits $30.92 or lower, then we'll sell our option to cut our losses.

OR

2.  If the price of the OPTION hits $2.05 or lower, then we'll sell our option to cut our losses.

Now we are all set on our managing our trade.  It's either going to hit our target, or it's going to hit one of our stops.  The next post shows what happened.

Entires - Example part 1

Here we have an example of a stock where we have the set up we're looking for.  Notice the higher highs and higher lows - i.e. the stock is in an uptrend.

In the green circle you will see that we have a close above the high of the low day - now is the time to enter a bullish trade.  

Look back a little further, we need to come up with a target for our trade.  We can't just enter without knowing when to get out.  That's kinda like just driving with no destination, you have to have a target on when to take your profits.

Look at this chart:

Notice the horizontal purple line.  That is our target based on past support/resistance, which is 36.  Currently our price is approx 32, so we're looking for just over a 10% move in the stock price.

Now that we have our set up and target,we will go to our broker's website/software to look for the exact option to trade.  We are looking to buy a Call Option since we are bullish on this stock.  This screen shot is from the broker I use which is ThinkOrSwim.

This screen shot is from 4/8/09, which is the date we got our entry set up.  Look at the yellow line on the left side of the screen about half way down.  

So let's go through our specific parameters of what we are looking for in an option to buy:

1)  Stock volume - toward the top middle of the screen you'll see the volume is over 126 million, which is just a tad above our 500,000 volume minimum.  Check, so keep on going through the list.

2)  Delta of the option - look at the yellow highlighted line, then look up at the columns.  The 3rd column from the left is the Delta, for the highlighted line we see the Delta is .71, which is .70 or higher which is what we want.  Check, so go onto the next parameter on our list.

3)  Open Interest - look at the yellow highlighted line, then look up at the columns.  The 1st column  on the left is the Open Interest, for the highlighted line we see the Open Interest is over 53,000 and we want 500 minimum.  Got that one covered, check, onto the next parameter.

4)  Bid/Ask Spread - again, looking at the yellow highlighted line and up at the columns you will see the Bid and Ask are the last 2 columns on the right.  Take the Ask (which is 4.10) and subtract the Bid (which is 4.02) and you get .08, which is well below our max spread of .30.  Now onto the last parameter.

5)  Expiration Month - we want 90 - 120 days ideally.  However, look at the screen shot below.  

Look at the listed months listed on the left.  After the month, you will see a number inside parenthesis.  This number represents the number of days left until the option expires.  Remember, we IDEALLY want 90 - 120.  However, we don't have that on this screen shot.  

We have June with 72 days left and September with 163 days left - do not pay any attention to the months with red lettering.  72 is closer to the 90 -120 range than 163 is, so our choice is June for the Expiration Month.

This date we are looking at for the entry is April 8th.  So, June is still plenty of time away for this trade to work out like we want it.

So, knowing we want June for the Expiration Month, and knowing we want all the other parameters we now know what option to buy (hint: the yellow highlighted one - but when you do this live, unfortunately the right one won't be highlighted for you!).

To enter this trade you would buy the June 29 Call Option, which would cost you $4.10

The next entry will show you how the trade is managed and the outcome.

Entries - specifics

Once you find the set up, you now must make sure that you use the right instrument to make the trade.

In my style of trading, I'm first buying (going long) an option on the stock.

**We are at a very important point.  If you aren't completely comfortable with how options work, including the greeks on the options, then don't go any further.  Instead look up options and learn the basics (including greeks).****

Here's a link from Investopedia about Basic Options.  Make sure you first understand about basic options.  If not, then keep researching on the internet about basic options.

After you understand Basic Options, then you'll want to get a good understanding about the Option Greeks.  Here's a link from Investopedia about Option Greeks.

After you finish the Option Greeks link, then go to this link from Investopedia for Getting to Know the Greeks.

***AGAIN - STOP HERE BEFORE CONTINUING IF YOU DON'T UNDERSTAND ABOUT OPTIONS AND THEIR GREEKS***

Onto the Specifics.  These are what I'm looking for regarding the particular trading instrument once I get an entry signal:

Stock Volume:

I want the volume of the stock to average at LEAST 500,000 shares traded daily.  The reason for this is because I want to make sure that there are enough people trading this stock that it will be less likely to be manipulated by individuals and that when I'm ready to sell my option, there'll be a demand for it.

Delta of the Option:

I want a Delta of my particular option to be at least 0.70 for a call option and -0.70 for a put option.  This means that for every $1 move in the stock, I get a 70 cent move in the option price.  As the stock price moves in my favor, the delta will increase.

Option Strike Open Interest:

I want the Open Interest of the particular option I buy to be at least 500.  This means that there are basically 500 options that are active.  This again deals with volume, the higher the better so you aren't faced with manipulation and you can sell the option easier.  See Bid/Ask next for further info on this.

Bid/Ask Spread:

This is the price that you can buy a particular option and the price that you can sell the same option.  The market maker is responsible for this.  You want the difference between what you can buy the option for and what you can sell the option for no more than 30 cents.  This goes along with volume, the more volume (i.e. Open Interest) you have the smaller the Bid/Ask Spread.  The less Open Interest you have, the wider the Bid/Ask Spread.  

Expiration Month:

You want 90 - 120 days (3-4 months) of time until your options expire with my style of trading.  I'll go more into this later.  If you can't get into this time range, then go with whatever Expiration Month is closest.

Well, there you have it, the specifics of my entries.  We'll go into an example next.

Entries - chart entry

ENTRIES:

We're now onto when to specifically enter a trade.  This first part addresses when to enter in regards to specific stock price.

Please refer to the chart above.  You will notice that we have an uptrending stock.

The green circles show you the higher highs and the red circles show you the higher lows, so as you already learned the stock is uptrending.

Our specific entries are the candles with the blue boxes.  What we are looking for is a CLOSE of a stock ABOVE THE HIGH OF THE LOW DAY.  In order to know if a stock is going to close above the high of the low day, we must wait until the end of the trading day to do this.  Because if we enter earlier in the day, the stock price may just reverse and close low enough to be below the high of the low day and we would not have an entry.

I usually enter within the last 15 minutes of the trading day, around 3:45 p.m. Eastern Standard Time or later - as long as it's before 4:00 p.m.

Looking back at the chart above, I put a blue line across the high of the low day to help you see it.  You'll also notice that you'll get this entry usually within a few days of the higher low.

Here's another chart, but this time, we are looking at a downtrending stock.

This time you would enter when you get a close below the low of the high day.  Again, the entries are in the blue squares.  

So, those are the set ups for entries we are looking for when it comes to price.

Bullish Entry:  a close above the high of the low day

Bearish Entry: a close below the low of the high day

Set ups - part 4

So now we know about trends and support and resistance.  From here we need to start honing in on more specifics on what we should look for in order to enter a new trade.

Stocks don't go up or down in a straight line.  They are kinda like an incoming or outgoing tide - they ebb and flow.  Have you ever seen a tide coming in?  It doesn't just come straight in from low tide to high tide in one big wave does it?  Of course not, it comes in, then goes back out, then comes in further then goes back out, then comes in further still and on and on until it hits high tide.  The same is true for a stock, particularly a trending stock.

An up trending stock will go up, then will come back a little, then will go up further, then come back a little again.  Another way of thinking of this is higher highs and higher lows - remember that from our trending lesson?

If you want to maximize your trade, would you want to get in at the top, or wait for the pullback (i.e. higher low) and get in then?  

You'd want to get in on a pullback.  This will maximize your gain and will help your risk to reward ratio, which we'll address at a later time.

For now, let's just look at the best place(s) to enter a trade for an uptrending stock.  Looking at the chart below you'll notice the higher highs (green circles) and higher lows (blue squares).  So, you would want to get in on a pullback, which would be as close to the blue squares (higher lows) as possible. 

This is what you are looking for regarding set ups.  You want a trending stock with easily identifiable highs and lows.

Now onto the actual details on entering a new trade.

Support Resistance continued...

Here's diagonal S/R.  You can have these going up or down.

You'll also here traders talk about "channels", which is what this example is - a channel is where you have a nicely defined support and resistance levels.

That's it for now on S/R, again, I urge you to do your homework and really look into support and resistance as it's a major key to trading.

Set ups - part 3

Now onto Support and Resistance (S/R).  I'll go over the most basic info, but I strongly urge you to go to this Investopedia Link to learn more.

Support is simply this:

It's the price where buyers believe that the stock is at a good price to buy.  So, there's a ton of buying at that price and therefore that buying makes the stock go higher.

Resistance is simply this:

It's the price where sellers believe that the stock is at a good price to sell and take profits.  So, there's a ton of selling at that price and therefore that selling makes the stock go lower.

Also, once support is broken it then automatically becomes resistance.  Once resistance is broken it then automatically becomes support.

Think of support as a floor and resistance as a ceiling.

S/R can be horizontal or diagonal.  Moving averages can also be S/R.

Also, you need the stock price to touch S/R at least twice to make it valid.  One other thing to remember - S/R is an AREA not an exact price.  So when you make your S/R lines, think about making them with a marker not a laser.  

Looking at the chart above and following the top blue line:

1.  Initially, that blue line is resistance - you can see the stock went up to it and touched it a few times.

2.  Then the stock went lower, came back up to the resistance line, pulled back for 2 days, then hit it a final time and broke through it.  Now that resistance is support.

3.  The stock went higher, then came back down to the support (old resistance) line, touched it, and went back up for a couple of days.

4.  Finally, the stock broke back down through the support line and the line now becomes resistance again.

Now, lets look at the bottom purple line:

1.  The stock came down and touched the support a couple of times and went way higher.

2.  After about 6 weeks or so, the price comes back down to support and touches it once.  

3.  Some days later the stock then breaks down through the support, which then becomes resistance.

4.  Finally, the stock comes back up one last time, hit's that resistance (old support) and goes lower.

Set ups - part 2

Now onto trends.  A trend is simply the way the stock has been going in price - up, down, or sideways.

Trends come in all time lengths, from as short as a a few minutes to a day trader to decades as a VERY long term investor. 

The MAIN THING about trends is this:

Whatever your trading time frame may be, that's the TREND TO FOLLOW.  

A stock can be in multiple trends at the same time.  Look at the stock chart above, and you'll find the following:

1.  The stock is in a long term down trend that has lasted for approximately 9 months.

2.  The stock is also in a short term up trend that has lasted for approximately 1 month.

3.  The stock is now in a sideways trend that has lasted for 3 days.

So, as you can see, you really must know what your time frame for your trade will be in order to trade successfully.

Do you want to be in a trade for months on end, possibly even years?

Or, do you want to be in a trade for a few weeks?  A few months? 

What about for a few days?

My trading style is that I'm looking for trades that are usually anywhere from a couple of weeks to a few months.  So, when I'm searching for trades, I'm looking at what has happened for the past few months - I really could care less what happened 2 years ago, or 20 years ago.

The only time that I'm concerned with a longer time frame (and the main reason I will even look at 1 or 2 year charts is simply to find other levels of support and resistance).

Support and Resistance are EXTREMELY EXTREMELY EXTREMELY IMPORTANT.  Support and Resistance is an entire subject in and of itself.  I would highly suggest that you look into this subject on your own, but I will briefly describe it next in order to give you a basic understanding.

Set ups - part 1

Now we're getting down to the skinny on trading.  This section will show you the basic set ups that I'm looking for when trading.  I'll put in other sections to keep the snapshots from piling up.

The set ups are the same in all markets - up, down, or sideways.  As the "Option Addict" Jeff Kohler always says - "I don't think of it as a Stock Market, but rather a market of stocks".  This means that even though the overall market might be going up, you are always going to find individual stocks going down, and vice versa.

Let's get down to the very basics here:

When a stock is bullish (i.e. going up) it will have higher highs and higher lows.

When a stock is bearish (i.e. going down) it will have lower highs and lower lows.

The top graph is bullish - notice the green circles showing the higher highs and higher lows.

The bottom graph is bearish - notice the green circles showing the lower highs and lower lows.

This may seem basic, but it's a CRUCIAL STEP.  Countless traders have lost fortunes by not understanding this concept.  You must ALWAYS know what your current trend is - are you in a bullish trend or bearish trend?? 

The next part deals with trends...

Finding stocks to trade

A part of almost every trader's trading plan is finding stocks to trade.  There are many free and subscription websites out there to do this and there really is no right or wrong way to look for stocks as long as you are looking for stocks to fit your specific trading plan.

I used to use a subscription website, which was very useful and had great searches.  It was Investools website.  However, I found another website which I like quite a bit and it's free, it's www.finviz.com

On Finviz, you can do searches and even save specific searches to use at another time.  This makes for quick stock searching.

When I search for a stock, I'm looking for a few basic items:

1.  Volume - I want at least 500,000 shares traded daily.  The reason is because I want the bid/ask spread from the broker to be narrow and want to be able to get out of the trade quickly when needed.

2.  Optionable - since I trade options, I gotta have a stock that offers them.

3.  Price - I like stock prices between $15 - $80.  The reason for this is that I need room for downside plays, so $15 still has plenty of room to go down.  On the other side, I don't want a stock too expensive because that makes the options expensive as well.  There's TONS of stocks in that price range and I rarely have a hard time finding them in that range.

Those are my main 3 things I look for - in addition to trends, patterns, and support/resistance of course.  However, I sometimes will look at Relative Volume and use a setting of "3".  Relative Volume is a ratio between the current day's volume and it's 3 month average.  The setting of "3" means that the current day's volume is 3X higher than it's 3 month average volume - so way more than normal activity going on in that stock.

Another thing I sometimes use to filter my search is individual Industry Groups.  If Basic Materials are trading relatively stronger than the other industry groups, then I'll look for bullish plays within that group.  Or if, Biotechnology is trading weaker than other industry groups, then I'll look for bearish plays within that group.

After I do my searches and find stocks that fit what I'm looking for, I then will put them into a watchlist on my trading software.  This way I can quickly look at them every day for entries.  

ThinkOrSwim has a charting system called Prophet that allows you to have these watchlists.  Then you can quickly pull up your watchlist every day and just scroll down each stock's chart to see if you have an entry to trade.  Look at the screen shot above - the far left middle section has a list of stocks in my watch list that I look at every day.  I can scroll down the entire list (currently about 60) in about 5 minutes or less by having it set up this way.

A lot of traders will do searches once a week, which I think works fairly well.  I'm to the point where I'm very quick with my searches, they take me about 20 minutes, so I actually do mine everyday.  I do this especially when I'm using Relative Volume, because you never know when a major event is going to happen in a stock and you may be able to catch some good movement compared to finding this stock with your next weekly search and missing most of the move.

Another way to find stocks is from other websites.  Option Addict puts up his watchlist every week and provides outstanding stocks to watch.  Another great site is Dave Johnson's Chart Signals.  In addition, you can find TONS of trading websites out there that put up their stock picks as well - just do a little searching.

Your trading plan should include searches that are done the same time every week, or even day.  You always need to keep replenishing your stock watch list because stocks are always moving and when they don't move like you thought they may (while on your watch list) then you'll delete them from your watch list.  Of course, when they do move like you thought, then you'll take action and make an entry.  So, your watch list is ever changing - just like the market itself.

Charts

I'm a technical trader as opposed to a fundamental trader.

A technical trader only uses the price action of a stock, possibly along with some stock indicators to base his/her trades upon.  This type of trader does NOT care about the company's P/E Ratios, Profit and Loss, Earnings, Debt, Cash Flow, nor anything else to determine a trade.

A fundamental trader doesn't really care much about the price action of a stock.  This trader is most interested in the strength/weakness of the company.  They are interested in P/E Ratios, Profit and Loss, Earnings, Debt, Cash Flow, and many other items.  Basically they want to know as much as possible about the strength of the company.  When they find a company's stock that is trading at a lower price than what they believe it should be, then they buy.  A good example of a fundamental trader is Warren Buffet.  

A technical trader's main tool to see price action and to use that for trading is the Stock Chart.  A stock chart basically shows you the price of a stock in relation to time.  Stock charts come in many different styles and in many different time frames.

Each time period is represented by a mark on the chart showing the price that the stock traded for that time period.  The most common time period is a day.  Almost all time periods are available such as: month, week, day, multiple hours, single hour, multiple minutes, and the minute.

Each time period mark showing the price can be any of the following:

A.  Candle - Shows you the price that the stock opened, the price where the stock traded for the entire time period, and the price where the stock closed.  (top chart).

You will notice that the body of the candle is enclosed.  If the candle is white, then it means that the opening price was at the bottom line of the body of candle and the closing price was at the top line of the body of the candle.  Vice versa for black bodied candles.

The candle wicks, above and below the body of the candle (if any), shows where price has also traded for that time period.

You may want to look up more on candles via online resources.

B.  Bar - Shows you the same info as the Candle Chart, just in a little different way.  (2nd from top).

You will see one long vertical line.  That represents where price has traded during the entire time period.

The horizontal line to the left of the vertical line is the opening price.

The horizontal line to the right of the vertical line is the closing price.

C.  Area - shows you the closing price of the time period, but then shades in the chart below the price (2nd from bottom chart).

D.  Line - this shows you the closing price of the time period (bottom chart)

Charts are a personal preference.  There is no one correct way of viewing charts.  However, I would encourage you to use either Candle Charts or Bar Charts as they supply you with more info than the Area Charts and Line Charts.  This is because the Area and Line Charts only show you the closing prices and nothing else.

I personally use and prefer 6 month candle charts, where each time period represents a single day and I look at 6 months of the candles at a time.  However, I will sometimes use 1 year and 3 month daily candle charts as well.   It's simply a matter of preference and circumstance.

Back to the basics

I wanted to let you know about that crossover in the market when it happened.  So, now I need to back up a little and give you a bit more information on:

1.  Charts

2.  Finding stocks to trade

3.  Set ups 

4.  Entries (including position sizing, time horizons, targets, etc.)

5.  Position Management

6.  Exits

From here we'll get a bit more into the specifics.  There'll be a ton of info here, but also much will be left out due to time and space.  So, at times I may refer you to look further into certain items via other resources.  

I'll be updating this blog periodically and sporadically.  But, I'll eventually get all the info down and then I'll move onto specific trades.

If you have any questions or comments, please leave them on this blog and I'll reply when I get to them.

The Market Crossover!

The S&P 500 market just went onto a "buy" signal following the 100 & 200 day simple moving averages.  The 100 day moving average (shown in purple on the chart) crossed up above the 200 day moving average (show in blue on the chart).   You can see that this happened on 7/23/09.

I put up the SPY chart for you.  This would be a good choice for trading this crossover.  Simply buy shares of the SPY and hold onto them until you either get a desired percentage return on your investment, or until the 100 day moving average crosses back down below the 200 day.

I bought my SPY shares on 7/29/09.  

***Note:  I'm not a licensed stock broker or anything of the like.  All trading involves risk, and you are solely responsible for your own trading.