Today’s Trader T S R FI UE! ISS
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The Real Reasons Why PRICE Moves Trade Management STOP’s & Stop-Loss
July 2012
Technical Analysis Beginner Series Video Lessons
Harmonic Markets Understanding Nature
S&P 500 Year-End Target 1500?
Walking Forward Systems Analysis
Averaging Down Or Average Up!
Options Education
E SU IS EE FR
The Quarters Theory
Introduction Against The Crowd Covered Calls
The ENERGY Report Interview
The GOLD Report Interview
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Today’s Trader
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Editor’s Note
Welcome to Today’s Trader Magazine ISSUE No. 1
Today’sTrader Magazine Editor
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Pete Moxon
elcome to the inaugural edition of Today's Trader Magazine. I am really excited to bring you this first edition that has been made exclusively for the Apple iPad Newsstand.
This months magazine has got some fantastic content in the form of video as well as written articles. We cover topics from Stocks and Options to Forex and Commodities including special interviews covering the Gold and Energy markets. We have brought together an excellent mix of experienced trading and investment professionals from around the globe to give their views on current market conditions, advice on trading strategies, how to manage your trades and even dip into the psychology side of trading. I really hope you enjoy this first issue. I would love to hear what you think. Leave a comment in iTunes!
Enjoy! Pete
This Month’s Contributors John Bartlett Sally Lowder Zig Lambo Carley Garner Dr. Edward Olmstead Igor - Traders Labs Sam Evans Leslie Jouflas Michael Michaud Dr. Kris Daniel Fernandez Joshua Hayes Vadym Graifer Ilian Yotov MissionIR
Interested in Contributing? We are always looking for engaging content from experienced traders, investors & bloggers
Email Us: editor@todaystradermagazine.com
Or visit: TodaysTraderMagazine.com/ Contribute
Published by Disclosure & Disclaimer: All information and tips included in Today's Trader Magazine is intended for educational purposes and general information only and not intended to be relied upon by individual traders in making specific trading or investment decisions. Information found within the magazine is checked for accuracy, but we recommend that you make your own enquiries and if necessary take legal advice before entering into any transaction. You should always obtain appropriate independent advice before making any trading and investment decisions. Today's Trader magazine, its staff and SAPPROUK Limited do not accept any liability for any loss suffered by any reader as a result of any such decision. Contributing authors of Today's Trader Magazine may hold shares in some of the securities written about in this magazine. Today's Trader Magazine advises all traders to do their own research and testing to determine the validity of any trading idea mentioned or not mentioned inside the magazine. Trading and investing carry high levels of risk. Past performance does not guarantee future results.
SAPPROUK Limited
Design & Layout SAPPROUK Limited
July 2012
Today’s Trader
Contents
Magazine
Contents Cover Stories
26 Averaging Down
52 The Real Reason Why Price Moves
Dr. Kris teaches us why averaging down is a bad investment strategy
Supply, Demand and Human Behavior Relationships
34 Trading With A Stop-Loss
78 Beginner Guide To Technical Analysis
Advice on how you can use Stop orders
We kick-off a video series teaching how to read and use Financial Charts.
38 Harmonic Trading Patterns
Features
Options
4 S&P 500
56 Introduction To Option
Profiting With Repetitive Swings
A Look at the Year-end targets for the S&P 500
Take your first steps to understanding Options
6 The Quarters Theory
58 Covered Calls Are Not A Conservative Trade
Learn how the Quarters Theory Works From The Creator Himself
12 STOPS Are Essential
Have you ever tried Covered Calls? Dr Olmstead teaches us a valuable lesson
A look at trading STOPS & why traders don't have the discipline to use them
62 Selling Options Against The Crowd
17 The Psychology Of Drawdowns
Interviews
Why traders need to understand & accept them
Take a journey against the tide
68 Investors Need To Understand Basic Geology: Chris Wilson
21 Walking Forward Test your Trading System using Walk Forward Analysis
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73 Falling Oil Prices Offer Great Stock Buying Opportunities: Byron King
July 2012
Today’s Trader
STOCK Market
Magazine
Year-End 1500 for S&P 500? What It Will Take to Crack March Highs
By MissionIR.com
A handful of four primary vectors were drawn up on June 26th by the chief investment strategist over at Wells Capital Management, Jim Paulsen, in an interview on his 1,500 target for the S&P 500. In an opening salvo against market crisis neuroses, Paulsen pegged Europe as no longer being a crisis in any proper sense, as the cyclical nature he predicts will be evinced once again at the European Summit this week. The argument is that Europe is basically a “chronic problem.” Europe is a problem that will be with us for decades, but not one that will derail a global recovery Paulsen argues, pointing more to emerging markets like China and India which have seen bad growth metrics recently, and arguing that the biggest substantial risk to markets at this point, especially the S&P 500, would be a recession in the emerging world. However, the caveat here is obviously last Fall’s strong, accommodative policy measures (easing, etc. as opposed to the late 2010 rate hikes) and the projection that China’s slowdown is already bottoming-out, with a potential nadir being around Q4. The probability curve is pretty clear to Paulsen on such policy initiatives already getting ahead of the problems at some level, ensuring that the growth potential in emerging markets isn’t something to be too worried about. So if the Euro fear flare up cycle is largely digestible and emerging markets can pull out of the dive easily enough, the other two major factors from Paulsen’s point of view are an under-quantified robustness in the domestic economy coupled with exceptional earnings multiples. Pointing to $100-level trailing 12-month earnings per share estimate for the S&P 500 in a recent research note, that gives us a price-earnings multiple of around 13 times on trailing earnings (year-end consensus-estimated earnings of around 12.3 times), Paulsen confidently characterized it as a cheap buying opportunity.
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In fact, he characterized Europe as such and argues generally that too much of an internationalism bent exists, where too much focus on external economies in Europe and China for instance, has upset domestic perspectives. Paulsen made a strong case that the initial overstatement of U.S. growth data, followed by a huge failure to adequately state the realities of the problem, effectively short-circuited perceptions to a large extent, and he remains very bullish on the domestic economy. People may be selling the market based on low GDP projections but Paulsen argues the U.S. economy is doing “far better than people think,” pointing to his own figure of around 2.5% growth, and underlining several elements that could push it as high as 3%. July 2012
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1500
STOCK Market
Stimulating factors cumulatively make this possible according to Paulsen, like mortgage rates under 3.75% (5% last year), money growth at around 10% since Fall (was growing at only 5% a year ago), a dollar that is still off 10% from 2010 highs, falling prices at the pump on fuel, and the recent Case-Shiller 20-city Index (Mar – April period) which shows a 1.3% jump in home prices, breaking a seven-month down trend streak. Also noted was the inflation rate falling from 4% last Fall to 1.7%, which, alongside China being able to buck the down trend and interest rates being so low amid prime earnings multiples, gives credence to the argument that the S&P 500 could rally through March highs of 1,440 in the second half of the year. Paulsen said that the combination of low interest rates/ inflation and choice earnings multiples has never been seen before in the post-War era.
This article was written by: MissionIR is committed to connecting the investment community with companies that have great potential and a strong dedication to building shareholder value. We know our reputation is based on the integrity of our clients and go to great lengths to ensure the companies represented adhere to sound business practices. To learn more about us and our featured companies, visit www.MissionIR.com
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July 2012
Today’s Trader
TRADING Insights
Magazine
The Quarters Theory:
By Ilian Yotov
The Revolutionary New Foreign Currencies Trading Method In recent years, three words - The Quarters Theory - have gained recognition and popularity with currency traders around the globe. Created by Ilian Yotov, Chief FX Strategist at VanguardAxis, LLC and founder of AllThingsForex.com, The Quarters Theory has been embraced by the FX trading community for its unique premise and revolutionary approach, serving traders as a reliable new compass to help navigate the complexities of daily fluctuations in the prices of currencies. In this Today’s Traders Magazine exclusive, readers now have the opportunity to get acquainted with this new and exciting theory and methodology with the following excerpts from Ilian Yotov’s book “The Quarters Theory: The Revolutionary New Foreign Currencies Trading Method” published by John Wiley & Sons, Inc.
THE FOUNDATION OF THE QUARTERS THEORY Price is the most basic and most important unit of information available to a trader. Price represents the monetary value assigned to goods, services, and assets. In the financial markets, price is the numerical monetary value of equities, commodities, currencies, and other financial assets, determined as a result of an exchange or trade transaction between market participants. Price is measured by numbers grouped as mathematical objects in a numeral system. The writing of numbers in the base-ten numeral system is known as decimal notation and uses various symbols, called digits, for ten distinct values 0, 1, 2, 3, 4, 5, 6, 7, 8 and 9 to represent numbers. The most universally used numbers are the whole numbers as part of the real numbers.
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Let us glance through the table of whole numbers in Table 1.1.
0
1
2
3
4
5
6
7
8
10
2 12 13 14 15 16 17 18
20
3 22 23 24 25 26 27 28
30
4 32 33 34 35 36 37 38
40
5 42 43 44 45 46 47 48
50
6 52 53 54 55 56 57 58
60
7 62 63 64 65 66 67 68
70
8 72 73 74 75 76 77 78
80
9 82 83 84 85 86 87 88
90 ... 100 ... TABLE 1.1 - Table of Whole Numbers
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Have you noticed the first number in each row? The number 10 is the base and we know that the first number in each row of this table (except for the number 0) can be represented as a set of ten. The first number in each row of the table of whole numbers represents a critical junction that marks the end of a previous set and, at the same time, the beginning of a new set of ten numbers. For example, the number 10 marks the end of the set of ten single digits and the beginning of a new set of ten double-digit numbers known as the teens; the number 20 marks the end of the teens set and the beginning of the twenties; and so forth. Because of their significance, The Quarters Theory gives the name Major Whole Numbers to the first numbers in each row of the table of whole numbers. The precision needed to represent currency exchange rates requires the use of decimal whole numbers. These digits have a decimal point that indicates the start of a fractional part (1.1, 1.2, 1.3, etc.). Digits are placed to the left and right of a decimal point in order to indicate a number less than or greater than 1. The Major Whole Numbers can be easily distinguished in currency exchange rates even with the decimal point numeral representation. Every one of the Major Whole Numbers in currency exchange rates represents a critical junction that marks the end of a previous set and, at the same time, the beginning of a new set of ten numbers. For example, if the EUR/USD pair’s exchange rate reaches $1.2000, the Major Whole Number 1.2000 would mark the end of the set of ten numbers: 1.10, 1.11, 1.12 . . . 1.19
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(or the dollar teens) and the beginning of a new set of ten numbers: 1.20, 1.21, 1.22 . . . 1.29 (or the dollar twenties). Currency decimalization has caused traditional denominations of currencies to be converted to the decimal system. Through the process of currency decimalization, one unit of the main currency is usually divided into 100 subunits. For example, 1 dollar and 1 Euro are divided into 100 cents, 1 pound into 100 pence, 1 franc into 100 centimes, and so forth. For even more precision, currency exchange rates are decimalized even further by dividing the subunits (1 cent, 1 penny, 1 centime) or the main unit of some currencies (e.g. 1 yen) into 100 additional subunits, called Price Interest Points (PIPs). A PIP is the smallest unit of price for any foreign currency (e.g., for EUR/USD one PIP—Price Interest Point— equals .0001 U.S. dollar). Whether the subunit is 1 cent, 1 penny, 1 centime, or 1 yen, each has 100 PIPs; 10 cents, 10 pence, 10 centimes, or 10 yen have 1000 PIPs. The Quarters Theory recognizes that when represented in terms of Price Interest Points, the distance of 10 cents, 10 pence, 10 centimes, 10 yen, and so on between each two Major Whole Numbers establishes welldefined ranges of exactly 1000 PIPs. Consider the illustration in Figure 1.1 showing the 1000 PIP Range between the Major Whole Numbers 1.3000 and 1.4000. 1.3000 represents a critical junction that marks the end of a previous 1000 PIP Range between the major Whole Numbers 1.2000 and 1.3000 and, at the same time, the beginning of the 1000 PIP Range between 1.3000 and 1.4000.
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FIGURE 1.1 - 1000 PIP Range between the Major Whole Numbers 1.3000 and 1.4000
THE QUARTERS A quarter is one of four equal parts of something. It can be one-fourth of an hour, one-fourth of a kilo or a pound, or with money, it is the U.S. or the Canadian coin equal to one-fourth of a dollar. The Quarters Theory focuses on the 1000 PIP Ranges between the MajorWhole Numbers in currency exchange rates and divides these ranges into four equal parts, called Large Quarters. Each 1000 PIP Range contains four Large Quarters and each Large Quarter has exactly 250 PIPs (1000 PIP Range/4 = 250 PIPs). The numbers that mark the beginning and the end of each Large Quarter are given the name Large Quarter Points. The Large Quarter Points that coincide with Major Whole Numbers are also called Major Large Quarter Points, because they represent
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critical junctions that signal the end of a previous and, at the same time, the beginning of a new 1000 PIP Range. The exact half point of each 1000 PIP Range coincides with a Large Quarter Point and is also called the Major Half Point of the 1000 PIP Range. The illustration in Figure 1.2 shows the 1000 PIP Range between the Major Whole Numbers 1.3000 and 1.4000 divided into four equal parts or four Large Quarters of 250 PIPs. The four Large Quarters are marked by the Large Quarter Points: 1.3000 and 1.3250, 1.3250 and 1.3500, 1.3500 and 1.3750, 1.3750 and 1.4000. Note that the Major Large Quarter Points are also the Major Whole Numbers 1.3000 and 1.4000 that define the 1000 PIP Range. The exact half point of the 1000 PIP Range between 1.3000 and 1.4000 is the Large Quarter Point 1.3500 (LQP 1.3500), which is July 2012
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also the Major Half Point of the 1000 PIP Range between 1.3000 and 1.4000. The Large Quarters within the 1000 PIP Ranges may be represented by different digits measuring the exchange rates in a variety of currency pairs, but the price ranges remain constant. The range between two Large Quarter Points is always exactly 250 PIPs, and the range between two Major Large Quarter Points (Major Whole Numbers) is always exactly 1000 PIPs, no matter which currency pair and no matter what digits represent the currency exchange rate. For example, an exchange rate between the EUR/USD may show a 1000 PIP Range between the Major Large Quarter Points 1.3000 and 1.4000 with four Large Quarters of 250 PIPs each between the Large Quarter Points: 1.3000 and 1.3250, 1.3250 and 1.3500, 1.3500 and 1.3750, 1.3750 and
1.4000. On the other hand, the USD/JPY pair may have its exchange rate within the 1000 PIP Range between the Major Large Quarter Points 100.00 and 110.00 yen, with four Large Quarters of 250 PIPs each between the Large Quarter Points 100.00 and 102.50, 102.50 and 105.00, 105.00 and 107.50, and 107.50 and 110.00. Obviously, the Major Whole Numbers and the Large Quarter Points in the exchange rates of these two currency pairs have different digits and numeral representation. However, whether a 1000 PIP Range is between the Major Large Quarter Points 100.00 and 110.00, or the Major Large Quarter Points 1.3000 and 1.4000, the range between two Major Large Quarter Points (Major Whole Numbers) always remains in a range of exactly 1000 PIPs. Whether a Large Quarter is between the Large Quarter Points 1.3500 and 1.3750, or between the Large Quarter Points
FIGURE 1.2 - 1000 PIP Range between the Major Whole Numbers 1.3000 and 1.4000 Divided into Four Equal Parts or Four Large Quarters of 250 PIPs
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The Quarters Theory
105.00 to 107.50, the range of each Large Quarter remains the same and is always exactly a range of 250 PIPs. The Quarters Theory offers universal, constant, and familiar price ranges that allow quick and precise price analysis of any currency pair.
THE PREMISE OF THE QUARTERS THEORY The Quarters Theory is based on the premise that the daily fluctuations of currency exchange rates are not random and that currency exchange rates fluctuate in an orderly manner between the Large Quarter Points within each 1000 PIP Range defined by two Major Whole Numbers (Major Large Quarter Points) in a systematic effort to complete the Large Quarters. The Quarters Theory proposes that every significant price move in currency exchange rates takes place from one Large Quarter Point to another, in gradual increments of 250 PIPs, the range between two Large Quarter Points. The Quarters Theory challenges the notion that the financial markets are chaotic and that market prices are random. With its clearly defined, constant price ranges of 250 PIPs and orderly price moves from one LargeQuarter Point to the next, The Quarters Theory organizes the daily fluctuations of currency exchange rates in a systematic arrangement. The Quarters Theory provides the roadmap—the 1000 PIP Ranges divided in four equal parts or four Large Quarters of 250 PIPs each—and establishes the route with a distinct starting point and a clear destination—every significant price move begins at a Large Quarter Point and ends at a Large Quarter Point. The Large Quarter Points serve as constant support/resistance levels, as well as familiar, invariable price targets. When a targeted Large Quarter Point is reached, the Large Quarter is considered to be completed. If prices fail to complete a Large Quarter, the unsuccessful completion of a Large Quarter usually causes a reversal that takes prices back toward the preceding Large Quarter Point. The outcome of both events always leads to a price move that targets a familiar level—a Large Quarter Point. The repetitions of the series of Large Quarter completions from one Large Quarter point to the next, or reversals back toward a preceding Large Quarter Point as a result of unsuccessful completions, regularly manifest themselves as recognizable price patterns in the daily fluctuations of currency exchange rates.
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TRADING Insights
FIGURE 1.3 USD/JPY Pair Large Quarter Price Pattern Repetitions
This article was written by: Ilian Yotov Ilian Yotov is a Chief FX Strategist at VanguardAxis, LLC- an absolute return manager that specializes in discretionary investment strategies in a Global Macro Fund focused on currencies. He is responsible for driving the company’s research initiatives and turning them into actionable trade ideas and trading strategies. Ilian is the founder of AllThingsForex.com, a website dedicated to the education of retail FX traders, and host of the popular All Things Forex Broadcast, a daily one-hour program offering expert FX market analysis and outlook to listeners around the globe. Ilian Yotov is best known among industry peers as the creator of The Quarters Theory, a revolutionary methodology applied to the price behavior of currency exchange rates. His FX market analysis and insights are sought by popular financial publications worldwide and he is a regular guest speaker at industry events. Ilian Yotov is author of the book "The Quarters Theory: The Revolutionary New Foreign Currencies Trading Method", published by John Wiley and Sons, Inc
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STOPS
Why Don't We Keep Them? By VADYM GRAIFER
W
ith everything said and written on the subject of stops, it should be given that everyone is conditioned to keep them religiously even before they start trading. No matter what source a newer trader turns to, utter importance of stops will be underlined and emphasized up to the degree that keeping them is heralded as the ultimate key to success. We all heard adages like “Take care of your losses, profits will take care of themselves”. Do all the stern warnings work? Not really. Time and again traders blow their stops, widen them in a course of a trade, hold losing position in a false hope it will make them whole. If this destructive behavior continues despite all the warnings, there must be deeply rooted reasons for this. As with most trading flaws, failure to keep stops roots in fundamental misconceptions about the very nature of the market and trading. Such misconceptions cause incorrect psychological makeup which, in turn, results in behavioral patterns that harm a trader’s July 2012
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performance. In order to re-condition oneself it is necessary to work out fundamental, even philosophical if you will, understanding of the market as an environment in which a trader operates. Let us list and analyze the misconceptions that cause failure to keep stops.
Right Action Must Result In Profit This misconception stems from misunderstanding of the very nature of the market as an uncertain environment. Newer trader sees a market as a conglomerate of firm links between reasons and outcomes. In such a conglomerate, every reason results in single possible outcome. The simplest case of such link would be “good news – up, bad news – down”. We know it’s not true – price reacts to news in a wide variety of ways. Similarly, an inexperienced trader applying the setup he knows “should work” expects every trade to be a winner, providing all the components of the setup are right. Have you ever heard complaints like “Everything was exactly like in that book, yet the trade failed”? That is direct result of this misunderstanding. Everything may be right, yet the trade fails – just because markets work in probabilities and not in certainties. f a system produces certain percentage of wins over time, it’s just statistics – and, as it is always the case with
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statistics, it cannot predict an outcome of any particular trade. No matter how good the setup is, any given trade can fail. That’s why it’s imperative for a trader to distinguish between two kinds of losses. The first kind is a loss caused by a trader’s mistake – failure to follow all the rules of system applied, or impulsive entry without any reason at all. Such losses must be taken as a lesson. The second kind is the case where every piece of puzzle was in place, yet the trade failed – such losses must be written off as a part of trading game, as a tribute to uncertainty of the markets. Of course, if you identify a component of your trading system that regularly causes trade failure, you can and should tweak your system in order to minimize failures. However, during the trade a stop must be taken as soon as signal of failure appears. The line of thinking “The setup was so good, it must work eventually” is a disaster waiting to happen. Failure to perceive the market as an uncertain environment can result in another misconception:
Losses Can Be Eliminated In a paradoxical way, this erroneous notion leads to more losses. A trader tweaks his system endlessly trying to get rid of losses completely. In such constant adjusting and re-adjusting, the system evolves into something totally different,
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losing its original logic, or even stops producing entry signals at all. As a result, a trader either abandons his system, which was not a bad one to begin with, or worse yet, simply refuses to take losses. After all, he made his system so perfect by eliminating all the reasons for failures, it just MUST work! Meanwhile, had he stayed with original approach, maybe with some minor tweaks, it would continue producing steady results.
My Trader Is Who I Am This is one of those hidden subconscious misconceptions that cause us to refuse to take our stop. A trader perceives the result of his trade as a reflection of his personality, his abilities. A trade failure makes him feel as though he is a failure. Winning makes him feel "right", while losing makes him feel "wrong". Nobody likes to be a failure, to be wrong. That’s why, in order to avoid being wrong, we refuse to take our stop. In reality, you can be right and still lose on this particular trade; You can be wrong and win, too. It’s important to differ between good and bad trade, and we will be back to this later, in the Random reinforcement part. At this point it’s important to separate your self-perception from the result of your trade. Taking a stop loss, you are stopping your loss – nothing foolish about that. The major trigger for the right approach here is a realization that by accepting the market as an uncertain environment, we already have accepted the possibility of losses. If we haven’t expected the market to work in our favor every time, there is no reason to feel foolish when it doesn’t.
A Loss Is Just A Paper Loss Until It’s Taken This is a big mistake in thinking. If a loss gets out of hand, it’s very real. It paralyzes you, it clouds your judgment, and it makes you miss plenty of other
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opportunities. Instead of taking a pre-determined loss and moving on to another trade, you sit and watch your losing one, twitching in pain and feeling remorse. Your chance to take a small stop is long gone. You are agonizing now over big one that is going to deplete your account too much and inflict serious emotional wounds. You hardly notice many other opportunities. The market has moved on, other sectors and stocks are in play, and you still nurture your losing trade, hating it and not being able to finally drop it. At some point you will ask yourself "Why was this trade so important to me? What made me hold onto it?" And this takes us to the next common error:
Putting Too Much Importance Into Single Trade A newer trader tends to see each trade as overly important, as if it’s going to make or break him. In reality, the market is an endless stream of opportunities and the next trade is right around the corner. July 2012
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No single trade is so important that it would be worth abandoning all other opportunities. Perceive your trading as a process, not as separate events. This approach makes taking a stop easy and effortless – much like throwing rotten apple away to pick up the good one. With this approach trading becomes natural, like breathing. Each entry is inhale, each exit is exhale. Breathe in and breathe out. Don’t choke yourself trying to hold onto each breath.
Random Enforcement This is an important concept to understand. The market is not rewarding all right decisions and punishing all bad ones. The practical implication is that a trader runs a risk to stop applying proper discipline if he sees wrong ones being rewarded sometimes. Take a stop, observe a stock reversing and going into profit zone – and you get tempted to skip your stop next time. If you try it and it works, there is significant chance that you continue doing just that – the bad habit gets reinforced. You may win several times by breaking your rules. What happens eventually is that one trade that does not reverse destroys your account. It’s important to define what good and bad trades are. Unlike many think, good trade is not always a winning trade; a bad trade is not always a losing trade.
TRADING Insights
can be a winning one when the market acts accordingly to what your system indicates. It can be a losing trade when the market acts against it, but it’s still a good trade.
✦A bad trade is a trade made against your better judgment, against your rules. It can be a losing trade when a market acts as it “should”. It can be a winning trade when the market rewards your bad judgment, and it can be a very dangerous trap as a bad habit gets reinforced. The last thing to say in conclusion is that it’s a certain psychological barrier for a trader to overcome to start applying his stops with no hesitation. When this barrier is taken, things suddenly become so clear and automatic that a trader can’t even believe it was ever a problem for him. When this barrier is overcome, you feel that stops became natural part of your trading, that you take them with no slightest hesitation and forget about them instantly, moving on to search for your next trade, that taking stops do not trigger any negative emotions. This is wonderful feeling of total self-control. Not only will it do plenty of good to your trading performance, it’s a very rewarding feeling in itself.
✦A good trade is a trade where you kept all your rules that you know to be working in a long run. A good trade
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This article was written by: Vadym Graifer Vadym Graifer is a full-time professional stock trader, teacher, and author of Techniques for Tape Reading (McGraw-Hill 2003), The Master Profit Plan (Trafford, 2005) and unique video course How to Scalp Any Market (2004) where he recorded his trades and narrated them in real time.. He is also the co-founder and a head trader for RealityTrader.com, an online educational forum on trading principles, methods, and techniques. Mr. Graifer is a featured speaker at Trading Expos, Financial Forum and private seminars; he has been interviewed and published articles in industry magazines and trading forums such as Active Trader magazine, Stocks & Commodities magazine, Trade2Win forum and others. With over fifteen years of experience in the field, he utilizes his techniques to be a consistently profitable trader over the same period.
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TRADING Insights
Trading Psychology ‘Drawdowns’ By JOSHUA HAYES
Every new trader I know enjoys talking about their winners. However, almost across the board, the one thing you will not hear them discuss is their losers. It is important to talk about your losers because your losers are the only thing that can completely knock you out of the stock market.
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However, almost across the board, the one thing you will not hear them discuss is their losers. It is important to talk about your losers because your losers are the only thing that can completely knock you out of the stock market.
always hurts more than taking small losses. Getting into a position and taking a 5% loss isn’t fun but not taking the trade you just knew was going to work and watching it run 50% to 75% is going to sting a lot more.
Everyone knows the mantra cut your losses when you are wrong. However, even if you cut your losses religiously, it is possible to go very long periods of time where your methodology is simply not going to work. If you continue to do what you always do, and those small losses continue over a length of time, you will eventually have a combined big total loss or what those in the profession call a death-by-a-thousand-small-cuts.
The risk management methodology I have used for 16+ years takes a different approach. Normally, when I go long or short a position I use anywhere from 5% to 20% of my total capital per trade. When I receive perfect setups-which is not often--I know I can press 20% up to even 50% of my capital. When the setup is not perfect but really strong it gets 10% most of the time.
WHAT SHOULD A TRADER DO? So what do you do when those periods of time come along and nothing you do seems to be working? For one, you can simply stop trading and wait for conditions to favor your methodology. Sounds good at first read. However, this is difficult for a lot of traders because they are never sure when the conditions are back in their favor to return to the market. When you are out of the market for a long time, sometimes you can hesitate jumping back into the market. The next thing you know, the market takes off and doesn’t look back, leaving you more upset than when you were taking a lot of small losses. Missing big gains
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After making money for a period of time, if all of sudden a new round of longs or shorts start to not work I begin reducing my size. If the next round of new longs or shorts do not work, I will reduce my size even more. I will continue this process until my new positions start to work in my favor. If the new round of longs or shorts work, I will then continue to increase my size. If the next round works, I will increase my size until I finally get back to my max size per position.
RISK MANAGEMENT Using this risk management philosophy, I am able to protect my capital when nothing is going right and increase my commitments when everything is working correctly. This allows for two things. July 2012
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Number one, it allows me to minimize my damages during a drawdown. Thanks to the trendless tape this year, I am currently in a drawdown for 2012. The losses are extremely small (-4% YTD) thanks to this risk management procedure. The second advantage of using this methodology is that after a sustained period of producing gains eventually you are going to run into a trend reversal. When new longs or shorts stop working as we press higher, instead of saying “this market has more room to run” and pressing bets, I know that I need to begin to reduce positions until new positions prove themselves to me. This allows you to keep the meaty portion of your gains made during trending periods. The past two years have been the most difficult two years of my short 16+ year career. I have never gone any significant period of time where I have not made gains. From January 2011 to July 2012 there have only been two significant periods where I have made money (July-August 2011
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on the short side and January to March 2012 on the long side). Besides these two periods, it has been trendless and volatile within the trendless periods. This means there have been a lot of false signals.
KEEPING AFLOAT Drawdowns in 2001 and 2007 occurred for months on end, in the accounts I run. Those two periods helped create the risk management methodology that has kept me afloat the past two years while I wait for another sustained period of rising or falling asset prices. A period like July to August 2011 is all you need in a year, as long as you are cutting your losses and reducing your size continuously when you are in the middle of a drawdown. Sadly, the uptrend from January to March 2012 was not steep enough to prevent those gains from turning back into small losses. Recently, I have been able to slowly increase my positions on the long side, after the major market indexes retook their 50 day moving averages on the final trading day in June. Each day new longs keep working. Therefore, each day position sizes increase. However, until I get a “perfect” buy signal (only five have been produced this year and only two worked-FLT and LQDT--the lowest W/L YTD record for “perfect“ signals in my 16 year career), I will continue to slowly build up my long positions. Especially, in this tape. Overall, the trend is still unclear and we could easily roll over here just as easily as we could rally. The landscape it still too unclear as we continue to be in a market environment where we sell off on heavier weekly and monthly volume and then rally higher on lower weekly and monthly volume. There is no other point in time, in the history of the Dow Jones Industrial Average, SP 500, or Nasdaq
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where you will find the markets rally on below average weekly and monthly volume for a sustained period of time. This has been happening for three years in the NYSE and two years in the Nasdaq.
ADJUST YOUR RISK One day reality will return and proper price and volume parameters will come back. Until then, there is more than likely to be more volatile trendless price periods before trending price periods materialize.
The only thing you can do is reduce your size as you lose, increasing it back only as you begin to win again. The other option is to not trade. That is not an option for me. I have to always be connected to the market. In my opinion, it is impossible to predict the future (actually, that is fact). Nobody knows when the big trend up or down is going to start. You can only be prepared for either outcome. As the great Paul Tudor Jones said, “where you want to be is always in control, never wishing, always trading, and always, first and foremost protecting your butt.” I couldn’t agree more.
This article was written by: Joshua Hayes Joshua "MauiTrader" Hayes is CEO, President and founder of Big Wave Trading Inc., a Maui, Hawaii-based stock market advisory service. Hayes is a well-respected stock trader who combines fundamentals, technicals, psychology and money management to trade professionally for his personal, family, and friends accounts for 16 years. Hayes also runs BigWaveTrading.com, an online stock market commentary and stock selection service for intermediate-term investment strategies using CANSLIM and other strategies. Hayes is a contributor to SeekingAlpha.com, MotleyFool.com, and TheStockMarketWatch.com and has been a contributor to Telechart as Sir Aloha, Realmoney.com, InvestorsParadise.com, BestWayToInvest.com, iStockAnalyst.com, and StraightStocks.com.
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Walking Forward
TECHNICAL Analysis
By Daniel Fernandez
More Robust Development With More Realistic Expectations It is no mystery that one of the most important challenges in the development of trading systems is to be able to get a good estimate of future risk and profitability. The first approach to do this is to back-test the strategy across a large segment of time (usually 10 to 20 years) but this approach is plagued with problems that become more and more apparent as the degrees of freedom within trading strategies start to increase. Within this post I want to talk to you about some of our experience in the area of trading system development, why the above approach is problematic and why walk forward analysis can help us eliminate many of the above mentioned issues. Our journey starts with a very important question. How do I know the amount of profit and – more importantly – risk that I should expect from a trading strategy in the future? The obvious answer would be to carry out simulations of the strategy over a long period of time in the past and then determine – through these results – what the expected boundaries for profit and risk might be going forward. The problem with this approach comes when you consider the inherent plasticity of strategies, natural to the degrees of freedom contained within them. How do you know if your strategy matches some ever-present aspect of the market or if it just happened to profit from randomness in the market through what is nothing but random chance?
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TECHNICAL Analysis
It is important to notice here that I have not even mentioned optimization. This is because the above problem is inherent to all systems, even if you decide not to optimize them at all. The fact that there is some inherent parameter selection in your strategy – even if you just don’t get it through optimization – creates a selection bias which gives you a probability of having a strategy just fit to the random motions within the market, achieving profit out of some aspects of the market which might not be robust enough for trading into the future.
Survive The Markets The most important problem in the creation of trading strategies is to be able to know if your strategy is in fact able to survive to future market conditions, if your strategy is able to overcome the power of the selection bias. What you need is to know the expected characteristics in future trading, outside of any in-sample trading. The first way to do this is simply by adding an out-of-sample test to the end of your testing period. If you optimize a strategy for 8 years and then perform a back-test for the out-ofsample period you could get some information about the robustness of your strategy by watching how the strategy performs during the period for which there was no information available for selection. This in fact gives you an idea about future performance. The problem – and a big one it is – is that the spectrum of acceptable conditions within an out of sample test is huge unless the out of sample test is tremendously big. For example if a strategy is in-sample optimized for 8 years and then out-of-sample tested for 3 years, is the fact that the last out of sample year was unprofitable enough reason to avoid trading? The fact is that this could just be normal behavior of the strategy because it might be within its acceptable statistical limits. Due to the above it becomes clear that out-of-sample testing in this way is not enough to establish survival to selection bias. How do you do it then? The answer – made famous perhaps by Robert Pardo in his book “ Design, Testing and Optimization of Trading Systems” – is to do a walk forward analysis in which we derive our statistics from the construction of many in and out of sample tests.
In And Out Of Sample Tests In the walk forward analysis routine we use a “moving window” of optimization and then we use a “forward window” to evaluate our strategy, at the end of each forward window analysis, the optimization moving window is slid and a new forward period is evaluated. In the end the merging of all the forward periods builds a long term test which is – for all practical purposes – entirely out-of-sample, there is in fact no parameter selection bias and these results can be used as a valid expectation of future performance (to a very good extent).
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It’s Not So Easy However things are not as easy when it comes to out-of-sample testing. The first thing that you will find is a good deal of disappointment relative to in-sample conditions. The main indicator by which a system is measured – when doing walk forward analysis – is the walk forward efficiency, which compares the profits of all forward periods against the profit of all the optimized periods. A ratio of 1 or higher implies that the system is exactly the same in insample testing as in out-of-sample testing (meaning that your selection process is perfect) while a lower ratio indicates that you lose some profitability. However the worst case is when your ratio is negative, meaning that you are just chasing some aspects of the market which are very variable and from which you will never be able to profit from (because – as a dog chasing its tail – you’re always too late to the party, trying to cash on some phenomena which happened yesterday but will not repeat itself going forward).
There is another caveat to walk forward analysis which is the selection of optimum parameters in the optimizations. Which is the best method to select parameters? Most profitable, least drawdown, highest profit to drawdown ratio, most winning trades? Well, experience has showed that the most significant way of doing this is actually not by selecting any particular statistical value but by imaging the whole parameter space as a function of a profit to drawdown statistic and determining which areas of the space are the most “flat” (meaning have least variation). By building an n-dimensional topological map of system parameters and evaluating the statistical characteristic as a function of “parameter proximity” we can generate a selection of results which has a very good probability of performing better.
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It is important to realize that the above selection process is fundamental because otherwise the achievement of profitable walk forward strategies becomes extremely hard as the number of degrees of freedom grows too large. For example a strategy like Teyacanani – with very few parameters and a limited number of degrees of freedom – can give walk forward efficiencies of even 50-80% using simple “highest profit” as an optimization selection criterion while a system like Atipaq – which has about three times more parameters – struggles to get above 0% using this same selection process. As the degrees of freedom get larger, so does the need to evaluate the entire parameter space of systems in order to carry out the “best parameter” selection in the in-sample part of the walk forward process. Sadly when developing strategies using walk forward analysis the options are quite limited because programs such as MT4 include no walk forward capabilities and other software packages don’t give you the needed freedom to explore the adequate system selection processes (as in MT5). Therefore the best option is to develop the back-testing, optimization and parameter space evaluation inside your systems in such a way that your systems will be able to adequately go through this process regardless of the trading software you are using.
Asirikuy Community In Asirikuy we aren’t using walk forward analysis up until now, but it has become clear that we want to move in this way and our implementations of internal back-testers, optimizers and parameter space analyzers is on its way. The F4 framework has opened up the doors to the use of tremendously fast internal ANSI C back-testing capabilities, something which will give us the ability to optimize our strategies within the back-testing process (running it normally in MT4 or MT5) being able to also select parameters in whichever way we want. Although the challenges remain to build adequate parameter selection algorithms – potentially the topic of a future post – we currently know that all the tested Asirikuy systems can give profitable walk forward efficiencies and it will therefore be a very big step forward to move in this direction. If you are currently developing trading systems I would advice you to perform walk forward analysis to see what the potential of your strategy might be (and to obtain much better risk and profit targets). It is also very important to reduce the number of degrees of freedom if you want to get away with using simple selection criteria or to come up with more complex methods to select best parameters if your degrees of freedom are high. Another important point is also the choice of sizes for the moving in-sample window and the forward window, something which we will be discussing on a later post. If you are using MT4 you might also consider using this software (not affiliated in any way with me or Asirikuy) to perform very simple walk forward analysis although your systems will need to be compatible with open price simulations to give any meaningful result (meaning that they should give reliable tests using only OHLC data of previously closed bars).
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Gain A Deeper Understanding About Algorithmic Trading As you can see walk-forward analysis is a very powerful stress-test for your systems and it definitely opens up the way for the elimination of the parameter selection problem in trading system creation. If you would like to learn more about the things we have developed in Asirikuy and gain a deeper understanding about algorithmic trading please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach towards automated trading in general . I hope you enjoyed this article ! :o)
This article was written by: Daniel Fernandez First published on Daniel’s blog - Click Here to visit
Daniel Fernandez is a seasoned forex trader and mechanical/ automated trading system designer. He has been heavily involved in forex for many years and has been enjoying profitable trading from automated trading strategies for over two years. My formal education as a chemist trained me to have a rational and analytical approach towards the phenomena I want to study and forex trading was absolutely no exception. By analyzing the market I was able to come up with very simple, yet robust and reliable trading strategies that I use to profitably trade the currency exchange market. I have created a website – Asirikuy.com – to attempt to educate new traders as well as to develop new and exciting mechanical trading strategies with other experienced traders. In Asirikuy not only will you be able to have access to many trading systems developed with sound concepts, simplicity and adaptability in mind but you will be able to learn about many relevant aspects of automated trading and all the important problems that are found within the road towards long term profitability using algorithmic trading strategies.
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AVERAGING DOWN
Why Averaging Down Is A Bad investment strategy By DR. KRIS (Kristine Andersen)
W
henever some financial “pundit” says that the best way to get into a stock is by averaging down, I cringe. Why? Because at best you'll be getting into a stock at a lower average price (which can also be accomplished to the very same effect when the stock is rising but more on that later) but more importantly, you can be getting into a stock that's poised to sink much, much lower-and that's a risk no one wants to take.
What Is “Averaging Down”? The concept of “averaging down” is straightforward. Say you buy a hundred shares of a stock at $100. It goes down to $90 and you buy more a hundred more. Your average cost per share has now been lowered to $95. Repeating this action as the stock falls will lower your average cost per share even more. Sounds good, right?
Investing Or Trading? It depends. If you're investing in the stock—that is, you're viewing this as a trade and not a longterm investment--then averaging down is a strategy that runs counter to your goal of making a profit. Traders use buy and sell July 2012
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indicators to determine when to enter and exit positions. Should a stock fall enough to trigger a stop-loss, they exit the position and take a small loss at the most. Stock traders either don't care or don't know enough about the company's fundamentals to determine whether or not the drop in price is due to a temporary lack of buyers or whether it's reflecting a more serious problem that they don't know about or hasn't yet surfaced.
were kept so hush-hush that even top Wall Street analysts were fooled? Think Enron, Tyco, and WorldCom--companies that wiped out many a retirement account.
The situation may be different, though, if you're investing in the company itself. If, after doing your homework, you are convinced that the company is a good value and you are planning on holding the stock for a long time, then averaging down may work to your advantage. The operative word here is “may.”
A Case Study: It Seemed Like The
Even if you're convinced that management is on the right track and the fundamentals are solid, I still have a bias against this approach for a couple of good reasons. One is the fact that hype and circumstances can blind even the most judicious, rational investor. Previous Federal Reserve Chairman Alan Greenspan dubbed this condition “irrational exuberance.” Remember the dot-com bubble in 2000 when internet stocks were bid up to frighteningly high valuations? How many of them are in business now? Go.com and Pets.com were two internet darlings that quickly flamed out once the bubble burst. Or what about accounting scandals that
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If you can't rely on market hype or trust fundamentals, then what recourse do you have other than using your mattress as a retirement plan? The answer is to follow the technicals because, unlike people, numbers don't lie.
Perfect Candidate Let's take a look at a recent example of a market darling that has been experiencing a fall from grace. Last year this company was on everyone's buy list —Wall Street loved it, Main Street loved it. This is one of those “buy the dips” stocks making it a perfect candidate for the averaging down strategy. What is the company? It's Deckers Outdoor (NASDAQ: DECK), the maker of outdoor footwear and apparel. Their top brands include Teva and recently acquired Sanuk, but it's the Ugg brand of sheepskin footwear that makes up at least 80% of their sales and for which they are most known.
Brand Popularity Raises The Stock Deckers' stock suffered along with the rest of market during the 2007-2009 subprime crisis. In March of 2009 the market turned around. The S&P 500 staged a
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two year rally that ended in early May of 2011 when it hit a multi-year high. During that time, the S&P made a spectacular 100% return but as nice as that was it was chump change compared to the 650% return made by Deckers during the same period. Clearly, investors and consumers were in love with the Ugg brand. In the months that followed, the market began to slip as debt problems from the Eurozone surfaced. Deckers, however, was marching to a different drum beat. It couldn't help but fall a bit in August of 2011 when the crisis was at its darkest, but it picked itself right back up. Late that October, the company reported earnings which blew out Wall Street estimates. The next day, the stock jumped over 10% and went on to post an all-time high of $118, tacking another 22% onto its previous gain. Investors were euphoric.
The Stock Begins To Loose Its Luster But the bloom began to fade when the stock quickly reversed course in what would be the start of a major slide. Buying volume dried up reflecting a shift in institutional attitude. Because of the slack in buying pressure, the stock began to fall in tandem with the overall market. On December 15th, an analyst at Sterne Agee downgraded the company citing
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slowing sales due to milder weather and rising material costs (mainly sheepskin). The price target on the stock was slashed from $130 to $72. The news triggered a 10% drop in the stock, breaking a major support level at $95 along the way. Many institutions and investors viewed this event as a shift in perception and began exiting their positions. Trading volume on that day was three times normal. Was this a time to buy the stock? At $87 per share, it must have seemed like a bargain to those who were still enspelled by the Ugg mystique. Even CNBC's “Mad Money” maniac, Jim Cramer, named Deckers as one of his top holiday picks on December 27th. But some investors clearly didn't share his views. Just two days later, the stock dropped another 8% on heavy volume. There was no news to account for the sell-off, but my guess is that investors and portfolio managers smelled a dog and were looking to shore up their books before the end of the year.
Another Nail In The Coffin For the next couple of months the stock languished in a narrow trading range between $80 and $90 until its next earnings report on February 23rd of this year. Although the company beat again on earnings, it guided fiscal year 2012 earnings well below consensus. The reasons that management gave echoed the Stern Agee analyst's concerns:
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increasing material costs coupled with unseasonably warm weather. There is another possibility, however, that management would never stake claim to and that is this: Could the consumer's passion for the Ugg brand be waning? A company issuing downward guidance is not the news investors care to hear and they responded by pulling out en masse. The stock tanked, losing yet another $10 per share along with 10% of its value, closing under the $80 support level for the second time. It proceeded to fall from there. The downward trend came to a halt in mid-April when, with just a little more than a week before its next earnings release, the stock rallied back to $70 resistance on the anticipation of better news. To die-hard investors, hope springs eternal. Unfortunately, their hopes were dashed when the company missed estimates-something it hasn't done in six years. The next day the stock opened down over 18% in yet another mass exodus. You have to hand it to that Stern Agee analyst—he was right on direction but a wee bit off on price target. Not only was his $72 price target violated, the stock broke support at $60. And it's been sliding ever since.
The Cost Of Averaging Down There are many ways to construct an averaging down scenario on this stock but let's just say that you've been following the company for months or even years since the 2009 market low. In October of 2011, you witnessed the earnings blowout and were finally convinced that the company was “the real deal” and decided to buy the stock “on the dips.” The first dip following the earnings release occurred when the stock broke support at $110 on November 9th. If you had gone on to accumulate the stock using the “buy
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the dip” mentality, you would have bought at the events listed on Chart #1. These events include the break in support, the aforementioned analyst downgrade, and the subsequent disappointing earnings reports. If you would have stuck with the averaging down philosophy by buying on the dips (using an equal share strategy and not including commissions Averaging Down Date
Price
11/09/11
106.39
12/15/11
86.46
02/24/12
77.72
04/27/12
51.83
Average Cost
$80.60
or fees), your cost basis would now be near $81, as determined from the table. At the time of this writing, Deckers stock is at $44. That's a 45% discount from the average price of $81. If that statistic doesn't bum you out, this one will: You'll need an 84% move to the upside just to get back to your break-even point! Seriously, is that what you want or would you rather try a different approach?
The Opposite Approach: Averaging Up Instead of the “buying the dips” mentality, how about buying the pops? That is, buy when the stock gaps up either due to a compelling technical fundamental reason such beating
(Closing prices are used unless otherwise noted.)
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earnings estimates, raising earnings and/or revenue guidance, making key acquisitions, etc. Let's use this “averaging up” approach with our candidate company, Deckers, and see how it compares with the opposite strategy of averaging down.
The Market Is Rising And So Is The Stock Let's say it's early spring of 2009 and you've been making a list of stocks you'd like to buy once the market rallies. You find the Ugg brand appealing and are interested in possibly buying a piece of the company. You research the fundamentals and like what you find. Next, you turn to the stock chart and see
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that it's beginning to rise along with the overall market. You patiently watch it, waiting for a catalyst to give you the buy signal. Finally, you get one in late October of 2009 when the company easily beats Wall Street's earnings estimates. The next day, the stock gaps up on heavy volume and you jump in. You keep on doing the same thing— buying the pops--for the next several quarters as the company continues to thrive and beat estimates. Chart #2 below shows the dates of the last three trades that are included in the following table. (There wasn't room to show all four trades, but suffice it to say that the first one is very similar to the others.). Note the “pop” in the stock and the spike in volume following each earnings report.
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If you had bought on each of these earnings “pops”, your stock position would look like this: Averaging Up Date
Price
10/23/09
32.36
02/26/10
40.03
04/23/10
52.35
10/29/10
58.1
Average Cost
$45.71
Sure, your average cost basis is more than your initial price of $32.36, but you still have the satisfaction of knowing that you're holding a position that's
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profitable down to your break-even point of $45. That's quite a sizable safety cushion! And isn't having a safety cushion a lot better than trying to play catch-up?
Deciding When The Buying Stops And The Selling Begins You could keep on accumulating shares as the price rises, but a prudent investor (without a very long investment horizon) would begin selling his or her position at the sign that the company's fortune is reversing. The first technical indication that Deckers may be in trouble came on 11/9/11 when the stock broke its $110 support level. (This was the date of the first “buy the dips” purchase.)
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The “official” tell, though, was the analyst downgrade on 12/15/11 mentioned earlier. You would have seen the stock gap through its $95 support level (see Chart #1) and either have chosen to sell some or all of your position. If you had sold all of it at the closing price of $86.46, you still would have made a profit of $40.75 a share—that's a gain of 90%! But even if you had steadfastly held onto your entire position throughout the stock's further decline, you'd just be at the break-even point right now (at the time of this writing). Isn't it comforting to know that you're even able to weather such a tough storm?
Summary We've seen how averaging down can lead to disaster while the opposite approach, averaging up, can lead to higher profits at lower risk. I can hear your thinking: Why would someone buy a stock on the way down when the fundamentals are indicating a contraction in growth? Don't forget the power of irrational exuberance--even a seasoned Wall Street professional like Jim Cramer gave Deckers a two thumbs up following a 30% drop in stock price AND a major downgrade. Just remember that investor perception can take much longer to shift than the price of a stock. So, if you're ever tempted to buy a stock on the way down, recall this “Ugg-ly” example and resist the urge. Don't let it happen to you!
This article was written by: Dr. Kris Dr. Kris (aka Kristine Andersen) has been trading stocks, futures, and options for over 20 years. Her daily market insights, articles, investment "recipes", and trades of the day appear on her website StockMarketCookBook.com.
She also provides a monthly portfolio asset allocation service called the Portfolio Protector (tm) designed to maximize returns at minimum risk while avoiding the devastation of severe market corrections (see AlphaSigmaMarketSystems.com). A popular contributor on SeekingAlpha, Dr. Kris has 65,000 followers. She can also be followed on Twitter @StockMarketCB and on Facebook @StockMarketCookBook. Dr. Kris holds a B.S in mathematics and a Ph.D. in geochemistry, both from M.I.T.
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Trading With A Stop-Loss Advice On How You Can Use Stop Orders By MICHAEL MICHAUD
Trading with a stop-loss is extremely vital for all traders to cut losses when they are still small and preserve capital in case the market goes against your trade. Especially traders trading on margin or high leverage. "Trading with a StopLoss" explains the basics of a stop-loss, buy sell stops, trailing stops, and how to use them. Don't be foolish! Use a stop-loss and live to trade another day! July 2012
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Do you use stops on all your trades? Trading without stops is the ego wanting to never be held accountable to admit that a position was a mistake if a certain level is breached or if a certain set of circumstances play out in an unexpected manner. Let the market take you out. This takes your ego out of the decision - the decision on what stop level to exit should be calculated before entering the trade. You want to prevent your mind playing tricks on you by rationalizing a new reason to hold on to a poor performer. I review my trading journal each day in order to remind myself of the #1 Entry Driver for the positions and key stop levels. If any of these are broken, I have lost the edge projected and should exit such busted trade’s immediately.
STOPS ARE NOT ONLY FOR YOUR TRADE EXITS Most traders think of stops relating to the exit of a position, but one of the most preferred entry techniques also involves a stop. A stop order to buy (or "buy stop") becomes a market order when the price trades or is bid at or above the stop price. A stop order to sell (or "sell stop") becomes a market order when the price trades or is offered at or below the stop price. The objective here is to only buy when the price takes out a
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significant prior high, or sell when the price breaks to a meaningful new low point. In this way I make the trade prove to me that it wants to make the anticipated move. If it doesn't, I don't get into the trade. Many times this method is far superior to the limit order technique of trying to buy below the current market price or sell above the current market price. What I have found is that limit orders hoping for a better price are merely another ego behavior to believe that we can tell the market what we want it to do. In turn when I miss out on getting filled due to a tight limit order, I was often left watching from the sidelines as the price mounted a continued trend. The stop entry has triggered me into some trends that I would have otherwise missed.
DEFINE YOUR RISK EARLY You should define an initial exit stop point for your trade before you enter the trade. This determines the risk you are willing to take. The whole purpose of a stop in my opinion is to define the point at which the trend is invalidated. The potential reward should preferably be three or more times the risk you are willing to take. Next, you need to determine if a position is working for you, how will you protect your profits? This is known as a trailing stop.
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In a good uptrend, I prefer to use a close under the 10-day exponential moving average as my trailing stop, unless I am using another method as my driver in the trade.
CLOSING STOPS At this point, let me explain my preferred stop method. I tend to use "closing stops", meaning I don't want to place my stop order intraday to be gunned by the floor or taken out by day-trader noise. Many battles are fought during the trading day, but the war is won at the close. We want to wait to see who wins the war at the end of each session. If XYZ stock is going to close against my closing stop level, then I place a market
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order to close the position in the final minutes of trading (if you miss this exit for any reason, you can still place a market order to exit on the next morning's opening price). If the stock happens to be within a few cents of this level and it is unclear, I will wait for the close, and if my level breaks, I will make sure to sell it at the market on the next trading day's opening price. This has kept me from getting whipped out of a number of good swing trades during the day, while still giving me the ability to exit when the stock has proved me wrong by day's end. Some traders worry that a stock may move too far against them by the close compared to an intraday stop and
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occasionally a stock will be filled well against our closing stop by the end of the day. But that risk is small compared to the bigger risk of getting whipped out of a position intraday only to have it post a strong reversal in our favor and be off to the races. I call these "Bend But Don't Break" points. You want to wait for the end of that bar's close. If the chart is a weekly chart, wait until the end of the week's close to stay with the true trend while others get faked out.
PROFITS The final exit issue I'll deal with here is how to take profits. Should we use a
fixed target, or should we only use trailing stops on winning positions until the trend breaks? The answer depends on your risk tolerance, as well as the market environment. For conservative traders, I recommend sticking with price targets compared to defined risk levels, as you can lock in profits more safely that way. In addition, in more choppy markets the target profit approach is advisable, as noise can work to your advantage in taking profits at targets. But in trending markets, we want to be able to keep at least a partial position on, and then use a trailing stop like the 10-day exponential moving average to stay with the best trending situations.
This article was written by: Michael Michaud Investor and trader since 1989. Writes daily for his blog on a variety of investing trading subjects, and provides professional investing trading education training software systems at his http://www.invest2success.com. Review our sites for professional investing trading education, training, and much more. Free investor trader information, articles, blog, software and signal comparison trials for stocks, options, futures, forex, and commodities. Web Site http://www.invest2success.com Blog http://invest2success.blogspot.com
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By Leslie Jouflas
Profiting With Repetitive Swings Using Harmonics Portions of this article were excerpted from ‘Trade What You See – How to Profit from Pattern Recognition’ by Leslie Jouflas and Larry Pesavento, Wiley and Sons, 2007
LEARNING TO UNDERSTAND HARMONICS
H
armonic numbers are fascinating vibratory swings that occur in each market and each individual stock. Each market is made up of energy that is fueled by the market participants. This in turn creates swings of price that are measurable and repetitive which we refer to as harmonic. Harmonic swings are also the underlying structure of other profitable trading patterns such as the AB=CD pattern covered in ‘Trade What You See – How to Profit from Pattern Recognition’, by Leslie Jouflas and Larry Pesavento, Wiley and Sons, 2007. Studying and learning the harmonic or repetitive swings in markets that you trade can greatly aid traders in several ways; 1. Identifying Entries 2. Identifying Exits 3. Placing Stop Losses (Figure 1) Illustration of repetitive or harmonic swings
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TECHNICAL Analysis
WHERE THE TERM HARMONIC NUMBERS ORIGINATED Although harmonic numbers have been inherent in markets and individual stocks all along, the term “harmonic numbers” came from Jim Twentyman. Twentyman was a broker at the Conti Commodity office in Westwood, California and had studied Gann extensively. He is considered an expert on Gann. He had worked for over a year in the 1970’s at a book store called The Investment Center, which was located a short distance from Conti Commodity Trading Offices. The bookstore had an extensive library of over 5000 investment books. This gave Twentyman an opportunity to study all of Gann’s works. Twentyman’s knowledge of numbers from sacred geometry evolved from these studies. He had worked with one of Gann’s concepts of squaring price and time together. By utilizing Gann’s square of 9, (which was a circle of 360 degrees divided into 30 degree segments), and the numbers from the Fibonacci summation series, he discovered what are now known as harmonic numbers. These are the numbers that repeat in all markets in all time frames.
DEFINING A HARMONIC NUMBER To understand the term harmonic as it applies to a price chart let’s start with a definition of the word “harmonic” as it pertains to physics; Har-mon-ic – Physics - Any component of a periodic oscillation whose frequency is an integral multiple of the fundamental frequency. As you study the markets or individual stocks you will see that they do only one of three things; 1. Move up 2. Move down 3. Move sideways Markets are either in a process of expanding or contracting. Generally, markets will spend more time trading in a range, trading sideways, forming support and resistance areas, than they will in a trend. Figure 2 illustrates a typical sideways moving market. A trend can be defined as higher highs and higher lows for an uptrend, and lower highs and lower lows for a downtrend. See Figure 3 for an example of a downtrend and Figure 4 for an example of an uptrend. When markets are in a range they are usually contracting and when they are in a trend they are usually expanding. Here is where you can begin to think in terms of vibrations, repetitions and swings.
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(FIGURE 2 Example of a sideways market)
(FIGURE 3 Example of a downtrend)
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(FIGURE 4 Example of an uptrend)
VIBRATIONS IN PRICE SWINGS Vibrations in the markets can be thought of as sound waves. The louder the sound the farther it will travel, eventually the sound will lose momentum as it travels and the momentum will dissipate. The same analogy could be used describing an object being dropped. The larger the object and the higher it is dropped from will create a larger vibration as it meets with a surface. Price movement is very similar to this. As an example, a release of an economic report or news related item could cause prices to suddenly thrust up or down. Figure 5 shows an example of a price thrust, or expansion after the release of an economic report. Shocks such as natural disasters, currency devaluations and wars, are extreme events that will have larger vibration effects on the markets. When prices stay within a range it is a matter of time before they move away from that range. Many times price will move away from the range with urgency in the form of a trend. Figure 6 is an example of a range that formed, and when price broke to the downside out of the range, it did so in a decisive manner that was evident in the long, wide range bars.
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TECHNICAL Analysis
(FIGURE 5 Range expansion following an economic report)
(FIGURE 6 Price moves away from the trading range in the form of a trend)
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TECHNICAL Analysis
Using the price behavior from Figure 6 as an example, price contracted as it formed the range and expanded as it broke the low price support area and then began trending. What we can say is strong vibrations can equal a trend. Milder to weaker vibrations will form a range. The trading range can also be thought of as stored energy. Eventually this energy will have to be released in one direction or another. The milder and weaker vibrations usually will not have enough strength to sustain a trend. Refer to Figure 7.
(Figure 7 False Breakout – not enough energy out of the coil)
It is possible to see increased volatility that creates strong vibrations or price swings. The market will trade in both directions as market participants battle back and forth until a winner is decided. Once the winner has taken control (either bulls or bears), the price can have very strong vibratory movements (such as a trend move) in one direction as the losing side liquidates positions and new participants in the direction of the trend pile in.
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TECHNICAL Analysis
(FIGURE 8 Strong vibratory swings as bulls and bears battle)
Figure 8 shows dramatic swings in the weekly gold futures chart as bulls and bears battle over the direction. Considering each 1 point move in gold equals $100 per contract, these moves are significant.
REPETITION IN PRICE SWINGS It is the repetitive and/or similarity in swings (vibratory) price that we refer to as harmonic. They are price swings that are similar in length, are repetitive, and found in all time frames. Figure 9 shows a 60 minute chart of the Dow Futures. At first glance this price movement can appear chaotic in nature; random up and down swings. In fact, many traders would not consider trading a chart with this appearance.
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TECHNICAL Analysis
(FIGURE 9 Dow Futures 60 minute chart showing random swings)
(FIGURE 10 Example of applying cloned lines to find the harmonic swings)
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TECHNICAL Analysis
If we look at the same price chart and pick out the repetitive or harmonic swings, we immediately impose order onto chaos. Refer to Figure 10. Trader’s can use simple cloned lines in their charting software to find those swings. What you see are harmonic swings in Figure 10 of the 60 minute price chart of the Dow Futures. This clearly illustrates the repetition that is present in this market on this time frame. Here are a few more chart examples illustrating these repetitions. Figure 11 is a 15 minute chart of IBM. This chart shows the repetitive swings- up. The two swings form an AB=CD pattern. You can start to get a sense of the importance of these harmonic swings and the role they will play in learning and trading specific patterns.
(FIGURE 11 Harmonic swings forming an AB=CD Pattern)
REPETITION IN PRICE SWINGS The next example is Figure 12, a 30 minute time frame chart of GOOG. It shows repetitive swings or harmonics forming both up and down. If you study the chart you will notice a set of smaller harmonics that form the second up- swing in the chart. Again, those swings are forming the AB=CD trading pattern through repetition.
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TECHNICAL Analysis
(FIGURE 12 Harmonic swings forming in both directions)
The S&P Emini chart shown in Figure 13 shows the harmonic swings in terms of points, as well as equal length in the swings. The up- swings are within 2 points of each other and the corrective swings down are within 1 point. Also interesting to note is each of the corrective down swings in Figure 13 related to the .618 retracement levels. They were each a .618 retracement from the swing low to highs. You want to learn to identify multiple areas of support and resistance using harmonic numbers, Fibonacci ratios and patterns. ere is another example of harmonic numbers that include vibration and repetition that is evident and simple to identify on the Wheat futures chart in Figure 14. The dashed line in this example is showing the smaller harmonic within the larger harmonic or swing. It is not unusual to see this occurrence where one swing is broken into 2 or more harmonic swings that make up the larger harmonic.
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TECHNICAL Analysis
(FIGURE 13 S&P Emini chart showing the harmonic swings in terms of point moves)
(Figure 14 Wheat chart showing repetition, vibration and smaller harmonic within a larger harmonic.)
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TECHNICAL Analysis
FINDING HARMONIC NUMBERS To find the harmonic or vibratory number in a stock or market is not difficult. You want to find the common swings using length, or in terms of points that recur over and over. You are looking for the most common repetition in that stock or market. If you trade a particular time frame such as a 5, 15, or 30 minute chart, (it does not matter which time frame you trade), you want to look for the repetition on that time frame. Using a 30 minute chart as an example, the easiest way to find the harmonic numbers is to look for and mark in (such as with a line drawing tool) the most common or repetitive swing. The chart can also be printed out and the swings drawn in by hand. Doing some of this work by hand makes a better connection with the brain, and helps train the eye for identifying these swings. Each market or stock in the various time frames seems to have their own set of harmonics and these can be expanding or contracting depending on the current volatility. For an example refer to Figure 15, the 30 minute chart of the Euro currency, there is a common swing (harmonic number) of approximately 70 pips. The vertical lines each represent 70 pips, (the arrows on the chart indicate if the line is showing an upswing or a downswing). You can see that some of these swings are almost exact and others are just a bit off the mark, but still within a close range of the 70 pip harmonic in that market. Keep in mind that the price swings will not always be to the exact number. Think of these numbers as areas or zones that price will move towards.
(FIGURE 15 Vertical lines represent a 70 pip swing)
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Another example is in Figure 16 of the SP 500 Emini. Figure 3.14 shows an excellent example of the common swings using harmonic numbers we see using a 5 minute chart of the S&P 500. You can easily see how each swing that occurred was within the harmonic ranges and the repetition that occurred. If you look at the dashed line area in Figure 16, you will see how the first leg up of that swing was a 5.5 point swing followed by a 4.5 point swing. The total leg was 8.5 points with the low at 1422 and the high of the swing at 1430.50.
(FIGURE 16 Harmonic swings on a 5 minute S&P 500 chart)
HARMONIC NUMBERS FOUND IN OTHER MARKETS Here are some of the Harmonic numbers found in other markets; Use multiples of these numbers in strong markets. Remember that different variations of these numbers will be found in swings depending on if the market is contracting or expanding.
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Bond Market – 20 ticks
Gold Market – 11 and 17
Crude Oil – 44 and 88
Silver – 18, 36 and 12
Dow Jones – 35, 105 and 70
Wheat – 11 and 17
Euro Market – 35 and 70
Soybeans – 18 and 36
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TECHNICAL Analysis
The harmonic for a 5 minute chart may vary as opposed to a 30 minute chart. They will be related however, by percentages. The harmonic on a smaller time frame such as a 5 minute chart may be 1/2 or .618 percent of the larger harmonic number. The only way to learn is to observe these numbers for yourself. If you were to, on a daily basis, track the swings in any given market on a 5, 15 or 30 minute chart and keep a record, you would then begin to see the repetitions that occur frequently. If you did this over a 30 day period you would see almost every type of pattern occur within that time period; up, down and sideways, contracting and expanding.
This article was written by: Leslie Jouflas Leslie began trading in 1996 and left a 17-year airline career in 2000 to pursue a full-time trading career. She has studied many trading methodologies, including Elliott Wave, options strategies, momentum trading, classical technical analysis, and Fibonacci ratios and patterns. After trading stocks and options on stocks, she now trades futures and commodities with an emphasis on the S&P 500 EMini market. Leslie has co-authored two books, Trade What You See – How to Profit from Pattern Recognition (Wiley & Sons, 2007), published in English, German Italian, Chinese and Japanese, and Essentials of Trading: It’s Not WHAT You Think, It’s HOW You Think (Traders Press, 2006), and has many published articles for such publications as Trader’s Journal, Active Trader, and Technical Analysis of Stocks & Commodities. In addition she teaches live workshops and webinars providing ongoing education for traders. Leslie has been an invited speaker at many of the Trader's Expo's and has done several interviews with the Money Show . Leslie founded www.tradingliveonline.com website which is an educational website teaching traders to become confident, consistent and proficient using specific pattern recognition.
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FEATURE Article
The Real Reasons Why PRICES Move By Sam Evans
Having been an instructor with the globally recognized Online Trading Academy for around 5 years, I meet many individuals with a keen interest in increasing their consistency in their market speculating on a daily basis, yet most are struggling with the same hurdles and problems. With such an overwhelming variety of different information sources available to us, it can often be challenging for newer traders and investors to decide which of these is best to trust. Typically, the novice speculator acts like a sponge and attempts to digest pretty much every single book, webinar or article which promises the secret to consistent market gains. In reality however this usually turns out to be a somewhat futile activity, given that the vast majority of information available on trading is taught from completely the wrong perspective. I know this because I have also been there myself and experienced pretty much every single challenge anybody else has. This only stopped when I taught myself to focus on why prices moved in the market and how to objectively analyze a chart without the need of emotion.
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The most important lesson I learned about the markets from my mentor was this: Movement in price is based simply on Supply, Demand and the human behavior relationship that exists in any market. Opportunity always arises when this simple and straight forward equation is out of balance. W h e t h e r t r a d i n g t h e S & P, B o n d s , Currencies, buying a house, a car or trading collectible comic books, how we make money buying and selling anything never changes. Personally, I have always been a Technical Trader, choosing to focus on Price for my entries and exits. For some, this can be a challenge as there is so much fundamental news coming out each and every day related to the markets, that we often feel that we need to use it to make our trading and investing decisions. When I am teaching a class, I try to keep things as simple as possible for my students, illustrating to them that prices in all markets (and any other markets) around the world, change as a result of the changes in Supply and Demand at any given time. If you know what you are looking for, this can be seen on a price chart but we also need to understand that advanced forms of technical analysis mean little if you don’t fully understand why novice traders and investors lose money in the markets day to day. I learned from training with literally some of the best traders on the planet, that if I respected two key rules in making my
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trading decisions, I would already have an edge over the consistent losing speculator. These were as follows:
1. Understand that buying into objective areas of supply and selling into objective areas of demand will always be the lowest reward and highest risk trade to take. 2. Understand that prices can only go up if more people are willing to buy and they can only go down if more people are willing to sell. The losing speculator will typically fall foul of their emotions because they buy after a period of buying and sell after a period of selling. For humans in general, it is emotion that drives behavior, not intellect. Traders who make trading decisions based on emotion versus objective information will almost always be invited to enter a position when the objective risk is high and reward is low and with trading being a zero-sum game, this means that when one trader loses, their money flows into the account of the trader on the other side of the position. The educated typically get paid by the uneducated.
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FEATURE Article
Let’s take a look at a recent chart of a key stock traded on the NASDAQ, Microsoft (MSFT):
Price alone and nothing more reveals buyers and sellers on a chart only if we can remain objective and follow our rules. A price chart makes it easy to see which group – buyers or sellers – is controlling the market and also, which group is about to lose or regain control. Candlesticks (price) represent trader’s beliefs and expectations and hold the true objective information we need when trading without emotion and according to our plan. The above Daily chart shows a scenario that plays out time and time again. Area "A" represents a price level where supply exceeds demand. We know this because of the pivot high at "A". Price could not
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stay at level "A" because there were simply too many sellers and no buyers and when that happens, price declines. As price falls from "A," we can objectively conclude that we have a supply and demand imbalance. At "B", one can objectively conclude that the majority of traders who bought on that candle are not consistently profitable. They are buying after an advance in price, and just as important, they are buying right into a price level where objectively, supply exceeds demand (supply / demand imbalance). We simply want to sell to these novice buyers. Selling short at "B" is the low risk / high reward / and high probability trading opportunity.
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On the flip-side we can see that at point “C” there is an objective level where demand is greater than supply. Only the novice seller would ever hope be profitable by selling at “C” into a supply level and after a period of selling in the market. This will never be the low risk, high potential reward trade on offer. This scenario show above is one which takes place over and over again the markets across all asset classes. Online Trading Academy Graduates are aware of this, as they have learned to identify the mistakes which most traders and investors make and capitalize on this
by practicing their trades with our money live at the market, which in my humble opinion is the only way to learn how to be consistent in the markets. Join me next time for a deeper look into the powerful dynamic of Supply and Demand and how a simple understanding of this concept can form a rule-based core strategy which can be used to identify the lowest risk and highest reward trades in the markets, using knowledge of Latent Institutional Order Inventory. Take care and be well, Sam Evans
This article was written by: Sam Evans sevans@tradingacademy.com www.tradingacademy.com Sam's trading career has been quite exceptional. In seven years he has progressed from an Online Trading Academy student, to full-time trader, to Fund Manager to Lead Instructor Forex XLT. More recently he has taken on the role of UK Education Director and is one of a handful of instructors teaching the All Asset Mastery XLT to our elite group of Mastermind Graduates. Onlocation, Sam is certified to teach equities, forex, futures and commodities. Sam decided to learn to trade when he became jaded with his media career. He dappled with life coaching but his passion for the money markets was too great. Sam's career history enables him to combine his trading knowledge with his presenting and coaching skills with ease - resulting in a great learning experience for students. Sam's style is all about keeping it simple. He focuses on strict risk management principles, a nogimmicks approach to price action and solid risk to reward ratios. Online Trading Academy has been teaching people how to trade for over 15 years. We run classes on Stocks, Forex, Futures and Options, plus wealth planning. We equip our students with an armory of trading styles including Intraday, swing, and position. We teach our students how to spot turns in the market and how to maximize their trades, plus more. We have won numerous awards including TraderPlanet.com and SFO’s 2011 Star Award for our Professional Trader Class and the London Investor Show’s 2012 Award for our Forex Trader Class
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OPTIONS Insights
Magazine
Introduction To Options Take Your First Look At Options
O
ptions are a high-risk investment, but they are also highly profitable. Traders enter the option market for many reasons. One reason is because the amount of capital required to enter the market is lower than regular stock. The fact that most options move faster (volume) and produce higher returns is another reason traders dabble in the option market. Many brokerage houses limit the amount of cash (margin) new traders can use to invest because of the market's high potential for loss. As option traders become experts, these limitations go away, and the trader is free to invest as much as their account allows. Once a new trader gets familiar with how the option market works, they can become an expert in no time at all. Stock vs. Option Regular or preferred stock is an asset. In other words, stock is equity, and it gives the holder ownership in the company where it's drawn from. It trades easy in the exchange because, like money, investors consider it a liquid asset. An option is a derivative of stock. This means that its value completely depends on the value of the equity associated with it. Option Buyers: Option buyers own a contract that says they have the right to buy or sell an asset by a certain date (expiration date). Option buyers are not obligated to buy or sell the asset, and if they choose not to, they let their option expire as it becomes worthless. Option Sellers: Option sellers own a contract that obligates them to buy or sell an asset by a certain date (expiration date), if the buyer excercises the option. Most option sellers hope the buyer's contract expires, so they can collect premiums. Online Brokers Most investors trade options using an online broker system that connects directly to the brokerage house
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By Igor
holding trader's investment account. Traders send orders through their broker, which go directly to an exchange. Their brokerage house, which has a seat on the exchange floor, receives the investor's order and sends the trader's request to auction after deducting or adding funds to their investment account. All this takes place in real-time, which occurs in a matter of seconds. Expiration Every option expires. Traders call an option's expiration date, the strike date, because it stands as a marker where all options must be either be bought or sold. On or before the strike date, the trader can either choose to exercise the option and buy the underlying asset, or they can let the option expire, where its value then becomes worthless. Strike Price, Exercise & Assignment An option's strike price is the value an investor will pay to exercise their right to buy or sell the option. If a buyer chooses to exercise the option, the brokerage house assigns the seller's assets to the buyer's account. Margin Requirements Margin is the total amount in which an investor can use to make a trade.Most traders make a deposit at a brokerage house, which serves as collateral for buying and selling options. Normally, the trader can only buy or sell options up to the balance available in their July 2012
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account (margin). Sometimes, brokerage firms extend credit to the trader, which adds on to their margin's limit. However, if at any time a trader buys an option on credit (borrowed margin), makes a bad choice, and their option starts to lose value, the brokerage house has the right to immediately sell the option to cover the margin (margin call). Order Entry Home broker systems basically have two types of transactions, buy and sell. Investors can fine-tune their orders by adding details to the order, including limit, stop or market, which directs their broker on how to specifically auction it. Types of orders In each of the two types of order entries, there are two types of orders that a trader can place. Call Orders Buying a call option - Trader buys a call option thinking its price will go up (longbuying). Buying the underlying asset is
OPTIONS Insights
not an obligation. Selling a call option - Trader sells (writes) a call option thinking its price will go down (short-selling). Trader must sell the underlying asset, if a buyer exercises the option. Put Orders Buying a put option - Trader buys a call option thinking its price will go down. Selling the underlying asset is not an obligation. Selling a put option - Trader buys a call option thinking its price will go up. Trader must buy the underlying asset, if a buyer exercises the option. Moneyness Moneyness is the real value of an option. An option starts to lose value the minute it enters the market. The closer it gets to its expiration date, the less it's worth. Investors call this occurrence time decay. Intrinsic value is simply the difference between an option's strike price and the underlying asset's market price. Option traders calculate moneyness by adding an option's intrinsic value to its time decay value.
This article was written by: Igor Empowering Traders with Knowledge Since 2006, we have operated Traders Laboratory mainly through the contribution of our members. We provide a powerful online financial network where you can find traders from around the world discussing on numerous forums related to the financial markets.
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OPTIONS Insights
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Dr. Edward Olmstead
Covered Calls Are NOT A Conservative Trade One of the first strategies that someone new to options hears about is the covered call trade. Frequently, this strategy is touted as a safe and simple way to make money with options. Many brokerage firms allow covered calls as the only options trade that can be made in a retirement account because it is “conservative.”
U
nfortunately, this description of covered call trades as conservative is highly misleading. Ask those same brokers who only allow covered call trades in retirement accounts how they feel about selling naked puts. They will explain how that type of trade is much too risky to be allowed in a retirement account. Well, at least they got that part correct ---- selling naked puts does involve significant risk. The truth is that a covered call trade
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significant risk. The truth is that a covered call trade has exactly the same risk and reward characteristics as selling a naked put. More about this later. In its simplest form, the covered call trade requires that you own 100 shares of stock. Then you can sell one call option contract with a strike price that is above the current stock price. In this situation, the call that you sold is said to be “covered” by the stock that you own. If it happens that the option is
exercised, your brokerage account possesses the stock that must be made available for sale at the strike price. The cash received from selling the call is yours to keep no matter what happens. Here is the idealized description of what happens when the call option expires. If the stock price is above the strike price of the call at expiration, your stock will be called away for a price that is presumably higher than your original July 2012
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purchase price ---- you have made a profit on the price increase in the stock and you also have the cash received from the selling the option. If the stock price is below the strike price of the option at expiration, then the option expires worthless and you keep your stock ---- you again have the cash received from selling the option, and you are free to repeat the process by selling another call in the next option cycle. As you can see in this idealized version, the covered call trade has the potential to generate regular profits by repeatedly selling call options against stock that you own. Unfortunately, the covered call trade is not nearly as straightforward as the idealized description would suggest. Stock prices undergo considerable fluctuation over time and, all too frequently, the stock price on the expiration date will be either well above or well below the strike price of the short call. Both scenarios present a difficult decision going
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forward. If the stock price is much higher than the strike price of the call at expiration, you may be reluctant to give up your stock at a price that is well below its current level, and thus forego any future gains in the stock price. The only alternative is to buy back the short call for a significant loss in order to continue holding the stock. If the stock then fails to perform as expected, it may be quite difficult to make up for the loss incurred from buying back the short call. If the stock price is much lower than the strike price of the call at expiration, you keep the stock, but you are faced with the challenging decision of which call strike to sell for the next option cycle. If you sell a high strike in order to give the stock price room to move up, the cash received from the sale may be minuscule. On the other hand, if you sell a strike nearer to the current stock price in order to receive more cash, you lose the
opportunity for the stock to regain all of its lost value. Now let’s get back to comparing a covered call with selling a naked put. To see that these two trades have the exactly the same risk and reward characteristics, examine cases in which the stock price at expiration is either above or below the strike price of the option. To make things definite, consider a specific example. Covered call: With XYZ at $53, you buy 100 shares of stock and sell one 55 call option for $2.0 per share. This means that you have equivalently purchased 100 shares of XYZ for $51 per share. If the XYZ has fallen to $40 per share at options expiration, you will have lost $1100 on this trade. The maximum reward that you can receive on this trade is $400, which occurs when the stock price exceeds $55 at expiration. Naked put: With XYZ at $53, you sell one 55 put option for $4.0 per share which pays you $400. July 2012
OPTIONS Insights
If XYZ has fallen to $40 per share at options expiration, the option will be exercised and you will be required to buy the stock for $55 per share. Subtract the $400 you received and your loss on this trade will be $1100. The maximum reward occurs when the stock price exceeds $55 at expiration and you get to keep the $400 received from the sale of the put. One of the first strategies that someone new to options hears about is the covered call trade. Frequently, this
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strategy is touted as a safe and simple way to make money with options. Many brokerage firms allow covered calls as the only options trade that can be made in a retirement account because it is “conservative.” If you are going to do covered call trades, then be aware that it is not a conservative trade and be prepared to make a challenging decision when the options expiration date arrives. Here are some suggestions for handling covered call trades: July 2012
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OPTIONS Insights
1.Since almost all of your risk is in what you paid for the stock, focus your attention on the stock price and to a much lesser extent on the option price. Decide on an appropriate stop loss price for the stock, and if it falls to that level, protect the major portion of your investment by selling the stock and buying back the call. Do not hang onto to a falling stock in order to collect an extra $.50 per share from the short option. 2.When deciding upon the strike price of the call that you are going to sell, make sure it is a price at which you will feel comfortable in giving up your stock if necessary. If your goal is to keep your stock under all circumstances, then select a higher strike price. If you are willing to sell your stock closer to its current value, then pick a nearby strike price to bring in more cash. 3.Do not sell a call with an expiration date too far out in time. Those juicy premiums in the longer-term options are tempting, but you will generally do better by selling the front month call. In today’s volatile market, a stock can have big moves (up or down) in 4-8 weeks. By selling near term options, you will be better placed to make an adjustment when the expiration date arrives. 4.Do not be greedy. If the stock price is above the strike price at expiration, take your profit and move on to a new trade. Avoid buying back the option for a loss unless you have a very compelling reason to do so. If you buy back the option for a loss and then the stock price subsequently collapses, you will have compounded a loss on the option with a loss on the stock.
This article was written by: Dr. Edward Olmstead Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com
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TRADING Insights
Magazine
Selling Options Against The Crowd By CARLEY GARNER
C
onventional wisdom suggests that time is on the side of option sellers; after all, more options than not expire worthless and for each minute that passes, it becomes less likely it will pay off for the buyer. Accordingly, many option sellers simply sell out-of-the-money options with little attention to timing, volatility, and price. The premise is to enter the trade and let Father Time do all of the work. Unfortunately, making money in trading isn't that easy; I argue that time often works against option sellers and as a result, it is more important to make sure volatility is in your corner and avoid following the crowd.
Types Of Short Options Call
Short Call - Bearish
Put
Buy
Limited Risk/ Unlimited Profit
Sell
Unlimited Risk/ Limited Profit
Call “writers” receive income (option premium) in return for the liability of honoring the option buyer’s right to buy the futures contract at the strike price. A short call is an eroding asset to the buyer and an eroding liability to the seller.
The buyer has the right, but not the obligation to take delivery of the underlying futures contract at the stated strike price but the seller is obligated to accept the assignment of a short futures contract at the strike if the option is exercised. The seller's risk of being forced to honor the buyer’s rights diminishes with time; all else being equal the value of the option will erode. July 2012
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Short Put - Bullish Put “writers” receive income (option premium) in return for the liability of honoring the option buyer’s right to sell the futures contract at the strike price. If exercised, the option buyer has opted to exercise the right to go short a futures contract at the strike price and the put seller is obligated to buy the futures at the same price. Identical to a short call, a short put is an eroding asset to the buyer and an eroding liability to the seller. Also, the seller's risk of being forced to honor the buyer's rights diminishes with time and volatility. Some option sellers practice what is known as a delta neutral strategy in which both calls and puts are sold to create a trade without any directional bias. Nonetheless, we are going to focus on directional option selling strategy. This involves the trader selling an option in conjunction with their expectations of the price of the underlying moving in a particular direction. In this instance, the trader is entering the market with much more room for error than other directional players might, such as an option buyer or even a futures trader. Unlike a trader that buys or sells futures contracts, or practices a long option strategy, an option seller can be wrong and still make money if the circumstances are right. This concept will become more clear as we discuss a trading example.
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The additional room for error is nice for option sellers but it is the occasions when they are really wrong that have the potential to wreak havoc on their trading account. It is important that short option traders exercise risk management techniques that prevent the handful of losers from engulfing the gains and possibly the entire principal of the trading account.
Option Selling 101 The premise of option selling is to collect premium through the sale of options in hopes that the time erosion and volatility decay will overcome any adverse price movement in the underlying futures market. The strategy offers unlimited risk and limited reward, which is opposite of what many might consider rational. Nonetheless, the odds of success on any given option trade are arguably in favor of the seller over the buyer. The practice of option selling is similar to the business of selling insurance policies. Most of the time, premium is collected and kept, but there will be times in which unexpected circumstances arise and trigger "claims" against the policy, or in the case of option trading a large drawdown. In other words, the odds of success on each individual venture are high, but the challenge is to keep the magnitude of the losing ventures to a level in which it is possible to be profitable in the long run. Similar to buying a car and watching its value drop as you drive it off the lot, (all
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else being equal) options lose value with every minute that passes. In fact, some studies have suggested that somewhere between 70 to 90% of all options expire worthless. Because of these characteristics, option selling is the only strategy in which a trader can be wrong and still make money! The most common turn-offs to option selling are fears of margin calls, stories of account threatening losses but the truth is trading of any strategy involves substantial risk. At least option sellers are putting the odds in their favor. On the contrary, option buyers are in essence purchasing lottery tickets in which their risk is limited, but the odds of success are unattractive.
It Takes Money To Make Money Short option traders must be properly funded to be capable of riding out any storm that might materialize. During times of excessive market volatility, many traders turn to the limited risk of option buying and this has a tendency to inflate option prices, arguably artificially, due to the increase in demand for the securities. Also, in a more volatile market, traders often believe it is more likely that an option will have an opportunity to pay off. I argue this is a false perception because option buyers must overcome their cost of entry before turning a profit; the higher the price of the option on the way in, the bigger the obstacle to being profitable. Nevertheless, in all of the excitement traders often behave
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emotionally rather than logically; as a result, they exuberantly bid up the prices of low probability options to shocking levels. In most options and futures markets, you would want about $10,000 in a trading account for one, or two, options sold. In some of the higher margined markets such as the full-sized S&P and gold, it would likely be in your best interest to have much more. If you are undercapitalized, it is very difficult to stomach the normal ebb and flow of the market.
Most Traders Lose Money! A common mistake traders make is to blindly follow the lead of business news stations and popular financial newspapers and magazines. The ugly truth is that with most options, or leveraged futures, traders lose money. Knowing this, why in the world would you want to do what "everyone else" is doing? Instead, I feel like the best odds of success is to patiently wait for market panic or excitement of the masses and to play the other side of the trade. Warren Buffet said it simply, "Be fearful when others are greedy, and greedy when others are fearful".
On The Contrary Selling options as a contrarian isn't easy money, but I do believe it might be advantageous from an odds perspective. After all, times of directional volatility and emotion often involve excessive option premium and this makes it a great time to be an option seller.
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Of course, the trick is to be patient enough to improve the probability of your entry being at the peak of volatility and this is easier said than done. However, completely disregarding volatility when implementing a strategy could lead to painfully large losses regardless of whether the futures price ever touches your strike price.
Who Are Candidates To Sell Options? Before choosing to implement an option selling strategy, you must first honestly assess your ability to accept the prospects of unlimited risk and margin calls. Not everyone is capable of managing the emotions that come with these two characteristics of the strategy; and even those who are will have moments of weakness. Failure to keep emotions in check could mean letting losers get out of hand, or panicked liquidation at unfortunate prices. Either scenario could be psychologically and financially devastating.
Example In June of 2012 crude oil futures had dropped 27% in six weeks time with little signs of a rally on the way down. The move left prices at a technical extreme in which moderately new lows were possible but dramatically new lows were unlikely. Aside from the commodity collapse of 2007 and the financial market collapse of 2008, markets tend to stair step with the trend rather than experience one directional trade. In other words, markets typically don't go straight up or down; instead there will be digestive counter-trend bounces as
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traders square positions to adjust to the new price. At the time, market sentiment had shifted from being overly bullish in the first quarter of the year to overly bearish early late in the second quarter. Ironically, when it seems like "everyone" is bearish in a particular market, it is typically closer to a bottom than a top. The reasoning is simple, if all of the bears are in, and the bulls have thrown in the towel, there isn't anyone left to sell. At some point, a news event will act as the catalyst to prompt all of the bears who are currently short the market to cover their positions. The only way to do this is to buy their contracts back; in many circumstances, the short covering rally is even swifter than the original decline. Such position squaring moves can occur regardless of market fundamentals, seasonals, or what most analysts and traders think "should" happen. On June 21, 2012, crude oil futures had fallen $29 from their peak set on May 1st. This was one of the largest sell-offs in history and, from peak to trough, the market had yet to forge any significant short covering rallies. The result was a massively oversold market and expensively priced put options due to severe bearish sentiment and the subsequent trader demand for put options. At the same time, technical indicators were suggesting the futures market was trading at an extreme based on common oscillators and was within striking distance of major support levels set in May 2011. July 2012
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This is exactly when traders might find the best opportunities to sell options. For instance, in the midst of the panic it might have been possible to sell a September $62 crude oil put for 53 cents, or $530. The same option was worth only 17 cents ($170) just two days earlier. Although the option nearly tripled in value, the odds of crude oil being below $62 at expiration 55 days away hadn't necessarily tripled, but market expectations of such an event were at such an exuberant level traders were willing to price in such. On the contrary, already being short the 62 put prior to the two-day sell-off would be an unpleasant experience.
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This just goes to show you how important timing and volatility can be, even in a so-called passive strategy such as option selling. This short option position pays off at expiration with the price of crude anywhere above $63.47. This is because the premium collected of 53 cents, or $530, acts as a buffer to the risk of being assigned a futures contract at the strike price of $64. As you can see, it is possible for this trader to be profitable whether the market goes up, down, or sideways; the only risk is in a massive price collapse.
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The Bottom Line... Selling options can be a high probability trading strategy, but it doesn't come without stress and risk. Although option sellers are betting against extreme price moves, it is critical that traders attempt to time their entry in regard to market analysis, sentiment and, most importantly volatility. Failure to do this
will increase the odds of panicked premature liquidation, large drawdowns, or worse. Be selective and remember, it is better to miss a trade than to impatiently enter a market only to suffer the consequences of exploding market volatility, and therefore option values.
This article was written by: Carley Garner Carley Garner is the Senior Analyst for DeCarley Trading LLC where she also works as a broker. She authors widely distributed e-newsletters; for your free subscription visit www.DeCarleyTrading.com. Her books, "Currency Trading in the FOREX and Futures Markets," "A Trader's First Book on Commodities," and "Commodity Options," were published by FT Press.
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GOLD Reports
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Investors Need to Understand Basic Geology: Chris Wilson Source: Sally Lowder of The Gold Report (6/29/12)
Chris Wilson, president of Exploration Alliance, a niche consulting group, believes education is an investment basic. In this exclusive interview with The Gold Report, Wilson shares his guidelines for winnowing out the crowded junior mining sector to find the companies worth serious investigation and urges investors to know their porphyries from their narrow veins. The Gold Report: Chris, you have described the junior mining industry as being "in disarray." Do you have any ideas for investors who might want to participate in the space, but may be a bit confused or discouraged? Chris Wilson: Well, upfront I would say do not lose heart, but do not go throwing your money at just any junior at the moment. We have to find 80 million ounces (Moz) of gold a year just to replace what is being mined. That is equivalent to the whole of the production from the Carlin Trend. Clearly, any company with a significant discovery will be extremely valuable. That value will grow exponentially moving forward because new discoveries are getting harder to find. The value most likely will be unlocked by the major companies buying the juniors out. It is a big leap for a junior trying to be a miner. When the major companies are mining successfully, but not exploring successfully, acquisitions have to become part of the future. The trick will be finding juniors that have a commodity and a deposit style that are attractive to the majors. There are probably 3,000 junior explorers on the Toronto, Australian and London stock exchanges. So, you have to do your homework. First, you discount the 20% that
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have managements with a reputation for pumping and dumping or that lack technical prowess. Next, you eliminate companies working in countries you do not like for reasons of geopolitical risk. With a little bit of research you can see where mines are being built successfully and where potentially good mines are not being built. For example, take Gabriel Resources Ltd.'s (GBU:TSX) Rosia Montana mine in Romania. This mine has been in existence since Roman times. It is a 10 Moz deposit that would make a difference to the region. It would remediate the legacy of 2,000 years of mining history. But, it has been shut down by popular vote and sentiment on the Internet. Once you discard management and geopolitical risk, you have 1,500 or 1,000 names left. Next, you have to look at deposit style. Irrespective of grade, major companies do not buy small vein deposits with often complex and discontinuous ore shoots. Such deposits will always remain the remit of Junior explorers who may struggle to stack together resources or commercialize production. Neither do major companies want small copper mines with difficult metallurgy. It may take $4 billion to put a big copper porphyry into production. As an investor, you have to target companies with the potential of finding July 2012
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a deposit in the commodity of choice, probably copper, silver or gold, that has the chance to get the attention of the majors. Of course, you want to look at the number of shares a company has out there and how much cash it has in the bank. If a company is going to have to raise money in the near term, that will be dilutive and something you want to steer away from. You can go on to the System of Electronic Disclosure by Insiders (SEDI) to see if management has been selling their shares and have a look at the stock curve. If it is a typical up and down parabolic curve, it probably does that for a reason. Juniors with good assets tend not to have that parabolic curve up and down. They may have come off 20% or even 50%, but they are holding steady. What percentage of the shares is held with management? Put that into the equation. By now, the list of 3,000 companies is probably down to about 100, and that is a manageable number of companies to do your due diligence on. The last thing I would say is go and talk to a geologist. Not necessarily the company geologist, who will sell you any story the company wants. If you are going to invest in this commodity and you do not understand geology, you need to find a geologist that can help you. TGR: Is that what Exploration Alliance is? Are you essentially geologists for hire? CW: Exploration Alliance is a practical, hands-on niche consultancy started by a group of us who had worked as geologists at Ivanhoe Mines and wanted a change, a bit
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of fresh air. We tailor our services to meet the needs of junior and midtier explorers. We are the kind of consultants who can sit on boards and present to the market. We know what it takes to raise money and spend it wisely. We are very discerning when it comes to project selection and ensuring that each project achieves a definable benchmark before progressing to the next stage. Exploration is a game of statistics and most projects never make it. Over the last four or five years we have grown to a core group of 10 people. We could make it bigger, but the prerequisite to being an Exploration Alliance consultant geologist is practical, hands-on industry experience. The 10 of us have worked in over 90 countries. Most of our work has been for private groups. For example, a large, well-funded Kazakh group and a Middle Eastern trust with considerable billions in firepower, as well as some European funds. When you consult for private money, the clients just want to know if they should invest. They want the hard facts, without any lipstick on them. That suits the Exploration Alliance mandate. What has become apparent over the last two years is that the average individual commodities investor needs geology simplified. So, we are starting to morph the consultancy into an entity that interfaces more with public companies. Before we take on a job, we do our own internal review. We try to hedge our bets by taking jobs in companies that have projects of merit. Then we try to write the reports in a way that the people the report is intended for can actually understand it.
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We want to leverage our years of experience, the input and knowledge from hundreds of geologists we have worked with and our familiarity with many types of deposits. If we can simplify that and get it right, that will be valuable for the investors and for companies with good projects. We think that is where our niche will be. TGR: Do you specialize in looking for precious metals assets or all types of minerals? CW: We specialize in gold, silver and base metals—copper, lead, zinc, etc.—as well as bulk commodities such as iron ore. We have coal experience but it is limited. There is a lot of positive sentiment for gold. You can transport gold in a helicopter—fly it out of a property—without the massive capital expense and infrastructure you would have with a big copper porphyry project. TGR: You are basically banking on the idea that demand for precious metals will continue to increase. Why are you so convinced that gold will increase in value? CW: Gold is a finite resource. You've got to find 80 Moz a year to be ahead of current annual production. So, from a supply and demand perspective, each year we're spending more in exploration yet finding less. All things considered, that means that good discoveries will be increasingly valuable. In addition, politics today works in gold's favor. Recent elections prove that people do not want to vote for austerity. People vote for an easier life. In some respects, this forces governments, if they want to be reelected, to print money to keep things humming along pretty much as they have been. That is going
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to lead to inflation and to paper money being devalued. TGR: You have years of experience traveling the world, exploring for gold deposits. Some people believe all of the big deposits have been found. Do you agree? CW: Not all, but a large number of the big gold deposits have been found. Professors Roger Taylor and Peter Pollard, consulting geologists and good friends, are fond of saying that big deposits generally stick out of the ground. That is because big deposits require very large fluid circulation cells capable of carrying the metal endowment, and these hot fluids generally alter the rocks around the deposit, resulting in large and obvious alteration systems. Moreover, large deposits are generally associated with major structures and may present large geophysical targets. TGR: Based on your years with your boots on the ground, where do you think the remaining big discoveries might happen? CW: You need both a discovery and a good environment to develop a project. There are countries where you clearly should not invest even if they have good geological potential. China, for instance, has excellent potential, but I have yet to see a mining company succeed. Many people are fans of the former Soviet Union republics. They are very difficult places to get ahead. There are a lot of insider deals and corruption. Then you go to the other end of the spectrum to great mining jurisdictions where investments are safe: Canada, Australia, Peru and Chile to name a few. But, those countries have been through several cycles of exploration over the last 100 years, which
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means it is getting harder to find deposits there. So, where do you go for new discoveries and what would those new discoveries be like? This is a personal choice, but I favor less explored countries with excellent geological potential that have a manageable degree of political risk. Colombia is an obvious choice, parts of northeastern South America fit the bill, as do countries in West Africa that are emerging from conflict. West Africa has some of the greatest mines on earth. For example, Obuasi has produced 30 Moz and probably has about 35 Moz left. To date there has been over 200 Moz of gold discovered in approximately 30 mines and the potential remains excellent. West Africa was joined to northeastern South America for much of its history and shares the same geology. In comparison to West Africa, northeastern South America is significantly under-explored, so all things considered, countries such as Brazil, Suriname and Guyana have excellent potential. Venezuela also has excellent potential but the politics are problematic. There also is potential in past-producing mines. There have been some very good discoveries recently. Azimuth Resources Ltd. (AZH:TSX; AZH:ASX) is exploring around the past-producing Omai mine of 4.5 Moz in Guyana. A few weeks ago, the company announced a resource of 1.22 Moz. TGR: So, you are talking about a contiguous greenstone belt that existed millions of years ago that now extends from West Africa across the Pacific and into South America. CW: Correct, although it was actually formed 2.1 billion years ago. My point is that
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greenstone-hosted gold mineralization is well understood and has been the focus of successful exploration in West Africa, Canada and Australia. Greenstone belts of the Amazon have not been explored to the same extent. As long as you are prepared for the geopolitical risk of certain countries, you will probably get a lot of bang for your buck. There will be more world-class discoveries there than in some of the countries that have had more exploration. TGR: What is Exploration Alliance doing to reach out directly to investors with your expansive knowledge base? CW: A lot of people who invest in the junior exploration space, the midtier and to a degree in major producers have a fundamentally poor understanding of geology and key concepts. Too often, when I talk to investors, they have no idea of what a strike extension is or what makes for a great intercept. They do not know what the difference is in exploration potential between a porphyry and a narrow vein system. It is amazing that billions of dollars in speculative money is invested every year by a retail market that really does not know the basics of simple geology. That is a huge issue that needs addressing. That will become a focus of Exploration Alliance. We will keep the consultancy going because that is what keeps our edge. But, we see an opportunity to offer something along the lines of a one- or two-day course that takes people through basic geological concepts. We want to educate investors in terms of geology, as well as risk and reward. TGR: Chris, thank you for your time. July 2012
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Chris Wilson formed Exploration Alliance Ltd. in January 2007 and serves as its principal. He has been the chief executive officer of Hunter Bay Minerals Plc since May 2007. He is an established geologist with over 20 years of experience in the design, implementation and management of exploration projects from grassroots to feasibility. Wilson has worked in over 40 countries and holds a Bachelor of Science (Honors) in geology from University College of Wales, Aberystwyth, and a Ph.D. from the Flinders University of South Australia. He is a Chartered Professional Geologist, a Fellow of the Australian Institute of Mining and Metallurgy and a Fellow of the Society of Economic Geologists.
This article was written by: Sally Lowder of The Gold Report http://www.theaureport.com/pub/na/13768
Want to read more exclusive Gold Report interviews like this? Sign up for our free enewsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Exclusive Interviews page.
DISCLOSURE:
1) Chris Wilson: I personally and/or my family own shares of the following companies mentioned in this interview: Hunter Bay Minerals Plc. I personally and/or my family am paid by the following companies mentioned in this interview: Hunter Bay Minerals Plc.
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ENERGY Reports
Magazine
Falling Oil Prices Offer Great Stock Buying Opportunities: Byron King Source: Zig Lambo of The Energy Report (7/3/12) The "experts" had been talking about oil prices going to $130 per barrel. Now there's talk of $50–60 per barrel oil. Either end of that spectrum is not sustainable in the long run, says Byron King. In this exclusive interview with The Energy Report, he explains why he believes prices will settle in the $80–100 range. In the meantime, the recent pullback offers some interesting buying opportunities for investors ready to pounce when the market finds a bottom, as well as some names investors can nibble on right now. The Energy Report: Things have been pretty hectic on the global economic and financial fronts lately and the energy markets seem to be defying the expectations and predictions of many analysts. What's your take on where we are and where things are headed? Byron King: We're living with volatility, most of which is due to international currency and exchange rates. The dramatic decline in the euro has caused a capital flight to the U.S. and a strengthening of the dollar, which results in lower oil prices. The other big macro-type issues include the looming economic slowdown in China. More news stories are coming out about negative demand indicators in China, which will definitely be bad for Chinese consumption growth. The country may use less oil than people forecast. The Saudis are producing at least 1 million barrels per day (MMbbl/d) in excess of what they normally would. So, between the rising dollar, slowing growth and excess production in Saudi Arabia, we're seeing these gyrating low prices. TER: One hundred and thirty dollar per barrel oil and $5 a gallon (gal) gasoline failed to materialize as predicted, and now there's talk of $60/bbl or even $50/bbl oil in the shorter term. Some oil analysts are now predicting
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$3/gal gasoline by early November. What's your expectation? BK: Extremely high or low prices aren't realistic for the long haul. The world economy will hardly function with $130/bbl oil. The airline industry shuts down right away and much of the rest of the world will suffer accordingly. A $5/gal gasoline price makes for an instant U.S. recession. Whatever economic strength we saw in late winter and early spring got stuck in the mud when gasoline prices went over $4/gal on the East Coast and toward $5/gal in California. All of a sudden, the U.S. economy lost traction, and we're sliding back into recession. And while the world economy can't deal with high oil prices, Credit Suisse's $50/bbl oil prediction, though it may happen, would not last long. For one thing, the seven sisters of oil exporting—Saudi, Iran, Nigeria, Kuwait, United Arab Emirates, Russia and Venezuela —simply cannot afford under $85/bbl oil because they have their own bills to pay. Those lowball prices could be reached because of events, but they won't remain because of supply-and-demand economics. TER: Is the $80–90/bbl range reasonable? BK: This morning, West Texas Intermediate July 2012
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(WTI) oil was trading in the $78/bbl range. That's rather low by recent standards. A WTI price of $80/bbl is enough to keep the North American oil industry working. A $90/bbl level for Brent, the international standard, will keep the international oil industry alive. It will tighten things up for the big oil exporting countries, but they'll be able to avoid bread lines and riots. The number that oil has to find is $80–85 in North America and between $90–100 internationally. TER: Have upside speculators been chased out of this market at this point? BK: This is still a trader's market, with rising prices and falling prices. For people with a really strong stomach and money to play the short term, have at it, boys. This is your market. The last thing the traders want is for oil to stay static at $85/bbl, though the rest of the world might like that for budgeting and projecting purposes. For traders, the last couple of months have been terrific. The people who understand the market and are successful over the long term know that you sell on the way up and buy on the way down. It's a question of understanding the market dynamics. As Mark Twain said, "If you're going to throw your eggs in one basket, you have to watch that basket." When you're trading at the margins and a move one way or the other could wipe out your capital, you have to keep your eye on things. But the big oil thinkers don't worry about today's headlines. They need to think about the very long term. TER: Big companies are usually able to absorb oil price fluctuations, but what happens with the smaller companies during periods of low prices and volatility? BK: It's been a tough world out there for
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small companies without deep pockets. The energy business, in general, is for companies with money. A small gold miner versus a small oil company carries a difference of at least one or two orders of magnitude. The equivalent of a $20 million ($20M) gold company would be a $200M oil company. With the small guys, the big concerns right now are geographic and economic. If you're in the natural gas business in North America, you have to be deeply concerned. Natural gas prices are at historical lows and the cash flow just isn't there to support much development. A small company may have tens or hundreds of millions of dollars tied up in leases. If you don't somehow drill or exploit these leases in one way or another, you're going to lose them. So not only would you not be drilling or extracting, but you'd lose your leases, too. That's a terrible predicament. So what will we see in North America? There will be some cutbacks in drilling. It's already happening, but we're going to see more of it. It will affect the smaller drillers and service companies first. The big guys—Halliburton (HAL:NYSE), Schlumberger Ltd. (SLB:NYSE) and Baker Hughes Inc. (BHI:NYSE)—will also feel it but, they have much deeper pockets and they're large and international. So we'll see some rigs get stacked, but I don't think we'll see as many as some of the gloomand-doomers are forecasting. A lot of these smaller companies have to keep their geologists and engineers working and drilling or all of that money that they spent on leases in the last five to ten years goes down the drain. Overseas is another story. You almost have to take each country as you find it. Argentina is a disaster with what's going on with
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Repsol YPF SA (REP:BMAD). A couple of weeks ago, a company called Pan American Energy LLC saw its operations literally overrun by rioting workers—one of the largest and oldest fields in Argentina was almost shut down because of political issues and labor unrest. Look at Poland. A lot of people were thinking Poland was going to have its own shale gas revolution, but a couple of weeks ago, Exxon Mobil Corp. (XOM:NYSE) decided to pull out of Poland after a couple of bad wells. Now, the cynics are saying that Exxon is getting better deals from Russia. Russia is the big fish that Exxon wants to land, so it's going to walk away from Poland. One more country I'd throw in is Libya, which was a big oil producer. With the recent shale revolution, its exports almost ceased. Now, it's put a lot of things back into shape, but what I hear is that many of those repairs were jerry-rigged and could start breaking down. Secondly, the security situation is not nearly as good as the operators would like to see. TER: Do you think that there will be enough cutbacks in domestic natural gas production to trigger a price rise in the foreseeable future? BK: Prices have to rise, and they probably will rise sooner than conventional wisdom suggests. I'm sort of a contrarian by nature, but the fact is they're giving gas away as it is, so I don't see much downside from here. I do see upside potential, as well as more demand from more places. We're already seeing a complete upheaval in the electricgenerating industry with coal-fired plants. There are no new ones being built and they're scaling back on upgrading the old
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ones because they may not operate long enough to pay back. That has impacts elsewhere in U.S. industry, such as with companies that do the engineering and supply the parts, engineering and such for upgrading pollution controls on coal plants. They're about to enter their own mini-recession because of lack of business. Natural gas is also playing havoc with the renewable energy space. Natural gas-fired energy is so cheap that the windmill guys and the solar guys are losing the battle of economics on that alone. I expect to see slightly less gas supply and likely more demand than what people have anticipated. TER: What are some of the oil and gas majors that would be good shots to weather the ups and downs? BK: In the international realm, Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) is in very good shape. It is a wonderful, technology-based company that has deep pockets and a very aggressive plan to grow its resources and reserves over the coming years. Another one that I think is just a spectacularly well-run company is Statoil ASA (STO:NYSE; STL:OSE), of Norway. It is truly one of the world leaders in offshore work and has made a major commitment in North America. People in North America should know there's a new kid on the block. I think we're going to see great things from Statoil. Further down in North American domestic plays, I'm keeping my eye on a company called Denbury Resources Inc. (DNR:NYSE). Denbury is a very advanced independent as independents go—and is making a lot of
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good moves in the tertiary recovery area using carbon dioxide to get the last drops of oil out of reservoirs. In Canada, I've been following a company called Cenovus Energy Inc. (CVE:TSX; CVE:NYSE) for two years now. It is a very rapidly growing player within the Alberta oil sands play. It has lots of acreage and lots of investment to grow things with very good economics. The one major issue for Cenovus and for all of the Canadian oil sands operators is access to markets. The Keystone Pipeline debacle was not good for the oil sands players. At the same time, the Canadians are moving very firmly toward finding another way of doing it. We may or may not see that northern pipeline get built to the upper Pacific Coast, but there is certainly a plan in place to take some of that Alberta oil sands product down to Vancouver for export, which will be to the long-term, strategic detriment of the U.S. Regardless of who is president next January, we will see some sort of a Keystone Pipeline expansion to move more oil sands product out of Alberta and down into the U.S. TER: Can you give us a little more detail on the revenues and market caps of Denbury and Cenovus and where you think they might be going? BK: Cenovus is a $32 billion ($32B) market cap company. The price:earnings (P/E) is around 12. It is making money, and it pays a nice dividend—2.8%. It's been a bit of a sleeper for many investors, but I think Cenovus is a great choice for investors looking for exposure to the Canadian oil sands plays. It is a good, strong idea with a lot of upside and a lot of growth potential, and it pays a nice dividend while you're waiting.
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Denbury has a $5B market cap. The P/E is about seven, with no dividend. This is a stock where I'm looking for internal growth to bring the capital gains back to investors over the long haul. TER: What other companies are interesting at these levels? BK: I'm a big fan of the oil service sector. Right now, Schlumberger is trading down around $60. Schlumberger is one of those companies that almost never gets cheap because too many people know how good it is. When it trades in that low-$50–60 range, I always consider it a buying opportunity. When oil prices recover, that $60 Schlumberger stock is going to be an $80– 90 stock. If you can just bear with the market gyrations, it's almost a guaranteed 40–50% gain. Right now, with things as volatile as they are, investors want to be very careful about going too deep into these very turbulent waters. To the extent that you do go in, it would be with companies that have a really strong upside such as Cenovus or Schlumberger. TER: Do you have any thoughts on Encana Corp. (ECA:TSX; ECA:NYSE)? BK: Encana is also a very strong Canadian firm. It has almost a $14B market cap and a relatively high P/E of 27. But the dividend yield is a nice 4%. If you're looking for yield, Encana would do it for you, but with a P/E of 27, I think it's priced more like a growth stock than others. In this oil market, I don't know if management can really live up to those kinds of expectations. I'm not negative on it; I'm just saying, be careful.
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TER: To summarize, what do you think the average investor should be doing these days if they want to play the energy markets? BK: I would be very wary of most gas plays just because of the economics. I would also be wary of the oil service sector, with the exception of Schlumberger, which happens to be cheap but won't be cheap for long. In terms of the larger oil plays, I'd suggest Statoil for international and technical competence with a good growth profile in front of it and, in the oil sands, Cenovus. I don't want to give too long of a list to the investors out there because this is not the time to be too bold. This market could confound people greatly. We're at the beginning of a presidential election cycle where government statistics and government announcements will become completely meaningless because everything will become politicized.
There are many beaten-down ideas out there. The market is filled with underpriced value, but you want to find the best of the best of those underpriced values. I think I've given a few names in this discussion. I'll be able to sleep well at night if investors act on those. TER: Should we wait a little bit for the oil market to bottom out before it's an ideal time to get in or should people be averaging in? BK: I think people should view the market as trying to find a bottom. Right now, it's OK to nibble, but it's better to watch and wait. TER: You've given us a good overview of where you think the market might be headed and some good names to look at. Thanks again for your time. BK: Thanks for having me.
Byron King writes for Agora Financial's Daily Resource Hunter. He edits two newsletters, Energy & Scarcity Investor and Outstanding Investments. He studied geology and graduated with honors from Harvard University and holds advanced degrees from the University of Pittsburgh School of Law and the U.S. Naval War College. He has advised the U.S. Department of Defense on national energy policy. DISCLOSURE: 1) The following companies mentioned in the interview are sponsors of The Energy Report: Royal Dutch Shell Plc. Streetwise Reports does not accept stock in exchange for services. This interview was edited for clarity. 2) Byron King: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.
This article was written by: Zig Lambo of The Energy Report http://www.theenergyreport.com/pub/na/13792 Want to read more exclusive Energy Report interviews like this? Sign up for our free enewsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Exclusive Interviews page.
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By JOHN BARTLETT
Charting For Beginners This is the start of an in-magazine video course in which John Bartlett will take you by the hand and teach you the fundamental tools and techniques of financial charts & trading. It's perfect for beginners and novices who have no knowledge of charting and are seeking a simple way to understand charts from which they will have a starting base from where they can learn the in’s and out’s of technical analysis.
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Video Highlights ✓ 01:15 Intro To Charts - DJIA 1928 - 2012 ✓ 04:00 Logarithmic View ✓ 04:52 Change Historical Data Displayed On The Chart ✓ 06:20 Changing Timeframes ✓ 08:18 Bar Charts ✓ 10:40 Candlestick Charts ✓ 12:40 Heiken Ashi Charts ✓ 13:40 Histogram Chart Resources:
Charting Software: ProRealTime.com
Next Month: ✓ Trends and Trend Lines ✓ Trend Channels ✓ Support and Resistance ✓ Moving averages
This video was produced by: John Bartlett A former Independent Financial Advisor for 30 years. John has been teaching trading for over a decade. Specialising in teaching beginners in a plain English and no hype fashion, he now enjoys semi-retirement and divides his time between his homes in France and the UK. Visit John’s website to find out more... http://www.learntrading.co.uk
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