10 Essential Trading Words

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1. Simplicity – have a simple, well defined way to generate trading ideas. Have a simple approach towards the market. You can’t simply take everything into account when you try to make an educated decision. Filter the noise and focus on several key market components. For me, they are relative strength and earnings’ growth.

2. Common sense – create a trading system that is designed on the basis of proven trading anomaly. For example, trend following in different time frames.

3. Flexibility – be open to opportunities in both directions of the market. Be ready to get long and short.

4. Selectivity – chose only trades with the best risk/reward ratio; stocks with the best set ups; it doesn’t make sense to risk a dollar to make a dollar.

5. Don’t overtrade – two or three well planned trades in a week (month) might be more than enough to achieve your income goals. Patiently wait fot the right set up to form and offers good risk/reward ratio.

6. Exit strategy – Always, absolutelly always have an exit strategy before you initiate a trade. Know at which point the market is telling you that you are wrong and do not hesitate to cut your losses short immediatelly. Don’t be afraid or ashamed to take a trading loss. Everyone has them. Just make sure that you keep their size to a minimum.

7. Let’s profits run – one or two good trades might make your month. One or two good months might make your year. Letting profits run is as important as cutting losses short. Bigger winners will allow you the luxury to be right in less than half of the trades and still be profitable.

8. Consistency – Stick to your method of trading ideas’ generation.

9. Specialize – Specialize in one or two distinct setups. It could be a combination of technicals and fundamentals, certain timeframe or special event as a trading catalyst, certain sector or trading vehicle.

10. Have a plan – Which are stocks that you will be paying special attention to – this week, today. Why those stocks? In which direction you expect them to continue their move? What will give you a clue for the beginning of the move? Follow them exclusivelly and enter without a hesitation when they give you a signal. Don’t  just wake up and sit in front of your monitor without having a clue what are you going to trade today.

Fast moves: TRA

 

 

TRA doubled since December 08 and rose 63% for the last month, which automatically put it in my watch list. I follow closely stocks that make 50% up or down moves in a short time frame, for which I consider a month or 20 trading days. I use a liquidity filter (average daily volume above 100k) and price filter (above $2.00) in order to escape from worthless OTC stocks.

50% move in a month is unusual and there is always a strong catalyst behind it. If you understand the catalyst, then you have better chance to understand the sustainability of the move. Many traders will consider 50% move in 20 trading days insane and will blindly short. Not so fast. A good number of those stocks have strong wind behind their back and continue to rise. I have seen stocks that rise another 50 or more percent after the initial big move.

Such types of stocks move violently and it is not wise to risk more than 0.25% of your capital on them. Always use stops. If you don’t know where you will exit in case you are wrong about the move, you are very likely to fail. Know at what point you are wrong. Remember, if you use stops, you are already doing better that 90% of the traders out there.

Certainly many on the stocks that appear on my 50% moves list are bouncing from their bottom after prolonged downturn. Such bounces are usually fruit of short covering and they are not sustainable. As a result, such stocks find strong resistance as their approach their 200-day MA and provide excellent short opportunities. Watch carefully for first signs of weakening of the trend and distribution.

In the case of TRA, the stock’s fast price appreciation was driven by a takeover bid in December. Last week it reported much better than expected earnings due to strong sales, which might add more fuel to its rocket. Last Tuesday it looked that the market was expecting this report and sold off the morning earnings’ gap. As a whole the first half of last week was charackterized by weakness in the fertilizer’s industry, which was likely the main factor that sent TRA from 25 to 22, later Wednesday afternoon. The stock managed to recover most of the move in Thursday. Friday, there was sideways action on much less than the average traded volume.

As a whole, the stock has been showing some signs of distribution lately and I would not get long before it manages for clear out 25.50 on strong general market. If you try to go against the trend and short TRA, good entry would be below 24.40 with a stop at 25.30. Target is 22.00. In this case, you will risk 90 cents to make 2.40, which is almost 3:1 reward to risk ratio. It is not the best risk/reward ratio, since the stop is relatively wide: about 3.7% of the stock price.Still  3:1 is better that 1:1. It doesn’t really makes sense to risk a dollar per share in order to make a dollar per share. Such type of thinking won’t get you very far. Your goal is to be immensely profitable, when you are right and to lose a tiny part of your capital when your are wrong. Remember, many of the best traders out there are right only half of the time and often even less than that.

 Risk 0.25% of your capital. If it is 100k, you will risk $250 on that trade. 250 divided by 0.90 will give you approximately 280 shares. 280 shares * 24.40 means that this trade will engage $6832 of your trading capital.

I will try to update several times a week with new trading ideas from stocks that have appeared in my “fast moves” watch list.

Have a great trading week

A smarter way to use leveraged ETFs

Double and triple leveraged ETFs were constructed to serve mainly as short-term trading vehicles. The reason behind is that they reflect the daily change in the underlying index (or basket of stocks).

Let assume that a triple bullish ETFs is promoted at the market with a starting price of $100. If the price of the underlying index goes up 10% for the day, the price of our leveraged beast will rise to 130 (3 x 10% x $100). If, on the very next day, the price of the underlying index drops 10%, the triple levered ETF should drop by 30% x 130 and to trade at 91 by the end of the day. The net result from those two trading days is 1% drop for the underlying index and 9% drop for the triple levered one. It is a simple mathematical rule. 10% drop in a price is recovered by 11.11% rise and 10% rise in price is erased by 9.09 drop. The levered ETFs are computed in a way that you might greatly benefit by this mathematical rule during certain market conditions.

November 2008 was the birthday month of triple leveraged ETFs. Two of the first were TZA and TNA, which were supposed to reflect 3 times the daily change in Russel 2000. They were both promoted at a price around $60 per share. Let assume that you were aware of the above mentioned mathematical rule and decided to short 50,000 worth of TZA and 50,000 worth of TNA in order to hedge your position. The net results is that you are short 834 shares of TZA and short 834 shares of TNA. Three and a half months later, the triple bearish TZA is traded at $56 and the triple bullish TNA is traded at 25. You decide to cover your short positions and in TZA you make $4 per share or $3,336 for the position; in TNA you make $35 per share or $29,190 for the whole position. The net result is $ 32,526 gain or 32.52% for 3.5 months. For the same period Russel 2000 is down about 16%.

This strategy provides best results and is safer to be used in range-bound markets, since more often retracements to a moving average will have higher depreciating effect on both levered ETFs. During periods of strong trending markets, the strategy could be detrimental for your portfolio if you don’t have percentage stops in place. Nothing goes straight up or down, but there are always exclusions and you should consider them in your risk management models. Chose levered ETFs that are well diversified, representing various sectors.

Options and Earnings



Options could be very useful tools for your trading arsenal during the highly volatile times of earnings’ season. They offer various combinations for more precise risk and performance management.

Selling a strangle (two OTM options)

Let take for example CME, which reports tomorrow, before market open. It is currently trading for $ 166.14. You look at its option chain and notice that: FEB 150 PUT is trading for $5.80 and FEB 180 CALL is trading for $6.80. You figure out that their earnings’ report won’t cause a significant stock’s move in neither direction. Then, you decide to benefit from the elevated implied volatility before the announcement by collecting premium from selling the above mentioned out-of-the-money contracts. The net result: a premium of 12.60 (1260 for the strangle) in your pocket.
– you keep the entire premium if CME closes in the 150-180 range at option expiration, which in this case is FEB 20;
– the position is profitable in the 137.40 – 192.60 range, since the received 12.60 premium upfront will offset a possible appreaciation in the put option if CME dives (break-even at 137.40 – brokers’ commisions) and it will offset possible appreaciation of the call option if CME jumps up (break-even at 192.60 – broker’s commisions);
– the downside of this strategy is unlimited and losses starts below 137.40 and above 192.60;

Selling a credit spread

Let say you are bearish on CME, but you don’t want to short the stock in front of an earnings’ event that might move it 20 points overnight in either direction. You don’t want to buy a put option of the stock, because premiums before such major announcement are highly elevated. An alternative approach for your bearishness is to use a bear call spread. In our CME example, you might buy FEB 175 CALL for 8.50 and sell FEB 160 CALL for 15.50. The net result is $7.00 in your pocket.
– your maximum gain could be $7.00 (or 700 for the spread) if CME closes below 160 at options’ expiration (FEB 20), because in such case both options will expire worthless and you will keep the credit;
– your maximum loss is $8.00 (or 800 for the spread) if CME closes above 175 at expiration, since at 175 your long call (FEB 175) will be worthless and your short call (FEB 160) will costs $15.00 per share;
– Break-even is at $167;

Call Ratio Backspread

Let say that you expect CME’s earnings report tomorrow to cause a significant move in the stock. You don’t want to buy a strangle or call and to pay premium before earnings and you have bullish expectations. In this case you might sell FEB 160 CALL for $15.50 and use the proceeds to buy 2 out-of-the-money calls. For example you might purchase two FEB 175 CALLS for 8.60 each or a total of 17.20. The net result will be a money outflow of $1.70 (17.2 – 15.5).
– maximum gain is unlimited and starts above 191.70; At 190, the short call cost 30, but the two long calls cost 15.00 each and from 190 + 1.70 up, the long position will appreciate much faster than the short, resulting in a net gain.
– maximum loss is 16.70. If CME closes at 175 at options’ expiration, your short call position will cost $15.00 and your long calls will be worthless;
– if CME dives on earnings and closes below 160 at options’ expiration, all calls will be worthless and your loss will be limited to the paid premium difference of 1.70 per share (or 170 for the whole spread);

There are many other way to utilize options for hedging and speculation and I might talk about them in another post.