Game Theory
December 31, 2004
The Smart Profits Report: Issue #171
Friday, December 31, 2004
Game Theory: Making Profits With Mathematical Precision
By Dean Albrecht
Advisory Panelist, Mt. Vernon Research
Last night there was a terrific documentary on PBS about mathematician John Nash. So what does that have to do with options? Well, quite a bit, as it turns out.
This particular mathematician - along with going completely mad at one point in his life - won the Nobel Prize in 1994 for his work on “game theory.”
Game theory is one of the most powerful mathematical models used by modern economists to explain and predict the behavior of the markets (and many other hard-to-grasp phenomena).
Predicting the behavior of the markets has obvious advantages if you’re trading options. In fact, by using a mathematical technique I’m about to show you - one Nash might appreciate for its simplicity - you can determine both stop losses and expectations of gains on any trade you enter.
You can also time your put and call trades with greater precision. In fact, the predictability built into this approach lets you know how large a gain to expect - or how far to let the price of a stock or option drop before bailing out of the position - with mathematical precision.
Let me explain…
Finding Meaning In Repeated Patterns
The strategy of game theory uses a mathematical system where we look at historical numbers that constantly repeat themselves. (People, as Nash’s theory proved, also behave in predictable patterns.)
We test for price patterns in stocks, options and ETFs. We look at percentage moves rather than penny or dollar moves, which makes it easier for us. We then look to identify repetitive instances of price action.
For example, in our research we found that stocks on the NYSE move just a little differently than stocks traded on the Nasdaq. We also found that AMEX stocks move differently than their NYSE and Nasdaq cousins. (By moves we mean distance and by distance we mean percentages.)
Game Theory & The QQQQ
Let’s take a look at the Nasdaq index (Nasdaq: QQQQ - formerly QQQ). The “Qs”, as they’re often called, move an average of 3.5% when they change direction, up or down.
This piece of information is valuable because it allows us to set profit targets and stop losses whenever we enter a position, by giving us the precise numbers of what to expect.
The interesting thing is that the percentage didn’t change when QQQQ was trading at $50, $60 or $30.
That gives us an expectation of gain. Let’s say you buy an ETF at $40, and you know from observation that the upside potential of a move is 3.5%. From that, you also know to expect a move of about $1.50 to the upside. So once that move is completed, you can take your profits - rather than buying and holding while the trend reverses against you.
Speaking of the downside… We do studies to get statistical averages of downside expectation of price, given certain market conditions. For instance, QQQQ is currently in an uptrend (see chart below), and pullbacks are smaller than when the QQQQ is in a downtrend.
That means the downside expectation is less than the upside, so we know how far to let a stock’s price go against us in all market conditions.
How To Take Advantage of Game Theory
So how to take advantage of game theory for yourself? If you have a favorite stock that you trade, such as QQQQ, then simply do the following:
Overlay a 50-day moving average line on a daily chart going back about one year. You can easily do this online at www.bigcharts.com (see chart below):
Then plot the move of the price in percentage terms when the price goes above and below the 50-day moving average.
You’ll find that the price drifts about 8% or so above or below the 50-day moving average.
Which means your expectation of profit on this simple crossover system is about 8%.
You can also count the number of times the price moves above and below the 50-day MA line, going back several years. Now you will have a gauge on how many positions (or potential option trades) to expect per year.
This is a simple example, but it should give you an idea of how easy it is to start incorporating quantitative research, like game theory, into your own trading.
Good Trading,
Dean Albrecht
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Today’s Smart Profits Cribsheet
- At Quantitative Equity Research, where I work, instead of doing our research by hand we use automated computers screening the data based on our inputs throughout the day. But again, you can do your own “quant” research using simple techniques like the one I showed you today.
- Check out the Smart Profits Glossary, chock full of over 150 option terms like “QQQQ,” “game theory” or “technical indicators.”
Related Articles:
- Quantitative Research: An Interview with Dean Albrecht
- Fundamental Analysis: Three Screens For Technical Traders
- Portfolio Diversification: Falling In Love With Investments Can Cost You Millions
Smart Money Investing
December 30, 2004
The Smart Profits Report: Issue #164
Friday, December 03, 2004
Smart Money Investing: The Four Rules of All “Smart Money”
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
As I was escorted to my daughter’s classroom for a fifth-grade “Career Day” presentation, one of my little handlers asked me if I “got nervous” before a speech. I said yes. He asked if it was the same kind of “nervous” as the competitors on the reality show Fear Factor experience. Within seconds I was standing in front of the class, beginning my presentation, a little more nervous than I otherwise would have been…
So what does all this have to do with options trading, exactly? Nothing. Except for the fact that four of the most important rules about money are so simple, even fifth-graders can understand them.
Yet, they’re so powerful - and so basic to smart money investing - that every trader should memorize and follow these four rules before trading a single option.
Let me explain…
The Four Rules of All Smart Money Investing
My goal for the class was to try and teach them four rules regarding money that I would encourage anyone to memorize before trading options. Now, I know from experience that even adults have a hard time learning just one thing in 30 minutes. And, when it comes to managing money - it might never make any sense.
I chose four things that I believe are the most important rules of dealing with money… rules that you may want to share with your kids or other loved ones, regardless of their age.
Smart Money Rule #1 - Go With Moderation Over Excess
I started with moderation versus excess - something a kid can understand and adults often forget.
The first example I gave the kids was the “need” for everyone to buy the biggest car with the worst mileage just to get from point A to point B. To an environmentalist, that’s excessive consumption, end of story.
I don’t go that far, but to a “money person” it’s excessive spending, especially for those who have trouble making car payments. (I also used the Halloween tummy-ache example - go overboard with the candy, and you pay…)
Moderation versus excess affects our future ability to achieve financial independence… To a fifth grader this means being able to buy another video for his Game Boy. To the options trader, it is spending a lot of money chasing hot short-term trades without a system, most of which go bust, instead of focusing on high-probability trades like the LEAPS options.
Smart Money Rule #2 - Stay on the Right Side of Compounding…
Second, I talked about compounding. The example I used here was a kid who got a dollar a day and spent it on candy and the kid who put the money (some of it, at least) in the bank. At the end of the year, I explained that Child A would not only have no money, but also lots of cavities. Child B would have all the money he saved, plus something extra for “lending” the money to the bank. I was quite impressed by how many kids actually knew that banks loaned out people’s savings at higher rates - I know I did not know that at age 10.
Smart Money Rule #3 - Use Credit; Don’t Let It Use You
Third, I talked about credit. I explained good credit (buying a house) and bad credit (spending money at a restaurant and paying for it six months later). I tried to impress upon them that spending more than you can afford would likely result in a sad retirement.
I told them that they would be getting offers for credit cards in the mail once they were in their senior year of high-school. My advice: Tear up the envelope before you open it. I also explained that if they did not know how to manage credit, they could spend 30 years paying for video games that may only be played for a year. The video game themes resonated well with this crowd.
Smart Money Rule #4 - Always Own Some Tangible Assets
Finally, I brought in 450 one-dollar bills and an ounce of gold. I asked the group which they though was worth more. They all pointed to the currency. I tried to explain fiat money and what tangible assets were.
I think I lost them on this one. But, there were a lot of oohs and aahs when they saw the stack of bills. (My favorite response from one girl who picked the gold coin was, “It’s worth more because it is so shiny.” Almost right…)
The day was quite a success and I enjoyed the Q&A. I encourage you to talk to your kids and grandkids often about smart money and investing. It could be one of the best early childhood lessons that you could impart to them.
And if they want to follow you into the options market someday - and win - they’ll need to know these basics first.
Good trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- By the way, I would also like to thank YOU for all of your comments and topic recommendations, especially the following readers: Sledd S., John A., John G., Sandeep C., Steve S., Claude S., Iaron S.
Related Articles:
- Portfolio Position Sizing: The “10% Rule” for Safe Option Profits
- Position Sizing: The Most Powerful Investment Concept
- Options Flyer: Three Rules for Profiting from an Options “Flyer”
Long-Term Covered Calls
December 21, 2004
The Smart Profits Report: Issue #169
Tuesday, December 21, 2004
Long-Term Covered Calls: The Best Way to Play Sirius Satellite Radio
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
A month ago I recommended buying shares of Sirius Satellite (Nasdaq: SIRI). At the time, Sirius shares were trading far below the current prices.
I gave subscribers to the my trading service very specific reasons to buy the company now. And I included a long-term covered call play that I think is the smartest way to play Sirius.
If you don’t know what a covered call is, here’s a quick take that will help you understand the Sirius play I’m about to describe… A covered call combines two instruments: an option and a stock.
Long-Term Covered Calls Just Make Sense
It works like this: You buy shares of a company like Coca Cola at, let’s say, $50. You think Coke will go no higher than $55 in the next 12 months. If it goes higher, you will sell since that is your target price.
So far, that’s just normal investing. Well, if you can handle that, then why not make MORE money than just the $5 that you projected to make?
To do this you would SELL (or write) a $55 call option against your Coke position. You can sell one option for every 100 shares of stock you own. When you sell your call, you will be obligated to deliver the shares if requested. That may or may not happen. Nonetheless, you will be sure to receive something for the option you sold. It’s called a premium. And it can amount to a good deal of money.
One way to view this premium is as rental income on your stock. You get the “rent” the minute you sell the option.
The transaction you entered - when you sold your call and collected your premium - has one consequence you have to find acceptable. It limits your upside gain on the stock (in the Coke example, to $55), since that is the strike price at which you’re obligated to sell your shares.
Looking for Reasons NOT to Buy
What we do with the Income Trader is trade covered calls using a system and a set of criteria…
We’ll take a company that we like, such as Sirius. And the first question I ask is whether Sirius is a company I want to add to my portfolio regardless of the circumstances. (Well, almost… To me the most extreme circumstance is when the management of the company lies, or another competitor is going to put my company out of business. And these are deal breakers.)
Then I look at the fundamentals…
- Can the company survive through thick or thin?
- Does it have enough cash?
- Are the insiders unloading or loading?
- Is the business competitive?
Basically I am looking for reasons NOT to buy a company. When I am satisfied with the fundamentals, I look to the options market.
I am looking for a specific return. I want to make at least 1% to 2% per month from my picks. AND, I want to buy the shares at a whopping discount to the current price, if possible.
Simply put, I want to buy the shares at my price, or I want to be paid at least 1-2% per month for trying.
And I got Sirius at my price… in fact, we’re holding it right now…
Our trade worked out like this. We have the following possible outcome:
Either we will make close to 20% on the position in a year, or we will own Sirius for $2.10 per share. At the time our downside cushion on Sirius was about 35%. This meant that Sirius would have to fall more than 35% from the price that we paid, in order for us to lose any money.
A Downside Cushion of More Than 70%
As it stands today - only a month later - Sirius is at $7.50. This means that Sirius must fall more than $5.40 per share for us not to win on this trade. That is a downside cushion of more than 70%! Here’s the great part: Many of my readers have already made close to 20% on this trade in one month. That’s right: They did not have to wait another 12 months.
Why? That’s today’s lesson.
When you sell the right to someone to buy your shares, as you do when you are writing a covered call, the person who buys the call can exercise the option to buy your shares AT ANY time as long as they pay your strike price.
In this case, the option buyer exercised his option - for whatever reason - 12 months early. That resulted in a gain of almost 20% in one month as opposed to 12 months. That is a good trade in my book. And it is not the first time this has happened.
A couple of years ago we covered our positions on Intel, Cisco, Motorola and Oracle for average returns of 15% to 20%, more than six months prior to expiration. If we held the positions to term, we would have made 1% to 3% more. In this case, the extra six months of risk was not worth the extra gain.
So we booked our profits and got out… always a great option to have.
Good trading,
Karim Rahemtulla
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Today’s Smart Profits Crib Sheet
- Check out our Smart Profits Glossary if you are having trouble defining option terms like “covered calls” or “strike price”, it’s chock full of over 150 option terms!
- For more on covered calls, swing over to Smart Profits #180, Deep-In-The-Money Covered Calls, also by Karim.
Related Articles:
- Selling Covered Calls: Getting Cash for Stocks You Already Own
- Strike Prices:Increase Your Odds by 99%
- Options Leverage: How to Use Delta to Maximize Leverage
LEAPS Option Strategies
December 6, 2004
The Smart Profits Report: Issue #165
Monday, December 6, 2004
LEAPS Option Strategies: A Gold Strategy That Beats Stocks, Bullion or Coins…
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
Like gold? Then read this… Back in January of this year I made a recommendation to the readers of the Daily Reckoning.
Knowing that the readership was quite fond of precious metals investing, I showed them an alternative way to profit from gold while taking 90% of monetary risk off the table.
It was partly based on a recommendation I made to my readers. I can tell you about this now, because it worked like a charm, proving that the LEAPS option strategies we used was considerably more effective than buying a gold stock… or physical gold bullion… or rare coins.
Let me explain…
Securing 291% Returns With LEAPS Options Strategies
The participants in my LEAPS service closed out a position in Placer Dome a few days ago for a return of 291% in less than 12 months.
We did this using LEAPS options and a bull spread. We basically bet that the price of Placer was going higher, and instead of buying the shares for $17 we bought the LEAPS option with almost two years of time value for about $2 or so.
Let me ask you a question… If you wanted to buy gold because you thought it was going much higher, what would you rather do: invest $17,000 to make $5,000 or invest $1,800 (about 10%) to make $5,100?
Well, if your answer is $17,000 to make $5,000 then you can stop reading right now!
The beauty of options is that if you know what to do, when to do it and why to do it, you can walk away a very wealthy person in a very short period of time. Right now you have a choice: If you are interested in investing in gold because you are convinced that it is going to $500 or $600 in the next couple of years, then you need to look at the LEAPS available on gold stocks.
Four Major Gold Producers With LEAPS Options
There are four major gold producers that have LEAPS options:
- Newmont (NYSE: NEM)
- Barrick (NYSE: ABX)
- AngloGold Ashanti (NYSE: AU)
- Placer Dome (NYSE: PDG)
If the price of gold were to hit $500 per ounce, all of the above companies - except for ABX - would move between 50% and 100% in price.
Any in-the-money LEAPS purchased would increase between 300% and 700% - if this were to happen over the next two years.
If gold were to hit $600, you would be talking about 1,000% to 1,500% returns across the board with LEAPS… and with only 10% to 20% invested versus buying the shares outright. In fact, at $500 per ounce the actual dollar profits from the LEAPS would even exceed the dollar profits from the stock investment.
So LEAPS are not just one of the smartest ways I know of buying any stock - this might be the best way to play the ongoing bull market in gold, too.
Good Trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- In our Placer Dome play mentioned in today’s article, we used a “bull spread” strategy. I talk more about this powerful options-trading tool in Smart Profits #151, Understanding Bull Spreads: Make 1,000% or More by “Spreading” the Wealth
- If you’re new to the world of options trading, all the terminology can get a bit confusing for example, do you know what a call option is? To help clarify the lingo for you, feel free to vist the Smart Profits Glossary to find definitions of terms like “LEAPS” or “bull spread” found in today’s article.
- For more information about gold visit The Investment U E-Letter’s: Is Gold’s Run Done? No…
Related Articles:
- Smart Option Trading: Four Critical Truths
- Basic Trading Rules: The Four Rules of All “Smart Money”
- Using LEAPS: These Options Are Set to Run Full Tilt
Hear It From Our Premium Members...
who you have been vastly outperforming. I did very well one of your recommended positions,
one of the few good positions I've had this year. Good job. Keep up the good work!
Cheers, Regards,
"
~Bud
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What Others Have To Say...
I sold ½ of the stock per your recommendation, which returned my original investment.
I sold the remaining stock under my regular account on 4/13/2008 for $32.19 and a gain of over $4000.
On May 21, 2008, I sold remaining shares in my IRA account at $39.75 for a gain of over $5,000.
Thanks for your recommendation on this stock."
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