Using a Probability Calculator
June 30, 2005
The Smart Profits Report: Issue #221
Thursday, June 30, 2005
Using a Probability Calculator - Know Your Trade’s Exact Chance of Success Up Front
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
I like to use as many tools as possible when trading options, and there’s one tool I always check before actually making the trade.
That tool is called a “probability calculator.”
A probability calculator will give you the odds of the stock price being above or below your option position’s breakeven point (or any point, for that matter) based on all the factors that affect your option at that moment in time. The three most important factors are:
- Price of the underlying security
- Time until expiration
- Volatility
Here’s a snapshot sample of a probability calculator that I use, and that you can use for free (it’s from: http://www.optionvueresearch.com/marketvue.aspx#):
As some of you might know already, I spend lots of my time watching the Walt Disney Co. (DIS). As I live in Orlando, FL, that company consumes every inch of the area. So, it’s hard not to be influenced by Mickey Mouse.
The probability calculator above shows me the chances of whether DIS will get down to my breakeven area of $22.40/share by option expiration in August. As I like to sell put options on DIS, and on this particular trade, my breakeven price of my short option (where I would start to lose money on the trade) is $22.40/share.
A 96% Chance at Success With DIS
Based on the current price of DIS - with 54 days remaining until August options expiration, and with a volatility estimate of 20% - the probability calculator is telling me that DIS has only a 3.4% chance of finishing below $22.40/share by the expiration on August 19, 2005. This figure is seen in the box labeled “Finishing below lowest target.”
So this means that I have a better than 96% chance of having a successful trade. I like that.
To use the calculator, you must type in each of the parameters in the top section, and then hit the “GO!” button. Not only does the calculator give the probability of the stock being at your breakeven point at expiration, it also gives you the probability of the stock EVER hitting your price at sometime during the life of the trade.
In my particular case, the chance of DIS ever hitting my breakeven point is only 13.6%. Still a great probability for me to take the short put option position.
Using the Calculator for Straddles
The calculator is also good for those who like to trade straddles, as it will give you the chances of the stock moving either above or below the two breakeven points by options expiration, or any time during the trade.
Look at the example below:
In this case, we’re buying an October $25 straddle (buying an October $25 call and $25 put together), for a total price of $2.40 per straddle.
To find our breakeven points, we first add and then subtract $2.40 from the current price of $25.63, and plug those numbers into the top section and hit GO!
The bottom section shows us that we have a 16.1% chance of DIS finishing at our lower breakeven, or a 25.1% chance of DIS finishing above $28.
Watching for the Breakeven Point
What you’ll notice about this particular trade, as is most often the case with straddles, is that the stock can hit your breakeven points at some time during the trade.
That’s when you either have to cash out or make an adjustment. The calculator is telling us that there is a 63.8% chance and a 91.7% chance that DIS will hit one of our breakeven points sometime during the life of the trade. That’s when you have to make your move.
These aren’t some hocus-pocus numbers. Probability is the basis of all options trading. Will the underlying stock get to our price or not? If so, will it do it in the time allotted, or will the level of volatility hold it back? That’s what the calculator will do for you. It takes all your input parameters and gives you your chances of being successful (or not successful) at that moment in time.
Every day, the figures will be different. DIS will be at a different price, there will be one less day to expiration, and the volatility assumption might change. But the use is still the same. It’s giving you an idea of your chances of winning based on your assumptions.
So, the next time you want to make an options trade, use a great tool and take a look at your probability of success.
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Today’s Smart Profits Cribsheet
- One of the factors used with the calculator is volatility… To learn more about volatility as it is related to options, read Smart Profits Report #107 - How to Pay $27 for a $50 Stock.
- Find that you need some clarification on option terms like “volatility”, “probability calculator” or “straddle” check out our Smart Profits Glossary, chock full of over 150 option terms!
Good trading,
Lee
Related Articles:
- Technical Analysis - Three “Fundamental” Screens - For Technical Traders
- Straddles Options - Using a Straddle for Safe, Double-Digit Gains in a Cagey Market
- Smart Profits Report Recommended Option Books
Option Trading Recommendations
June 28, 2005
The Smart Profits Report: Issue #220
Tuesday, June 28, 2005
Option Trading Recommendations: What Investment “Gurus” Do When No One’s Looking
By Karim Rahemtulla
Chairman, Mt. Vernon Research
While having lunch recently at Montien, an excellent Thai restaurant on Stuart Street in downtown Boston, I was engaged in a conversation with Kevin Kerr of the Resource Trader Alert and Lee Lowell of The Mt. Vernon Options Club. The subject was exploding soybeans. No, this was not a conversation about some gastro-intestinal issues suffered from the previous night’s dinner. It was about the action in the soybean market.
Kevin was involved in a bull-spread trade involving soybeans. He could not contain his excitement about the move in this commodity. It was up 18 cents, which may not sound like much, but in commodity-land, this is a huge move as the underlying multiplier is in the thousands. What struck me more than the trade was the palpable enthusiasm in Kevin’s voice. His passion was evident. And what’s more, I understood it well.
When we make option trading recommendations to you, the reader, you should know that we care deeply about what happens with the trade. If it goes up, we get excited right along with you; if it goes down, it can ruin an otherwise beautiful weekend.
Inside the Mind of a Professional Investor
Some might think that this is “just a job” for me and for my colleagues. But if this were just a job, we’d most likely stop doing it on weekends, holidays and, in some cases, in our sleep.
Fact is, we live, eat and breathe this stuff. It is on our minds all the time, and each time we make a recommendation, we are confident that it will be a winner. Sometimes it doesn’t work out and stop losses are triggered.
Sometimes we regret using stop losses, as we see a turn in the market or an option that actually would have made us and our track records look much better in hindsight.
I recall a LEAPS trade we made a few months ago. It was AngloGold. The option began its journey at $5, moved up to $6.80, and was a hair from allowing me to “leg” into a bull spread, one of my favorite trades. It would have taken 95% of the risk off the table.
But then gold turned suddenly and the options went down, triggering our sell stop.
Two weeks later, Anglo rebounded and, had we held on, we would have been off to the races again.
It stung - hard. But long term, I know that stop losses pay off. But I also know that a lot of folks who made the trade must have shook their heads at what could have been.
I was right there with you myself.
Our Obsession With the Markets Is Good for You - And Us
Anyways, back to the conversation at Montien… We all commiserated about the upcoming July 4 holiday. Not that we don’t like holidays, they are important.
But we are all on a 5-on-2-off schedule. Weekends are days off - a long weekend throws us out of sync. To us, July 4 means that we have no choice but to find something to do.
The markets are closed, the kids are at home and it’ll be time to relax - kind of. (I swear that if we were growing up today we would all be diagnosed with ADHD.)
So, the next time you wonder what we do in our spare time, here is a hint: We wait for the workweek to get started. Whether we are at home, at the office or on the road, we want to be at work, looking for the next opportunity for you… and for us.
Great trading,
Karim
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for definitions of terms like “LEAPS” or “bull spread” found in today’s article.
- For more information about Lee Lowell you can read his online biography.
Related Articles:
- Option Pitfalls: Avoid These Five Options “Red Flags”
- Position Sizing: The Most Powerful Investment Concept
- Hedging & Speculating: How to Enjoy Guaranteed Monthly Income With Options
Learning Options Trading
June 24, 2005
The Smart Profits Report: Issue #219
Friday, June 24, 2005
Learning Options Trading: How to Increase Your Options Understanding Ten-fold
By Mt. Vernon Research Team
Former Options Specialist with Mt. Vernon Research
In my last report, I talked about learning to trust your gut when it comes to learning options trading and trading options…
And I mentioned some specific cases in which you should always trust your gut - there were five of them, to be exact.
Today I want to hedge that “trust your gut” position by saying that you can’t trust your own feelings in every situation. Those feelings, while worth paying attention to, are not always good guides when it comes to trading.
For example…
- I’ve suggested many a trade that brought letters asking if I’d missed tightening a screw that morning. My system exploits some quite obscure phenomena, complex signals and tons of data. So I’m bound to come up with recommendations that don’t go down easily with everyone. Yet usually, they worked out just fine, just as I expected they would.
- And of course, I’ve suggested trades that I and my readers thought were brilliant, only to have those be the ones that failed.
So how can you tell when your gut’s leading you astray? There’s a way to get past this conundrum of when to trust and when to make your own decision, even though you don’t yet know enough to be sure you’re right… Let me explain…
The Importance of “Keeping Score”
First, you should always keep score. When you decide to skip a trade, do yourself a huge favor: Keep track of it anyway.
That’s right: I’m suggesting that you follow the trades you skipped, as if you were in.
Learn whether it worked out. If it did, try to understand why. This will do wonders for your confidence, and you need confidence (but not overconfidence) to be a good trader. It will enhance your understanding ten-fold.
One caveat here: I’m not talking about paper trading a bunch of trades at the beginning of signing on to a service to see if you like it, which I consider fairly worthless for most people.
I am talking about skipping an occasional trade that makes you extra-suspicious, and finding out what happened. This is how you find out where your boundaries are and whether they are realistic.
Gaining Mastery, Learning to Trust Yourself
At the beginning of your trading career, alas, your feelings are probably going to be a terrible guide to what to do. And your advisor’s system may be one that meshes well with your personal approach - or it may not.
You will only find out by trying it wholeheartedly and faithfully, even though a few of those tests may be on paper.
By learning what works, your own intuitions and feelings will become more reliable as they are based in real experience.
Then you’ll be able to trust yourself, and that’s the best of all.
Good trading,
Mt. Vernon Research
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for definitions of words like “paper trading” or “hedging” found in today’s article.
- Looking for more articles on options strategies? Try Smart Profits #282, Option Trading Strategies - Option Plays That “Earn” Their Keep… To the Tune of 633%
Related Articles:
- Option Pitfalls: Avoid These Five Options “Red Flags”
- Become A Better Trader: Small Changes You Can Make For Big Profits
Option Pitfalls
June 21, 2005
The Smart Profits Report: Issue #218
Tuesday, June 21, 2005
Option Pitfalls: Avoid These Five Options “Red Flags”
By Mt. Vernon Research Team
Mt. Vernon Research
Sometimes you have to trust other people… When you’re in for surgery and the anesthesiologist knocks you out, you don’t have a choice. You have to assume the staff is not going to insert a Whoopee cushion under your ribs.
When you are just beginning to invest, and especially when beginning to trade options, you will probably do a lot of trusting, too. Even for the self-directed, it is unavoidable, but you still need to be aware of a few option pitfalls.
A few examples:
- We generally believe the authors of the trading books we read know their stuff… And having read many of them on my way to learning, I can assure you: that’s not universally true.
- If you go to a seminar, you trust the tips you learn are true. Some aren’t.
- And even if you subscribe to a trading advisory, you trust your advisor to give you the best of the potential trades he or she finds, not to save the best trades for his own portfolio.
But I encourage you to learn not to trust authors, advisors or “gurus” too much.
Instead, learn to trust your gut feelings, as well… Starting with the five guidelines I lay out below.
Follow With Eyes Wide Open
One of the questions that new subscribers to my options-trading service often ask me is whether they should take every trade I suggest. My answer: I don’t have a black-box system that avers you must follow every trade or you will spoil the golden machine. (And if anyone tries to sell you one, slam the door fast.)
So, on the surface, the answer is “no, you don’t have to take every trade.”
But which ones do you skip? Now, there’s a problem. How will you know unless you know so much you hardly need an advisor?
It has been my experience after interacting with traders for many years that the trades people skip - especially new traders - are usually the ones they should have taken. It’s almost uncanny and certainly against chance how often they’ll reject the best trades.
The very thing that tends to make a new trader nervous is often exactly the thing that makes it a better play. It will be unexpected and you will have a bit of edge going against the crowd because your advisor sees something that others with fewer well-sharpened and well-seasoned analytical tools are overlooking.
Option Pitfalls: Five Signs You Should Skip a Trade
Still, even though I work with new traders all the time, I don’t encourage anyone to depend too much. And I say that you should never do anything that makes you extremely uncomfortable.
So what are the rules for picking and choosing? Simple:
In general, I say that if my service or any other one suggests a trade that seems outlandishly risky to you, you should skip it.
- If you don’t understand why the advisor believes the trade will work out, you should skip it.
- If it makes no sense, you should skip it.
- If it requires more investment than you find comfortable, you should skip it.
- If you think the premise behind the trade is wrong (and all of us will be wrong sometimes), you should skip it.
- Now this is good advice, but it is only half of it…
Next time, I’ll talk about the importance of tracking your trades - even the ones you don’t make. But more on that in Thursday’s report… Until then…
Good trading,
Mt. Vernon Research
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for definitions of terms like “derivatives” or “index options.”
Related Articles:
- What Investment “Gurus” Do When No One’s Looking
- Smart Profits Trading: Four Critical Truths
- Position Sizing - The Most Powerful Investment Concept
The Chicago Board of Options Exchange
June 15, 2005
The Smart Profits Report: Issue #217
Wednesday, June 15, 2005
The Chicago Board of Options Exchange: The Website Every Options Trader Should Know
By Karim Rahemtulla
Chairman, Mt. Vernon Research
There’s a lot of information out there. One of the things that we pride ourselves on is education (that’s a boring term for what we’re really doing: preparing you to do battle in the options arena).
We want you to learn more about options, more about strategies, and more about using options as part of your overall portfolio.
There are few websites out there that deliver the goods when it comes to learning about options. One of my favorites is the Chicago Board Options Exchange’s site - www.cboe.com.
The CBOE (Chicago Board Options Exchange) is one of the highest, if not THE highest, authority on options trading. And the website reflects that.
It is an SEC-regulated options exchange that provides investors with very important tools and education about options, ranging from complex strategies to calculating returns.
Where I Go for Fast, Free Online Options Info
In all of my options services, I make it a point to use the methodology that the CBOE uses for calculations of returns and explanations of how strategies work. Of course, your ultimate returns depend on how you use a strategy, where you use the strategy (an IRA, for example), and the tax implications of your transactions.
What the CBOE and other sites contribute is the nuts and bolts of options, written by options principals and experts licensed in the field of options.
And the great news: Most of this stuff is absolutely free.
A few examples of the “Trading Tools” offered at the CBOE site:
- Volatility optimizer: This includes a powerful options calculator that lets you calculate exactly how much you should pay for an option…
- Symbol directory
- New options listings
- Expiration calendar and a listing of holidays
- Cycle and strike month codes
Also, under “Quotes,” you can find current prices for all options listed on the exchange (the delayed quotes are good, but you can also fork over some dough for a premium membership to the site and get live updated data, as well).
I would absolutely encourage you to spend time exploring the CBOE site. It’s just one more resource you’ll need as someone who uses options - not just someone who “plays” options.
More Online Resources You Can Use Now
Of course, the resources you get through Smart Profits include folks who’ve traded on the floors of the markets themselves.
Take Lee Lowell, for example. Lee was an actual floor trader and market maker on the NYMEX who not only held numerous licenses, but was also on the hook for millions of dollars of REAL money changing hands at a hectic pace.
His experience with REAL money and REAL trading takes a lot of weight with me. It is the ultimate indicator of how well he knows his stuff - well enough that a lot of deep pockets trusted him to execute the right strategy and more importantly, UNDERSTAND what he was doing.
Lee also happens to be one of our most web-savvy advisors… Here are a few of the websites Lee recommends:
- www.ivolatility.com is an amazing site for volatility information, both historical and implied, and it helps me weed out stocks that have cheap and expensive options. Check out their volatility charts and option calculator.
- www.888options.com is the website for the Options Industry Council. Their main job is to get the word out to investors that options are available and useful for trading. The council does not charge fees, and you can call them toll-free with any option question you have. They also offer free software called the Options Investigator on CD-ROM.
- www.medved.net has software you can download for free called QuoteTracker that is great if you are looking for a free quote platform for stocks and indexes. QuoteTracker is a program that integrates with various datafeeds, brokers and financial sites to provide you with streaming real-time quotes, live intraday charts with technical indicators, Level II quotes, time and sales, alerts, news monitoring - and almost everything else you might need to effectively trade in today’s market.
So check out all the websites here, starting with the Chicago Board of Options Exchange. And remember: The best options traders take advantage of every good resource available - especially the free ones.
Regards,
Karim
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for definitions of option terms like “CBOE” or “market maker” found in today’s article.
- For more info on other websites that can help you with your day to day trading, swing over to Smart Profits #214, Technical Analysis - Two Simple Tools for Spotting a Technical Trend.
Related Articles:
- Smart Profits Report Recommended Website Listing
- Exit Strategies: Prenuptial Agreements for Options
- How the Market Makers Lose: Uneven Trades and Open Positions
Spread Trades & The Market Maker
June 13, 2005
The Smart Profits Report: Issue #216
Monday, June 13, 2005
Spread Trades & The Market Maker - Two Valuable Options Lessons From Boston
By Karim Rahemtulla
Chairman, Mt. Vernon Research
When was the last time a market maker from the NYMEX shared his secrets with you? Or an oil trader from the pits in New York explained how he covers $17,500 a month just for the privilege of trading on the floor?
These were just a couple of the insights at the recent Options and Traders Conference in Boston, where the line-up of speakers and information was excellent. But they weren’t the only profitable secrets investors heard about.
Today, I’m going to share with you two of my favorite secrets that the audience found profitable.
- One of them is among my favorite ways to play options. It allows you to limit risk without capping your profit potential too tightly. This is the “spread” trade. Less than 1% of traders out there are using it, but today I’ll give you the inside scoop on how it’s done, so you can start making gains right away.
- The other secret has to do with market makers. In fact, it answers that long-held enigma: What do market makers really do? Once you know the answer, you might not want to blame the market maker the next time you don’t get filled.
Let’s dig right in, starting with spreads…
Anatomy of the Perfect Spread Trade
In a spread trade, you try to limit your downside risk in exchange for some limitations on the upside… How? You buy and sell options in such as way that you buy at one price and sell at another price.
There are several types of spread trades. Some are based on time; some on price; some on other factors…
I like to use spreads AFTER I am already profitable in a trade. This way, I can pull most of my money off the table and maintain a very healthy profit target.
An example of this trade was when we shorted crude using the XLE LEAPS (long-term options). We bought the XLE puts for $2.45, and when oil fell, we were able to sell another put with a lower strike price (a bear put spread) and recoup ALL of our investment that we made in the initial trade.
This way we have $0 at risk to make $2 per contract if we hold until expiration and the trade moves in our favor. At worst, at expiration we will lose $0 on a 10-contract trade, and at best, we will make $2,000 on the same trade. Who says there is no free lunch?
Another time that I like to use spreads is when an option is very expensive. In order to reduce my cost and exposure, I will engage in a spread. This way I will still make a profit if the trade goes well, but I can cut my risk by 50% or more in case it goes sour.
I was happy to see that many of the top professionals in the industry not only embraced spreads as a sound strategy, but also were using it on a daily basis to rein in risk.
Dispelling Market-Maker Myths
The second secret that came out of Boston answered the age-old question of what market makers actually do…
This revelation came from one of my favorite options experts, Lee Lowell.
Some questions the audience asked were: Are market makers manipulative? Do they “suck” ordinary traders out of their positions? No, says Lee, because it’s really not in their best interest.
Lee was a market maker on the NYMEX for seven years. He knows his stuff. As he put it: “It’s not always the market makers who are playing the games. I should know: I was one of them.”
So what does a market maker actually do?
“In the simplest terms,” says Lee, “a market maker helps facilitate the execution of a trade by providing a continuous bid-and-ask market for a futures or options contract to any interested party.”
He also says market makers aren’t out to get the average trader: “When you ask your broker for a quote from the floor (which you should always do before placing ANY futures option trade), the market makers don’t know whether you want to buy or sell, so they aren’t out to get you.”
As Lee points out, a seat lease on the NYMEX costs about $17,000 a month, and a seat to buy cost $1.8 million! If you’re a market maker who leases a seat, you’re already in the hole $17,500 come the first of the month.
So in order to survive, you simply MUST provide a continuous flow of good, fair and quality quotes.
Next time your order doesn’t get filled, you might not want to automatically blame the market maker… You might want to have a little talk with your broker, instead.
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary, chock full of over 150 option terms like “spread trade” & “market maker” found in the article above.
- Lee Lowell talks more about the market makers in Smart Profits #241, Market Makers - Hand Signals, Stress and Million-Dollar Trades.
- Looking for another article on spread trades? Swing on over to Smart Profits #280, Spread Trades: Bull vs. Bear.
Good trading,
Karim
Related Articles:
- What Market Makers Really Do
- Understanding Bull Spreads - Make 1,000% or More by “Spreading” the Wealth
- Liquidity & Limit Orders - An Options Balancing Act
Index Options
June 9, 2005
The Smart Profits Report: Issue #215
Thursday, June 9, 2005
Index Options - A Billionaire’s Trading Tool Anyone Can Use
By Karim Rahemtulla
Chairman, Mt. Vernon Research
Most investors think that index options plays are tied only to individual stocks.
If you like Google, you buy a call.
Fact is, you can now buy options based on whole sectors, indexes or funds… not just individual companies.
If you are a bond bull, you can buy an option on a bond fund, for example.
These options can be extremely powerful to you as an investor. You can use them to accomplish a whole range of investing goals that single-stock-based options just cannot provide.
Let me explain…
How to Profit From Your “Market Wisdom”
It seems that every day, traders can choose from an ever-increasing number of options - name an investment and someone somewhere is selling options on it.
With index options, for example, you can trade your broad market opinions easily. Think the market is going to tank, buy a put on the Dow… or one of the S&P indexes… or the Nasdaq… or even the Fortune 500. (Or if you think we’re headed for a recovery, you can buy calls on those same indexes.)
Hate energy stocks? Short the energy ETF (Exchange Traded Fund).
How about chips - not the kind you munch while watching sports, but the type that operate everything from your computer to your washing machine? If you think semiconductor chips are going to be in high demand, you can trade the SMH, a basket of the top semiconductor stocks.
Index options are ideal for positions you want to take for strategic reasons when you don’t want to own shares for the longer term.
And if you think your portfolio lacks a certain balance, but you don’t have a particular stock in mind to fill the hole, you can just as easily buy a call on one of the sector options and participate in a rally without adding a single stock to your holdings.
Hedge Like the Billionaires
These “other” options are particularly suitable for one of the most conservative option plays, too -hedging. If you think your portfolio of tech stocks is vulnerable, but you don’t want to sell your shares, an easy-to-do put on the QQQQs - which is composed of the top 100 Nasdaq stocks - would bring you gains in your options to offset the losses in your stocks if you were right.
This is exactly the kind of safety-valve mechanism the ultra-rich access using hedge funds…
Let’s say you want to hedge a particular portion of your stock holdings, such as all of your NYSE stocks. You can do it just by going short with a put on the corresponding index or fund…
All this means you no longer have to risk thousands of dollars shorting stocks - with the unlimited risk that involves - to insure your portfolio against losses or simply to take a bearish position.
Index Options As Powerful Tools Are New - But Valuable
The message behind this explosion in options investments is: If there is demand, someone will create an option for it and one of the exchanges will list it.
As an individual investor this has greatly expanded your alternatives in just a few years. It might be time for you to start taking advantage.
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Today’s Smart Profits Cribsheet
- For more information on ETFs and their options, visit the www.amex.com website.
- Check out the Smart Profits Glossary for option term definitions like “ETF” or “QQQQ.”
Good trading,
Karim
Related Articles:
-
Fundamental Analysis - Three Screens For Technical Traders
Advance-Decline Line
June 7, 2005
The Smart Profits Report: Issue #474
Friday, November 16, 2007
The Advance-Decline Line: This Technical Analysis Indicator Will Show You Where The Market Is Headed Next
By Jim Stanton
Quantitative & Technical Analyst, Mt. Vernon Research
I got a phone call the other day from a friend of mine. Knowing that I’ve been in the finance and investment business for over 30 years, he turned to me to give him some answers.
His question was very simple - and he’s certainly not the only investor asking it these days: "What’s the deal with the market, man?"
Quite a task, considering how volatile and unpredictable it’s been over the past few weeks! But thanks to my many years of research and experience, plus my cutting-edge analytical system, I was able to give him some clues. And now I’m going to give you some, too. And we’re going to do it using one of the most powerful, reliable technical analysis indicators in the business, the Advance-Decline line…
Don’t Let Technicals Terrify You… Here’s One The Simplest, Most Revealing Market Indicators
When a bull market is in full swing, most ordinary investors don’t realize that in order for the run to continue, it needs a number of technical indicators to sustain its momentum. Some of the most common include:
- Increased trading volume
- Stocks making higher highs and higher lows
- Continued price action above important moving averages
- Holding support on market pullbacks
- Participation in the rally by all the indexes
But there’s another very important market indicator - and you don’t get many simpler ones than this. It’s called the Advance-Decline line. Simply put, this is a cumulative calculation, where the number of advancing (or declining) stocks is added (or subtracted) to the previous day’s total.
Typically, the Advance-Decline line should increase over time during a bull market or rally, and decline during a bear market or pullback.
Let me give you a real-life example of this indicator at work…
Giddy Investors Got Burned - Smart Investors Were Clued In
On October 31, the Nasdaq 100 index bolted to a new high for the year. Happy Halloween, right? Not so fast. Just as giddy investors prepared to ride the rally all the way to the end of the year, I spotted something that should have truly spooked them. The Nasdaq Advance-Decline was vastly underperforming the main index. A significant red flag.
Below is a chart of the cumulative Advance-Decline line for the Nasdaq exchange from mid June to the present date.
As the chart shows, the Advance-Decline reading was very high throughout June and the first part of July, as all the major indexes set new highs for the year. But just look at the way the line totally fell off the cliff in mid July. That coincided with the brutal market correction that bottomed out in mid August.
The indexes then rallied strongly off those August lows and went on to make new highs for the year on October 11. However, the Nasdaq 100, which was performing stronger than the other indexes, rebounded more strongly off the August lows. It actually continued to climb until the end of October, while the Dow and S&P 500 did not. (When looking for potential market weakness, it’s always better to take the readings from the index that has led the way).
But here’s where the Advance-Decline reading can really tip you off…
Look At What The Herd Is Doing With The Advance-Decline Line
As you can see, despite the August-October 11 rally, the Advance-Decline line didn’t make much headway. This was the first warning sign - but it got worse from there. Even though the Nasdaq 100 continued to move higher and set new 2007 highs at the end of October, not only did the Advance-Decline line lose ground, it was trading below the August lows.
Okay, so what does this mean? Simply put, this tells us that the Nasdaq rally from mid August was very narrow and was moving higher on fewer rising stocks. In this case, mammoth tech companies like Google (Nasdaq: GOOG), Apple (Nasdaq: AAPL), and Research in Motion (Nasdaq: RIMM) were supporting the Nasdaq.
This type of technical weakness in the Advance-Decline line is usually a key sign that the rally is running out of steam and that a reversal is becoming more likely.
On November 2, just two days after the Nasdaq 100 set a new 2007 high, I sent out a market update to my ESP Profit System subscribers. In it, I highlighted the vast underperformance of the Nasdaq Advance-Decline line.
And one look at the stock market’s brutal performance this month shows you that this weakness turned out to be a very accurate warning sign. Just 10 days later (November 12), the Nasdaq 100 had slumped 11.5%, from its 52-week high of 2,239 on October 31 to 1,980 - its lowest level since September 17.
Who Cares About Bulls Or Bears? The Advance-Decline Line Satisfies Both
The example above shows you how the Advance-Decline line is an invaluable indicator during rising markets. But you can also use it when the market is declining.
If an index is falling and approaching a support area, we’d be looking for relative strength in the Advance-Decline line for signs of a potential reversal. If that’s the case, it means the selling is occurring in fewer and fewer stocks and a reversal to the upside becomes more likely.
Although a divergence in the Advance-Decline line is not required for a market reversal, when it does occur, we want to be sure to wait for the index’s price action to confirm the move. The above example demonstrates this well: Although the Advance-Decline line began falling sharply on October 12, the Nasdaq indexes continued to rally and did not signal a breakdown until the first week of November.
You can find Advance-Decline statistics for the NYSE, Nasdaq and AMEX here.
Good investing,
Jim Stanton
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Today’s Smart Profits Action Center
- Jim Stanton is the Investment Director of the ESP Profit System (ESP), a cutting-edge, computerized trading platform that nails down the movement of stocks and indexes with pinpoint accuracy. Not only will you learn what’s going to happen, you’ll also find out when it will occur, and how much the asset could move, so you know exactly what action to take.
For three decades as a stockbroker, bond broker and commodity trader, Jim has used this powerful blend of technical analysis, chart pattern recognition, and quantitative data to make money for private investors, institutions and hedge funds. Over two years, he amassed audited gains of over 400% on S&P futures and scored more than two-dozen double-digit winners. He’s a winner of the U.S. Trading Championship (options division), with a return of more than 300% in just three months. For more information, please click here, or call our VIP Trading Services Team at: 888.570.9830 or: 410.454.0498. - The Commerce Department’s latest Consumer Price inflation report made grim reading this morning. Fueled by the biggest spike in energy costs in five month, the overall inflation number rose by 0.3% in October. It was the second straight month that consumer inflation rose by that amount. Through the first 10 months of the year, consumer prices have climbed at an annualized rate of 3.6%. That’s 1.1% higher than the rise for all of 2006.
- With a 1.4% rise in October, energy prices are soaring at an annualized rate of 12.3% this year, compared with a 2.9% increase for all of 2006. Americans are starting to endure the impact of oil prices in the $90s, with gasoline costs up 1.4% in October - the biggest rise since a 10.5% spike in May. The national average price per gallon is $3.11, just 12 cents away from the all-time record in May.
- The inflation news deflated investors again today on concerns that consumers will cut back on their spending during the crucial holiday season period and deliver a blow to the economy. The Dow Industrials dropped 120.96 points (0.9%) to 13,110.05, the Nasdaq shed 25.81 points (1%) to 2,618.51, while the S&P 500 lost 19.43 points (1.3%) to 1,451.15. The price advance-decline readings were brutal. Just 21% of stocks on the NYSE rose today, versus 77% that lost ground, while only 27% of stocks on the Nasdaq advanced against 69% that saw a drop.
Related Articles:
- The Stock Markets: Using ESP To Chart The Next Move As The Indexes Race To All-Time Highs
- Technical Analysis: Two Simple Tools for Spotting a Technical Trend
- Stock Market Volatility: Three Ways to Combat Volatility’s "Radical" Shift
Technical Analysis
June 7, 2005
The Smart Profits Report: Issue #214
Tuesday, June 7, 2005
Technical Analysis - Two Simple Tools for Spotting a Technical Trend
By Mt. Vernon Research Team
Former Options Specialist for Mt. Vernon Research
Traders are supposed to be good market readers and work with, not against, the market direction at all times.
This does not mean calling tops and bottoms! That’s an interesting but not critical exercise. And, as Karim has noted, two of the most common indicators - the put-call ratio and the VIX - are difficult to read and often give false signals.
Besides that, market turnarounds only happen occasionally, but the market is there every day. Better to learn a skill that’s always useful rather than one that’s sometimes useful, like the basics of technical analysis.
Using the Force to Reach Your Goal
Don’t worry too much about predicting bottoms and tops, especially not as you start out. At first, focus on learning where your stock is going right now and using the force of its trend to reach your goal.
This, by the way, is one of the subtle differences between thinking as an investor and thinking as a speculator. Sometimes, going with the market as a trader will mean going against your judgment as an investor.
Let me give you a concrete example…
As an investor, for instance, I'm keeping my eye on Avid Technologies because its earnings and profitability are growing. (Don't take this as a recommendation, just a good example.)
Eventually, this company is going to be a winner if it continues the progress it's made in the last couple of years. But as a trader, I wouldn't buy any calls on Avid right now simply because it "should go up."
The fact is, it's not going up.
The market trend is against Avid. The sector trend is against it. The stock's own trend is very much against it. Yet not so long ago, in April ‘04, I made 136% in three weeks with an Avid call. The company's the same. The trend changed.
Today, though, I still like the company enough to think about going long as an investor - as a trader I'd go short.
"A Simple Approach to Technical Analysis"
How do you know whether you have a good trend? This is where technical analysis comes in.
On the rough level, you can look at a chart and see whether the price is tracking up or down. But learning to draw trend lines is a simple task that takes it a step farther.
Though trend lines can get complex, as can all technical analysis, I’ll explain the simplest approach. It will be more than adequate to get you started, and may be all you ever need.
For a Rising Stock:
Here are some simple steps for tracking a rising stock (pull up any good one-year stock price chart from Yahoo! Finance and print it out for this revealing little exercise)…
- Find the lowest point on the chart and put your ruler under it.
- Now connect it to the next-lowest point (there may be some lows between these that don’t touch the ruler).
- Draw a line all the way out to the end of the chart. What you have is a line under the stock prices. Support.
If the stock is really bullish, you will be connecting a series of higher lows. A stock that is staying above that line is "respecting" the bull support trend. It remains bullish as long as prices are above that line. Every time the stock drops toward that line, bullish buyers tend to snatch it up and the price tends to rise again.
By the way, in the rare cases where you can’t get a very good fit - for instance, if two extreme lows create a line that is far away from the rest of the prices, choose a shorter, more recent section of the chart and connect the lows in that segment.
For a Falling Stock:
For a bearish stock, one whose price line is going down, do almost the same. This time you are interested in finding the line that is keeping prices down, overhead resistance.
- Find the highest peak on the chart and put your ruler on top of it.
- Connect that peak to the next-highest peak and draw your line.
You should have a line that is slanting down, with successive tops getting lower. As long as the stock price stays below this "bearish resistance" line you’ve just drawn, it’s still on its bear trend. Every time the price rises toward the bearish resistance line, investors tend to sell off to take profits and the stock resumes falling.
Trend lines tend to stay in place for months at a time, even years, which is why they are so worth your time.
Better than a Trend Line: the ADX Indicator
A more sophisticated tool that I rely on is the ADX line, also known as Wilder’s DMI. It’s not as well known as relative strength, momentum and some other indicators, but it is ALWAYS the first indicator I look at. Always.
That’s because the most important thing to know about a stock you want to trade is whether it is trending and how strong the trend is.
The ADX line will tell you that and also whether the trend is getting stronger or weaker. I do trade stocks that aren’t trending, but that takes special skills and more complicated analysis. As a new trader, you should stay with stocks that are trending. The ADX is your friend.
The way you read the ADX is simple. First, you want to know if there is a valid trend or not. The number will tell you. ADX goes from 0 to 60, or higher, although you never see a zero and rarely a 70.
The Key Number Is 20
When the ADX is below 20, there is no trend in the stock. It is ranging. It may go up and down, but not enough to make trading it easy. When the ADX goes over 20, you have a trend in place. (For Nasdaq stocks, I like to see it over 22 because they are more volatile and more likely to suffer a trend reversal.)
Once you know that you have a trend, look at the direction the ADX line is traveling. If it is rising, the trend is getting stronger. If it’s falling, the trend is getting weaker. This applies to bullish and bearish trends alike.
If the number was very high, say over 40, I don’t worry too much if the ADX is dipping a bit. The reason is logical: Even if the trend is tapering off, it’s still in the "strong" range.
But when the ADX drops from a good number to under 20, look out! Your trend is drying up and you should probably shut down your trade the minute it stops working for you.
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Today's Smart Profits Crib Sheet
- The essential tool for technical analysis is both powerful and easy-to-understand. So where do you get access to the ADX? Expensive charting software always has this choice, but you can find it for free at www.stockcharts.com.
- Also, check out the Smart Profits Glossary for more definitions of options terms used above like "technical analysis", "indicators" and "resistance."
Good trading,
Mt. Vernon Research
Related Articles:
- How to Overcome the "Evil Twins of Trading"
- Quantitative Research - An Interview with Dean Albrecht
- Fundamental Analysis - Three Screens For Technical Traders
Options Trading Tools
June 1, 2005
The Smart Profits Report: Issue #213
Wednesday, June 1, 2005
Options Trading Tools: Six Key Tools for Trading Options
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
When it comes to options, there’s no need to do all the work on your own, when there are plenty of tools and resources for options trading, right at your fingertips, that can make your job a lot easier.
I’m talking about the many free websites and fee-based vendors that save you time, trouble and headaches by allowing you to get quotes, place trades and check your order status - sometimes all in one spot.
Since I run my own trading business, I must use all real-time, professional-quality products, some of which are fee-based. Right now, for instance, I use eSignal as my data vendor for all of my stock, option, and commodity quotes. eSignal charges a monthly service fee as well as monthly real-time exchange fees.
But many great options trading tools are also free. Below is my recommended list of tools, some free, some not, that should provide just about everything you’ll need to trade options successfully.
Trading Tool #1: Free Quote Platforms
If you are looking for a free quote platform for stocks and indices, I highly recommend a software called Quotetracker.
QuoteTracker is a program that integrates with various datafeeds, brokers and financial sites to provide you with streaming real-time quotes, live intraday charts with technical indicators, Level II quotes, time and sales, alerts, news monitoring - and almost everything else you might need to effectively trade in today’s market.
The Quotetracker platform itself doesn’t give you the data-feed, but you can select one of the supported partners (which is just about every brokerage firm and data-feed vendor out there today) and trade through your own broker using QuoteTracker direct access interface.
So, if you trade through Optionsxpress, E*Trade, Scottrade, Schwab, TD Waterhouse, Fidelity, Ameritrade, etc., you’ll be able to get your quotes with Quotetracker. Even if you have a fee-based subscription to eSignal, IQFeed, or Interactivebrokers already, you can still use Quotetracker as a back-up platform.
Trading Tool #2: Online Options Brokers
There are many online options brokers available today. I haven’t tried them all, but I have personal trading accounts with Interactivebrokers, OptionsXpress and Schwab.
Interactivebrokers is a very sophisticated, high-end trading platform, geared toward the professional, active trader. They charge $1 per option contract, which is one of the lowest (if not the lowest) available out there for the retail customer.
OptionsXpress and Schwab both are competitively priced and serve most of the needs of an options trader.
A few others that I haven’t used personally, but have heard decent reviews about are CyberTrader, ThinkorSwim and TradeStation.
Trading Tool #3: Volatility Charts
Reading volatility helps you figure out which options are bargains, and which are not.
One of my favorite websites for useful options information is iVolatility.com. I use this site extensively in my own option analysis, and you’ve probably seen me reference this site before in previous articles.
iVolatility.com is an amazing site for volatility information, both historical and implied, and it helps me weed out stocks that have cheap and expensive options. Check out their volatility charts and option calculator.
Trading Tool #4: Tracking Software
When it comes to options software that tracks and graphs your positions, does what-if scenarios, and gives you basic help with options in general, there are a few sites I recommend:
The Options Industry Council’s main job is to get the word out to investors that options are available and useful for trading. They do not charge fees, and you can call them toll-free with any option question you have. They also offer free software called the “Options Investigator” on CD-ROM. Get it! And of course, here is THE source for all options information: The CBOE.
And here are some others that I’ve come across that are useful for setting up and tracking positions: Open Interest Options Browser, Option-Chart, and OptionVue Research.
These next few are good for Microsoft Excel users: Hoadley.net and OptionStar. Hoadley.net is a pretty intense and sophisticated options website for users of Excel. Give them a look.
If you need some scanners to help you find trades, here are a few that I’ve tried in the past. All have their advantages: PowerOpt, StockFetcher, MarketScreen and Trade-Ideas.
Options Trading Tool #5: The Web Sites
Let me round up here with a few more random websites that I’ve frequented that I feel can give you some more benefits to help with your trading and investing. These are in no particular order:
- http://www.elitetrader.com
- http://www.optionstrategist.com
- http://finance.yahoo.com
- http://www.sfomag.com
- http://www.stockcharts.com
- http://www.bigcharts.com
- http://www.marketscreen.com
- http://quotes.nasdaq.com/asp/MasterDataEntry.asp?page=holdingssummary
- http://www.dogsofthedow.com
- http://trader-source.com/forms/Signupform.htm
For more information on all of the above websites, you can click here to see our Recommended Options Website Listing.
Lots to look at. Have fun, and good trading,
Lee Lowell
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for definintions of terms like “Black-Scholes Model” or “volatility” found in today’s article.
- Also, for further reading about helpful option websites, click on over to Smart Profits #217, The Chicago Board of Options Exchange: The Website Every Options Trader Should Know.
Related Articles:
- The Smart Profits Report Recommended Websites
- The Smart Profits Report Recommended Reading
- The Smart Profits Report Recommended Brokers
Hear It From Our Premium Members...
~Joe B., Wilton, CT
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