Trading Short-Term Options

The Smart Profits Report: Issue #147
Thursday, September 30, 2004

Trading Short Term Options - A System for Reading the “Market Weather”
By Mt. Vernon Research Team
Former Options Specialist of Mt. Vernon Research

When it comes to trading short-term options, maybe the smartest thing you could do is follow a dope around. Watch how he loses money, then vow to do the opposite.

While there are dozens of workable systems for trading options, losers all make the same handful of mistakes.

One that is epidemic among losers is not paying attention to the here and now. Every successful trader has learned better. The short-term option traders who crack up spend too much time scanning the skies for rainbows leading to gold and not enough time looking at their feet.

As a group, we traders tend to be an ambitious lot. We’re always looking for the next 100%-er, and we know they’re out there. But sometimes the market is only offering 30% conditions and the traders who read it right and take 30% when that’s what’s on offer are the ones who live to trade a long time.

Bulls, Bears and Mud Holes

To start with, are you in the either/or habit? Always thinking bullish or bearish? If you want to be a trader, you’ll have to take your market reading farther.

It’s identifying a sideways, or “nontrending,” market versus a trending (clearly bullish or bearish) market that is more important to you now.

A bear market is just as good as a bull market for us because we can simply choose whether to buy puts or calls and take either direction. In fact, bear markets can be especially kind because stocks often fall farther and more quickly than they run up. A nontrending market, however, is much more difficult to trade than either a bull or a bear. It’s likely to bring you more 40% returns than lots of 100% returns. But that’s just one kind of market distinction.

For instance, when small-cap stocks are hot and larger stocks are idling, that’s a special market. You’re not going to find great short-term options trades easily. Small caps don’t tend to have options and the big-cap stocks that do are behaving lamely.

Another special condition is that when the market is very volatile, you’ll get lots of trades, but they’ll cost you more. High volatility equals higher options prices. And heaven forbid you buy your option when the market or stock is extra volatile, then hold it as it calms down.

If that happens, you’ll start losing money unless the stock moves very steadily in the right direction. When volatility is high, your trades need to reach targets very fast, before the volatility drops, which means extra caution about which strike prices you choose…

And for the worst conditions, a real mud hole with low volatility, well, just look at the current market.

Get a System and Tweak It for the Weather

For most of this summer, a lot of savvy traders were sitting it out. I told my people to trade lightly, at most. Why? Because there was no trend for starters, always a damper.

The S&P had been trapped in a 7% range for months, and most stocks meandered in similar ranges. But this time, to pour more water on that mud, you have a very nervous and reactionary market with lots of wide swings both ways during earnings season.

Officially, volatility is low. In truth, when it comes to optionable stocks, we aren’t seeing lots of calm 15% moves over a period of a few weeks, but we are seeing lots of wild 2-4% daily moves in the more active stocks.

Worse, they are going up 4% one day and down 4% the next. That’s enough to really knock the money off an option on the wrong side of the swing. And it adds up to a lot of time-wasting sideways movement without getting where you want to go.

Every system needs weatherproofing. You have to adjust. In some markets, I won’t even touch profits until I’m up 70-100%. In weaker markets I start taking profits as soon as possible.

As I adjust for current conditions, I keep 95% of my system intact. The idea is to make tactical, not strategic, adjustments if you have a good system.

For instance, I have lots of ways for searching for ideas. One of my favorite plays is the earnings-season gambit. I’ll follow stocks in the few days before they are due to report and look at fundamentals, then technical charts. If I spot a pattern of quiet buying and probable corporate strength, chances are the earnings are going to come out well and the stock will shoot up. Or vice versa. I’ve done this for years with great success. In this current earnings season, that tactic has been a disaster, and I quickly put it back on ice.

How to Be a Market Weatherperson - An Accurate One

So how do you develop this market sensitivity?

If you take an options newsletter or advisory for ideas, that’s a start. It gets you in the market and you have to be there in real time to get your training in. But you should also choose some favorite and unfavorite stocks to watch.

Make a list of bull and bear ideas. Look at them every day. Pay attention to the difference in the way they trade in the morning versus afternoon. See how they handle up and down market days.

You don’t have to trade those stocks, just plan trades to follow then watch and see what’s happening to them. I guarantee you’ll get a better feel for the market this way than all the index numbers in the world can give you.

Even if you are relying on someone like Karim or me for trades, this will make you a better trader. Over the years I have found that traders who take a more active role outperform the group even though everyone gets the same bulletins at the same time.

And if you learn to read the market weather and adjust, at least you won’t be the dope someone else is watching for pointers.