Trade with the Trend

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We have all heard the phrase, “Trade with the trend, the trend is your friend.” While there is much truth to this statement, what specific rule based action do we take to make money from this simple concept? To dive into the important details and make sure that by the end of this article you are a better trader, I will use a recent trade to make my points. But before we do dive in let’s define the word trend. Trend simply means “prices moving in a direction.” Trends begin and end at fresh supply and demand levels. The core strategy at Online Trading Academy is the simple combination of supply (retail) and demand (wholesale). By entering and exiting positions around supply and demand levels, we are entering the market just before the next trend which is low risk and high reward and exiting the market just before the opposing level.

Notice the trend on the DAX chart below from last week is clearly down. This means we only want to look for supply (retail) levels for our entry points as we are only interested in selling short when the trend of price is down.

DAX Futures Income Trade: 3/27/15 60 Minute Chart DownTrend 

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On the chart below, there may appear to be more than one supply level on this chart and you may be wondering why I chose the one I did (yellow shaded area). This is because, based on our “Odds Enhancers,” that was the only supply level that met our criteria. In other words, our rule based analysis told us that the supply level shown was a price level where there was a significant supply and demand imbalance. This means there was much more willing supply than demand. The reasons to sell at that price level should price rally back up to that supply level are as follows:

  1. Quality supply level with multiple Odds Enhancers at play
  2. Significant profit zone (that big base below is nothing to worry about)
  3. Downtrend

As you can see below, price soon rallied back up to that supply level, stopped and fell quite a bit to meet my profit target for a short term trading gain of $1,425.00. Market timing is what I specialize in and it is the sole reason why this trading opportunity was low risk, high reward and high probability. The professionals say you can’t time the market’s turning points, I say you can with a very high degree of accuracy. The key to doing this is the ability to truly quantify supply and demand in any and all markets. This means identifying price levels where supply and demand are out of balance as that is where price always turns. Another way to say this is… know what the picture of real significant buyers and sellers looks like on a chart.

There is another key component to consider along-side market timing. It is really understanding who is on the other side of your trade. We want to make sure the person on the other side of our trade is a novice market speculator and not a big bank or a major financial institution like Goldman Sachs. Let’s use this this same trade as an example and use simple logic to make sure that when we sold short, we were selling to a buyer who doesn’t know how to quantify true retail and wholesale prices in a market.

DAX Futures Income Trade: 3/27/15 The Result, $1425.00 Profit

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When price rallied up to the supply level the key question was this; who was the buyer and what do we know about them. Novice traders always make two key mistakes. The buyers in this trade were making three and they are as follows:

  1. The buyers who bought were buying after a rally in price. This is a big mistake in trading. Think about how you buy things in other parts of your life. Do you ever get excited about buying after prices rise? If you would not take this novice action when buying things in any other part of life, don’t do it when trading and investing.
  2. They were buying at a price level where supply exceeded demand (Banks Selling). The chart already told us that (yellow shaded area). This mistake is even worse than mistake number one.
  3. They were buying at Supply in the context of a downtrend. This is not smart trading. During a downtrend the odds are with the shorts which is why we focus on identifying supply levels as entry points during downtrends.

Free WorkshopThe odds are so stacked against the buyer which is why being the seller meant that the odds were stacked in our favor, the risk was low and reward was high for the seller. Understanding who is on the other side of your trade is a key factor in trading. Those who buy against the trend, after a rally in price, and at supply tend to pay those who trade with the trend. Again, this is one of the many ways the transfer of accounts happens from those who don’t know what they are doing, into the accounts of those who do.

Hope this was helpful, have a great day.

Sam Seiden – sseiden@tradingacademy.com

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It’s About What You Want “Most” in Your Trades

If I asked you to list the things that you want, my bet would be that your list would cover a lot of ground. No doubt, in addition to the many items that would be good for you, if you’re anything like me there would be a number of items that might not be so good for you. For instance, food items on that list might include ice cream, cake, candy or burgers with lots of fries and, let’s not forget, the occasional big gulp. Of course, it doesn’t stop there, you may want to have that extra cocktail, or you may want to drive a little too fast, or sleep in when you have important matters scheduled, or move that stop, exit prematurely or chase that trade. Now, what do all of these things have in common? All of these behaviors, in addition to not being very good for you, leave you feeling better…even if for only a brief period. Granted, some of these behaviors could be considered mild compared to others; that is, until we look a little closer. Sugar, fats and chemicals found in processed foods have been shown to put your health at high risk. Alcohol and its dangers have been well documented. When you get behind the wheel you are driving a weapon and speed kills. Missing important appointments needs no explanation. And, must the dire consequences of trade rule violations be spelled out? Now, before you think that I’m trying to be some kind of killjoy, let me assure you that I’m just as guilty of all of these from time to time and I’m a firm believer in moderation…even moderation. But, this is not my point. The point here has to do with the fact that human wants can vary greatly and they can have competing interests. And, of course there are those who encourage you to go after those things that you want. But, OK, wait for it…it’s not about what you “want” it’s more about what you want “most” as in what-matters-most.

Free WorkshopLet’s face it, it does feel exciting to think that we can avert the perceived “disaster” of a loss by moving or taking out a stop; or that we can jump onto a shooting candle and make a big profit. However, even though the interests involved seem on target; that is, they seem to be about making more profit and making more profit appears to be a good thing; it is, in fact, a sham. The competing interests here actually boil down to short term pleasure (temporary relief) against long term results; that is, protecting capital and creating consistency in implementation, execution and keeping commitments – all high on the what-matters-most list. So, as you identify and clarify those wants keep in mind that the crucial factor lies in what you want “most.” The most list includes personal growth, healthy relationships, integrity, honesty, and to be more specific with trading those behaviors that build capacity for emotional strength and endurance like setting your aim to always be in a position to skill build in your trades.

I had dinner with one of my good friends last night who happens to also be a trader. One of the topics of conversation revolved around the fact that trading, in some respects, involves entropy. Loosely, entropy is a measure of the amount of energy in a physical system not available to do work. The amount of entropy is often thought of as the amount of disorder in a system. Entropy is often used roughly to refer to the breakdown or disorganization of any system: “The committee meeting did nothing but increase the entropy.” (Dictionary.com). So let’s apply this to trading. As a conscientious trader with some years under your belt, you aim to ensure that you are supporting your ability to remain focused on what-matters-most. Additionally, you resolve to stay aligned in body, mind and emotions and to maintain system energy high towards optimal implementation and execution. Then as time goes forward you have 2, 4, 6, maybe even 8 weeks of peak performance trading; but the more time you go on like this the entropy of your system is breaking down your resolve and causing your focus to become disorganized resulting in an increasing fragmentation of your efforts. Then, BAM, that trade happens where you have effectively imploded…and you violate every rule in your book. You can’t help yourself, and end up losing a third of your account. Furthermore, you’ve wiped out all of your gains covering the past eight weeks! You feel like #@!*^%, and you don’t know what happened. The point here is to realize that this condition is not only possible but highly probable. To begin with, you must use your journal and document those thoughts, emotions and behaviors (internal data) and market situations (mechanical data) that led to this event in order to anticipate the future occurrence of the breakdown and successfully address it. By knowing what can bring it on and remaining vigilant and diligent you are able to incorporate mental and emotional tools to combat it. This is paying attention to and embracing what you want “most.” It takes an understanding that our systems never remain constant. Just as we get older and tend to breakdown, it becomes imperative to consistently and constantly do those things that support the system by optimizing our internal and external resources to counter the breakdown and disorganization. For instance, engaging in system supportive behaviors like meditation, visualization, using affirmations, nutrition, and exercise, to name a few, go a long way towards maintaining your edge. These should be activities of daily living (ADL’s) just like bathing, brushing your teeth, and paying your bills; because they support your success.

So, your consistent trading success is not about what you want, but what you want most. Trade in your best interests and aim to stay there. This is what we teach in “Mastering the Mental Game” Online and On-location courses. Ask your Online Trading Academy representative for more information. Also, get my book, “From Pain to Profit: Secrets of the Peak Performance Trader.”

Happy Trading

Dr. Woody Johnson

wjohnson@tradingacademy.com

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Iron Condors and Probability

One of the more interesting option strategies is the Iron Condor. This one takes advantage of situations where we expect a stock to stay within a range for a while, and where its options are richly priced.

The general idea is that we can sell options with strike prices outside the range where we expect the stock to stay. We get paid well for selling them and, if all goes well, they dry up and blow away (expire worthless). In case we read it wrong, however, we buy ourselves some insurance to limit our risk.

A case in point was Reynolds American Inc. (RAI), as shown on this chart:

RAI Chart 1

The stock was fairly near the middle of a range, between a solid demand zone near $75 and a strong supply zone near $67, which we expected to contain it at least for a few weeks. Its options were pretty highly inflated showing implied volatility of 25%. This was compared to a one-year range for IV that stretched from 12% to 30%.

Our plan was to sell put options at a strike price below the demand zone at the $65 strike, and also sell call options at a strike near the supply zone at $75. We used options from the April expiration, 22 days away. We expected these options to become worthless, leaving us to keep the premiums we received for selling them. That premium totaled $1.20 per share.

In case we got a nasty surprise in the form of a big move beyond either of our short option strike prices, we bought options at strike prices even farther away. These would be our insurance. We decided on the $60 puts and $80 calls, each one’s strike or $5 beyond our short strikes. These two insurance options together cost us $.50 per share out of our $1.20 proceeds, leaving us with a $.70 net credit per share, or $70 per 100-share contract.

With the addition of the insurance options our maximum loss was reduced greatly. In the worst case, on the upside the stock could shoot up past our upper call strike of $80. If so, the short call at the $75 strike would be deeply in the money. But our long $80 call would then also be in the money and we would have no further losses once that $80 strike was reached. The difference between the values of the two options could never be more than $80-75 = $5, so that $5.00 per share is the most we would have to pay to exit the trade. Subtracting our net credit of $.70, our maximum loss was $4.30.

Similarly on the downside, our worst case would be having to pay $5 to exit the trade if the stock dropped below our $60 long put strike. This would also result in a net loss of $4.30 per share.

Free WorkshopA side benefit of buying these insurance options was that they reduced our capital requirement greatly. To sell the $65 put and $75 call without insurance would have required at least 20% of the underlying price as margin, and even more at some brokers. This would have amounted to about $14 per share, rather than $4.30. The reason for the high margin requirement was that without the insurance both short options would be naked, and therefore have theoretically unlimited risk. We would have planned to mitigate this risk by putting in stop-loss orders to liquidate the trade if the stock passed our boundaries; but brokers don’t consider stop-losses when calculating margin requirements for option trades.

With the insurance options the trade became an Iron Condor. This is a limited-risk trade and as such has lower margin requirements. The most that we would be required to keep on deposit to secure this trade would be the $5 per share maximum liability. We received $.70 credit to enter the trade, leaving us to use $4.30 of our own money.

The return of $.70 on $4.30 was over 16% in just 23 days. This amounts to an annualized return too high to bother to calculate.

But wait, you’re saying: how can it make sense to risk $4.30 to make $.70? The answer is that it can make sense if the probabilities are strongly in your favor, as they were here.

In order for the trade not to make its maximum profit one of our short options would have had to end up in the money. For that to happen, the stock would have had to go either above our $75 short call strike, or below our $65 short put strike. We did not find this likely because of our chart analysis.

We could also use our analysis tools to get some statistical confirmation of the unlikelihood of RAI moving past our strike prices. One of these tools is the “Probability of expiring out of the money” indicator in the TradeStation platform. Some other trading platforms provide similar tools.

Below is the RAI option chain with the “Prob OTM” column activated:

RAI Option Chain 1

 The probability of the $65 put finishing out of the money was given as 94%. The probability for the $75 call was a little less, at 84%, still plenty high.

So, on the low side there was only a 100-94 = 6% probability of our $65 put costing us any money; and on the high side a 16% chance that our short $75 call would do so. This is an exercise in conditional probability – if the stock was above $75 there was zer0 probability of it also being below $65. So the total chance of not making our maximum profit was not the combination of the two options (14% + 6%). Instead it was the higher of the two possibilities or 14%.

The probabilities of our actually incurring the maximum $4.30 loss were even tinier. The probability of the $80 call finishing out of the money was given at 98.5%, and the $60 put at 99.9%

All in all, this looked to be an attractive trade. Our statistical tools gave us good confirmation of what the price chart told us in the first place. We would never take a trade based on the statistical probabilities alone because that’s just what they are – probabilities, not certainties. But when used in combination with proper supply and demand chart analysis they give us powerful backup.

For comments or questions on this article, contact us at help@tradingacademy.com

 

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