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Successful options trading requires a certain level of knowledge that is generally not taught in schools or universitiesTools of the Trade Options traders today have a wide array of tools at their disposal. Thanks to the Internet and the proliferation of finance-related web sites, a great deal of information is available at no cost at all. In addi , many online brokerage firms today provide a large amount of research, information, and analytical tools to their customers. At the same time, software and premium services like Optionetics.com Platinum are available for a fee and can greatly speed up the decision making process. However, the abundance of tools and information can also be a double-edged sword when traders get bogged down by information overload and subsequently lose sight of the real objective of options tradingmaking profits. In this chapter, we examine some of the tools traders use. Not all of them are necessary. Some, like stock charts, may seem essential; but a number of successful traders can even get by without those. So, when reading through this chapter, and learning about some of the featured tools of the trade, keep in mind that not all of them are absolutely necessary. Instead, think of them as shortcuts that are designed to make your trading life a great deal easier. WHAT YOU REALLY NEED TO KNOW Successful options trading requires a certain level of knowledge that is generally not taught in schools or universities. Options traders should know the basics of the stock market like understanding stock symbols, quotes, placing orders, and the factors that cause prices to rise and fall. In addition, traders should also understand options basics like the difference between puts and calls, the relationship between the strike price of an option and the price of the underlying asset, the impact of time decay, expiration dates, and the difference between opening and closing transactions. In short, trading options requires a basic understanding of how the stock and options markets function. The first few chapters of this book should have helped you to develop such an understanding. In addition to this book, a visit to the library or a bookstore can help traders acquire a basic knowledge of options trading. A visit to the local library will produce hundreds of books on the stock market and options trading. Watching financial television such as CNBC during the day and the Nightly Business Report in the evening can help you get a better understanding of the financial markets. Doing a search on the Internet will yield thousands of free articles that cover the markets and trading strategies. Optionetics offers free trading education, brokerage reviews, articles, commentary, and market data information on its web site. Once a certain foundation of trading knowledge has been attained, and an individual wants to begin trading, most brokerage firms will provide the required tools including the ability to place orders, assistance from a broker, and price quotes. So since learning the essentials of options trading can be done for a small cost, it is possible to become a successful options trader through self-learning. While much of the information and tools required to successfully trade options is widely available at no cost, some products and services can increase the odds of success by making life easier. For example, attending a seminar can save an enormous amount of studying time by providing a structured set of courses of proven strategies. In addition, students can ask their instructors questions directly before, during, and after the seminars. Technology and the Internet have also helped immensely. When I started teaching options trading strategies more than 10 years ago, most traders relied on magazines and newspapers to make trading decisions. More experienced traders knew how to use options pricing models, the Internet, and charting software, but the process of finding trades and creating risk graphs was extremely costly and time consuming. Today, a number of software programs greatly simplify the process of creating hypothetical trades, viewing variables (such as implied volatility, delta, and theta), and creating risk graphs. Again, using computer software is not essential to trading success, but it greatly simplifies the decision-making processespecially as traders become more experienced and develop a greater need for more sophisticated information. In order to determine what type of information they need, we encourage new students to focus on one or two strategies and paper trade them until they feel comfortable enough to create trades with real money on the line. The initial first step should be to develop a basic understanding of the market and options trading. The fact that you have made it this far in this book indicates that you are, or already have, accomplished the first step. From there, new students can begin creating hypothetical trades on paper using one or two strategies. In the beginning, the goal should be to master a small number of strategies. Dont try to become a jack-of-all-trades too quickly. Too many products and too many strategies in the early stages of this process can prove to be a distraction rather than an aid. Stock options trading in the United States began in the early 1970s. Obviously, many of the tools and services that exist today were not available to those early traders. So, if you are not sure what type of information you need, put yourself in their shoes for a few months. Rely almost exclusively on the resources available in your local library like Value Line Investment Survey, The Wall Street Journal, and Investors Business Daily. Do the math by hand and paper trade one or two strategies. Doing so will help you better understand the calculations and get a better feel for how option prices change on a daily basis. From that point, you can use an online portfolio service to track your paper trades. Paper trading will help you to understand which tools, products, and services you might need to foster consistent options trading success. CHARTS Technical traders rely heavily on charts and indicators. In todays market, most of this is done with computers and trading software. We will examine some of the software programs available to traders later in the chapter. For now, lets examine the three most commonly used chart types: the line chart, the open-high-low-close (OHLC), and Japanese candlesticks. The simplest type of chart is the line chart. This type of chart is plotted using only closing prices over a period of time. On the vertical axis, we have the underlying assets price. The horizontal axis plots the time useddaily, weekly, monthly or annually. Figure 18.1 provides an example of a line chart using the PHLX Bank Sector Index. When the graph moves higher, it tells us that the bank index, which is an index consisting of 24 banks, is increasing in price. When the chart moves lower, the BKW is losing value. Simple enough. The open-high-low-close (OHLC) chart (see Figure 18.2) is the one I use most often and is a common way of viewing the performance of a stock, index, or futures chart. Also known as the range bar chart, the graph provides the technical analyst with a great deal more information than the line chart because it includes more than just the closing price. It is constructed using the high of the day and the low of the day, along with the closing price. The chart shown in Figure 18.2 provides an example of an HLC for Microsoft (MSFT). In this example, we have created a daily range bar chart, which means that each bar (vertical line) represents one day of trading data. The length of the bar, or the highest and lowest points, reflect the high and low prices of the stock on each day. When the bars are long, it suggests that the stock traded in a wide range and when the vertical bar is short, the stock traded in a narrow range. Finally, a small horizontal line on the right side of each bar indicates the close, which is the last trade of the day. Some charting software allows traders to create OHLC charts, which include the opening price as well. In that case, the open appears as a small horizontal dash on the left side of the chart. Each OHLC bar gives a better idea of whether bulls or bears are in control of a stock or market. In a healthy advance, the bulls are firmly in control and driving prices higher. As evidence, the technical analyst wants to see the stock closing near the highs of the day. This is easy to do with an OHLC chart. Recall that the right horizontal on each OHLC bar represents the closing price. When these closing lines appear near the top of each vertical bar on the chart, it suggests that the bulls have the stock in control. However, when the bears seize a stock, the chartist is looking to see if the stock is closing near the low price of the day. For example, on the MSFT chart, during the decline in mid-October, the stock was finishing most trading sessions near the lows of the day, which was a sign that bears were firmly in control of MSFT during that time. The third type of chart that has become popular among traders is the Japanese candlestick chart. A candlestick is composed of two parts known as the body and the shadows. The body represents the range between the opening and closing prices. The shadow is the thin vertical line that can project outward above or below the body and represents the full price range for the stock, index, or futures contract. As a result, if there were no prices outside the range of the open to close, then there would be no shadows. If the market closed above the opening price, the body is often colored green or left blank (white). If the price closes below the opening price, the body is colored black or red. The colors will vary from one charting software package to the next, but green and red seem to be the most common. This color-coding of the body makes it easy to immediately see if the market closed above or below the opening price for the given time period. An OHLC bar gives you the same information, but the colorcoding of the candlestick bar can be a bit more convenient. Figure 18.3 provides an example of a six-month candlestick chart using Microsoft rendered in black, white, and grey. CHARTS, VOLUME, AND VOLATILITY A visual look at a chart can also give important information regarding a stocks volatility and, for that reason, it is extremely important to option traders. Since the length of each bar in an OHLC chart is determined by the high and low prices of the day, short bars suggest that the stock is exhibiting low volatility. In that case, the trading ranges between the daily high and low prices are small. On the other hand, when the bars are longer, it means that there is a bigger difference between the highs and lows of the day. Therefore, longer bars suggest greater volatility. Most charts will also plot volume underneath the price area. Volume refers to the total activity in the underlying asset during the course of a day, week, month, and so on. For a stock, the volume refers to the number of shares traded. To some traders, volume is the single most important indicator used in technical analysis. When a stock is rising and volume increases, it suggests that buyers are actively bidding the price higher and shorts are running for cover. Strong volume during an advance is considered a bullish sign. On the other hand, when volume swells during a decline, bears are driving prices lower, bulls are in pain, and the action of the stock is considered poor. Therefore, studying volume gives the analyst a better sense of whether the bulls or bears are in control of the stock. Volume is the total number of shares associated with a specific stock or market. Also known as turnover, it reflects the number of shares bought or sold relative to a specific security. For instance, if you purchase 100 shares of Microsoft, the volume of that trade is equal to 100. Volume is considered during daily time periods. For instance, on Wednesday, February 18, 2004, total volume on the Nasdaq Stock Market equaled 1,777,995,664 shares. Therefore, daily volume is generally defined as the number of shares traded in one day and can be considered for one individual stock, an options contract, or an entire market. On a chart, volume is plotted as a histogram such as can be seen in Figures 18.2 and 18.3. Tall bars suggest heavy volume while short bars indicate periods of low trading volume. |
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