Notes from a Profitable Investor

How to Make Money in the Stock Market in Your

Spare Time

G. Paul Gibson, MBA, CCE

with contributions from Bryan Burke and David Miles
Please note that this work is copyrighted by G. Paul Gibson, and no part
may be published without his express permission.
TABLE OF CONTENTS
INTRODUCTION
PREFACE
PLAN
CHAPTER 1. GENERAL BACKGROUND OF THE
MARKET—WHAT TO WATCH
CHAPTER 2. INTRODUCTION TO VOLATILITY
CHAPTER 3. FUNDAMENTAL ANALYSIS—THE LONG-
TERM VIEW: WHAT AM I INVESTING IN?
CHAPTER 4. TECHNICAL ANALYSIS—THE SHORT-
TERM VIEW—WHEN TO INVEST
CHAPTER 5. TECHNICAL ANALYSIS: INTRODUCTION
TO UPPER STUDIES
CHAPTER 6. TECHNICAL ANALYSIS:
INTRODUCTION TO LOWER STUDIES
CHAPTER 7. FINDING AND EXECUTING A TRADE
CHAPTER 8. INTRODUCTION TO STOCK OPTION
CONTRACTS
CHAPTER 9. CALCULATING BOUGHT OPTIONS
CONTRACTS PROFITS
CHAPTER 10. CALCULATING SOLD OPTIONS
CONTRACTS PROFITS
CHAPTER 11. OPTION COMBINATIONS: SPREADS
CHAPTER 12. MORE COMBINATIONS: BUTTERFLY
AND CONDOR
CHAPTER 13. FINDING GOOD INVESTMENT
OPPORTUNITIES: OPTION CONTRACTS
CHAPTER 14. TRADING SKILLS AND TACTICS:
OPTIONS
CHAPTER 15. SELECTING A BROKER
CHAPTER 16: PORTFOLIO MANAGEMENT (MODERN
PORTFOLIO THEORY)
CHAPTER 17. STOCK BUYING STRATEGIES
CHAPTER 18. STOCK SELLING STRATEGIES
CHAPTER 19. AND THEN THERE ARE MUTUAL
FUNDS
CHAPTER 20. THE CASE FOR DIVIDENDS
FINAL SUMMARY
APPENDIX A
APPENDIX B
APPENDIX C
APPENDIX D
APPENDIX E
APPENDIX F
APPENDIX G
APPENDIX H
APPENDIX I
Introduction
I have spent many years honing my investing skills on the market. At
some point, I decided I wanted to teach others the art of investing, and I
developed exercises and workshops—an entire curriculum—designed to
help students learn by doing.
Now, I find myself at another stage of the teaching process. I want to reach
a wider audience of students to help them become better, more successful
investors. The result of my desire is this book.
The concepts and methods that I cover here are based on several sources.
They include my years of experience, both successes and failures, and they
come from a variety of articles and notes I have archived in my career.
This writing is not meant to be seen as a definitive, scientific, or textbook
approach. It is, however, a presentation of some ideas that have proven
extremely valuable to me and many others.
You may not have heard of the Stochastic Oscillator. Many haven’t. In
these pages, I will explain many concepts and tools that you may or may
not recognize, and I will teach applications of them.
Fellow investors, I’m ecstatic to spend some time together.
Preface
Despite what market analysts would have you believe, the prices of stock
and the indexes are NOT caused by political and economic factors. The
prices move out of "market sentiment.” In other words, what are investors
thinking about stocks and price fluctuations? When do they think it’s time
to buy and time to sell, time to go long or go short on options? Yes,
political views and events, and perceived market economic gyrations may
influence the thinking of investors, but they do not directly affect the price
of stocks. But these events do affect the thinking of the investors who
decide to buy or sell and go long or short.
Example: Back in the 1970's there was an oil crisis—or was there? Prices
of oil started to go up. Investors became worried and the prices for oil-
related stocks began to go down as selling began. This affected the rest of
the market, even for otherwise profitable companies. The market had gone
bearish due to investor thinking.
Not long after, perhaps the next year or so, once again oil prices went up.
This time, however, investors started to buy. Why? Investors believed that
increased prices would increase profits and therefore earnings per share
would rise. In this case, the market had gone bullish. The difference?
Investor perspective.
And who knows what that is? No one, really, but it is reflected in market
action. We can only guess and listen to one analyst after another and try to
get a gut feel for what is really going on in an effort to forecast future
trends.
Trends, you see, are what we are truly investing in. If a company has great
financials and a great track record, it's easier to guess their future trend,
with some exceptions. If the company has a poor track record and not-so-
steady financials, one would intuitively think that the price would be more
volatile.
Yes, but maybe no. None of us have a crystal ball. All we can do is use
mathematical skills to help us see if we can find some reasons to justify
our thinking about future trends. So, a good thing to remember is that our
tools are mathematical and theoretical, but they are very poor tools indeed
for guessing the future.
But they are the only tools that we have. In these pages, I hope to teach
you how to use them well, and to be able to develop an intuition about
what all the other investors may be thinking at any given point in time.
With patience, a little science, and some good intuition, we can be
relatively successful on the market and put the odds in our favor. It’s not
perfect. We can win—and lose—using the same tools. If we win more than
we lose, however, we can make money.
Plan
To accomplish anything as an investor, you need a plan. Your plan can be
modified and expanded according to your experience, knowledge, and
preferences. You can also adjust your plan based on the individual stock
issue being considered. This plan should consist of three parts.

1. Vision and Goals

Before you can plan, you have to have a vision of where you want to
go and goals to take you there.
This is one of the key differentiators between someone who is poor
(those who spend as much, or more, than they make, and therefore
cannot invest surplus to generate income) and someone who is rich
(those who control spending and invest the surplus to generate
income, capital gains, and ultimately financial independence).
A vision and goals can help hold you accountable for how you
manage your most valuable resources: your mind, time, and money.
Remember, without a clear vision to guide you, it's much easier to
spend time accomplishing something that is a good activity yet isn't
particularly demanding, as opposed to accomplishing something that
is the best use of our time, but is more demanding. With goals and
vision, we always get to choose between the "good, better, and best"
use of our resources.
As part of your plan, if you don't already have a solid working
personal budget and good record keeping systems, manual or
automated, now is the time to establish them. Appendix A is an
exploration of section 1 of your plan with some examples and
resources.

2. Strategies
Jot down a general description of strategies that you favor. This part
of the plan should be updated as market conditions require. I hope
 that you will learn to diagnose the market in such a way as to know
which investing "tools" will serve you best, rather than try to apply
to the same technique to all market conditions. That would be like a
carpenter who only knows how to use a hammer and tries to use it
for every task on the jobsite. Sure, he could cut through a board with
a hammer, but it will be messy and exhausting. It would not make
sense to use a "bullish" technique in a "bearish" market condition.

3. Practice Skills and Develop a Flight Check

As you learn concepts and skills, practice them. It’s how you become
an effective investor. This book should also help you to develop a list
of criteria, or flight check, to make sure before you invest that all the
points of analysis are completed, the conditions are right, and you
have the right tools, thus assuring a higher level of success and
minimizing loss.
We should develop rules for investing and WRITE THEM DOWN
to assure consistency and codify a reliable way to diagnose trades for
success. Not doing so will lead inevitably to inconsistent results and
higher percentage of losses.
By having a set of rules and analysis patterns to always consider, one
is more likely to have consistency in investing, be able to spot flaws
in techniques, and to preserve capital.

Let's get started.

Rule Number One: Preserve Capital (Minimize
Risk and Loss)
This is our number-one rule—which is why I’m putting it before chapter
one. Don't take too much risk. Don't set yourself up for losses. Investment
capital is hard to come by, so we don't want to lose it because we are too
anxious to make money and rush through a hasty analysis to force the
trade.
Having said that, a practiced trader should be able to recognize market
conditions quickly. With experience in a particular industry, and
experience with a particular company, you can make an investment
decision in a short period of time, even minutes. However, the bulk of
your time will probably be spent in keeping up with market conditions. In
this manner, you will become very familiar with the industries and stocks
on your watch list. Spending a few hours a week watching the market and
interesting stocks will be the bulk of the your observation time, while
making that actual final decision will take merely minutes. Look to the
discussion on how to assess risk (appendix B) and to read how it can
affect you.
Chapter 1. General Background of the Market—
What to Watch
The foundation of your investing education will be learning to read the
market. What are the general market conditions? What forces are driving
these conditions? How should you use this information?
As the saying goes, "a rising tide floats all boats." You may notice in your
market observations that some stocks will actually be going down when
the general market is going up, but that is generally not the case. Most
stocks typically move in sync with the overall market. Those that do not
may actually be contrarian in nature, reacting in an opposite manner to
general market conditions. We can make money with these stocks, too, but
we must understand the relationship of the stock price to the economy and
the general market.
Then you’ll find stocks that are just the weirdoes, and it's almost
impossible to predict any kind of movement for them. It's like the crazy
neighbor on our street; we may wave at them as we pass by, but we don't
want to hang out with them.
Rule Number Two: Assess the Market
Peter Lynch once said that if a person is spending 13 seconds analyzing the
market each day, that is a good thing, but that they are probably spending
about 10 seconds too much time. 2
This is a tongue-in-cheek statement, but it hints at a truth: staying abreast
of the market, once immersed in current information, is not too difficult or
time consuming.
The same techniques for analyzing an individual stock can be used for
monitoring the market. It starts with watching the news and
announcements for the broad market. And it involves using technical
analysis tools to follow the price charts of the market indexes (SPX for the
S&P500, DJI for the Dow Jones Industrials, etc.).
There are many indexes and some analysts and investors like to use the
ETF (Exchange Traded Fund) ticker symbol as a substitute for the
industrial index. For example, many use the SPY fund ticker as a
substitute for the SPX, the ticker for the actual market index. The
sponsoring broker for the SPY has indicated that the stocks held in that
fund are the same mix and weight as the SPX and if one were to compare
the performance of the fund to the index they will seem almost identical.
(The word "almost" is a sticking point for me, so I prefer to look at the
"horse's mouth" rather than make an extrapolation.) However, over years
of observation, I would agree that generally the same volatility will be
seen even if the issue values of the SPY are slightly different from the
SPX index from time to time. One can invest in the SPY fund, which is
like a taxably unique mutual fund as are all ETF's, whereas one cannot
invest directly in the SPX as it is only an index and not a fund.
Figure A. The Standard and Poors 500 Index chart showing strong bullish
direction with occasional normal corrections.

Figure B. The Dow Jones Industrial (the 30 largest industrial stocks).

Similar time frame to Figure A.

Figure C. Russell 2000 Index. This is the same time frame as figures A and
B above, but shows broader approach to market perspective by showing
2000 of the largest companies
So, we are going from a narrow perspective on the Dow Jones Industrials
(compilation of data for 30 stocks) to 500 stocks in the S&P 500 and 2000
stocks in the Russell. Each gives a similar perspective of the general
market, with some differences. At the latest time frame as of this writing,
they are all showing BULLISH trending in general, with their own cycle
adjustments.
We could also look at the VIX (Volatility Index created by the Chicago
Board of Options Exchange) to get a mirror image interpretation of market
conditions. There will be more about the VIX in the chapter on Volatility,
but in essence, the higher the VIX score, the more BEARISH the market,
and the lower the score, the more BULLISH the market. The index
measures volatility on the S&P500 only, and higher volatility usually
indicates bearish trends.
Figure D. From this chart we can see the result of such a volatile market.
There’s nothing too steady about this chart, showing that there are a lot of
ups and downs in the S&P500 index.
Chapter 2. Introduction to Volatility
Volatility merely means that the market prices go up and down. In some
cases, this back and forth action is quite regular and frequent, so we would
call that "high volatility." Other stocks or indexes move at a more steady
and predictable pace and don't move very far very fast. This would be "low
volatility."
Volatility is at once our enemy and our friend. The higher the volatility, the
more likely it is that we will NOT be able to forecast where that stock price
may go. We can, however, make greater amounts of money. On the other
hand, while low volatility gives us a better edge in prediction, it does not
make much money, short or long term.
Volatility can be measured using several methods. I will cover a few of the
more common tools.

Eyeball It
Just as the name implies, take a look at the price chart. Does it move up and
down a lot, or not so much? The following charts show a high volatility
stock versus a low volatility stock. Figure 1 is an example of a highly
volatile stock.
(Note. I am using the free-to-users website of StockCharts.com since it is
easy to retrieve, web based, and free. It also offers a paid membership
featuring additional investing tools, including self-created screening tools.
Other fine sources of information are available from your individual
brokerage website, as well as other free sites that are web based, which will
be mentioned later on. I do not recommend any particular broker or
website, and each representation is for educational purposes only.)
Figure 1. This stock price is highly volatile. Note the up and down
movements over a short period of time.
In the case of Figure 1, we can see that a lot of money can be made—or lost
—quickly with the spikes and plummets of high volatility.
In Figure 2, because of lower volatility, we could make money more slowly,
but also have the opportunity to more accurately predict any changes in
price in the near term, and therefore be better able to react to changes in the
trends of the stock price (market conditions).
In the same manner, we can look at stock ticker symbols and related press
releases or market news and perhaps find a reason for the price changes
which would help us make more informed decisions and more accurate
forecasting of possible movements.
In the case of Figure 1. the following news was released: News:
BusinessWire

Jabil Posts Fourth Quarter & Fiscal Year 2017

Results
09/27/17 04:02 PM EDT
Today Jabil Inc. (NYSE: JBL), reported preliminary, unaudited financial
results for its fourth quarter and full fiscal year ended August 31, 2017,
including fourth quarter net revenue of $5.0 billion and fiscal year net
revenue of $19.1 billion.
For the fourth quarter of fiscal year 2017, U.S. GAAP (as defined below)
operating income was $118.1 million and U.S. GAAP diluted earnings per
share was $0.25. For fiscal year 2017, U.S. GAAP operating income was
$410.2 million and U.S. GAAP diluted earnings per share was $0.69.
For the fourth quarter of fiscal year 2017, core operating income ((Non-
U.S. GAAP) as defined below) was $191.5 million and core diluted
earnings per share ((Non-U.S. GAAP) as defined below) was $0.64. For
fiscal year 2017, core operating income was $667.0 million and core
diluted earnings per share was $2.11.
“I’m very pleased with our team’s performance throughout the fiscal year,”
said CEO Mark Mondello. “As we described at the outset of the year,
success would include solid revenue and core earnings growth coupled with
strong cash flow generation. Clearly, we delivered on these strategic
objectives,” he added.
Fiscal Year 2017 Highlights:
Net revenue growth: 4 percent
Core diluted earnings per share (Non-U.S. GAAP) growth: 13
percent
Cash flow from operations: $1.26 Billion
“Looking ahead, we expect continued revenue and core EPS growth in both
the first quarter and fiscal 2018. The success of our capabilities-driven
strategy is allowing for continued share gains and enhanced diversification
across the enterprise. As a result, our plan to deliver core EPS of $2.60 in
2018 and $3.00 in 2019 remains on track,” added Mondello.
First Quarter of Fiscal Year 2018 Guidance:

- Net revenue $5.25 billion to $5.75 billion

- U.S. GAAP operating income $111 million to $182 million
- U.S. GAAP diluted earnings per share $0.17 to $0.49 per diluted share
- Core operating income (Non-U.S. $198 million to $258 million
GAAP)
- Core diluted earnings per share (Non-
$0.65 to $0.91 per diluted share
U.S. GAAP )
Increase revenue 13 percent
- Diversified Manufacturing Services
year-on-year
Increase revenue 3 percent
- Electronics Manufacturing Services
year-on-year
Increase revenue 8 percent
- Total company
year-on-year
(U.S. GAAP diluted earnings per share for the first quarter of fiscal year
2018 are currently estimated to include $0.05 per share for amortization of
intangibles, $0.34 per share for stock-based compensation expense and
related charges and $0.09 to $0.03 per share for restructuring and related
charges.)
Figure 2.
Figure 2. is a much less volatile stock. The news announcements for this
company were found separately.
http://files.shareholder.com/downloads/JNJ as well as Morningstar.com (©
[2018] Morningstar, Inc. All Rights Reserved. Reproduced with
permission.)

Analyst Note 09/27/201 Johnson & Johnson

JNJ
J&J's diverse operations help mitigate increasing
generic pressures in the drug business.
Analyst Note 09/27/2017 (redacted excerpts, Morningstar.com (© [2018]
Morningstar, Inc. All Rights Reserved. Reproduced with permission.)
One of the guiding principles for what we think plausible tax reform will
look like is that it’s close to deficit-neutral after taking
into account economic growth stimulated by tax reform. The unified
framework looks similar to the House Republican blueprint, except for not
including the border adjustment tax that was estimated to raise
approximately $1 trillion of revenue. Without the border adjustment tax,
this framework would likely lead to a material increase in the public debt.
One of the largest levers that Congress could pull to make this framework
closer to revenue neutral would be to only lower the corporate tax rate to
25%, which is what we’re assuming, instead of the 20% in the framework.

Investment Thesis 07/12/2017

Johnson & Johnson stands alone as a leader across the major healthcare
industries. The company maintains a diverse revenue base, a developing
research pipeline, and exceptional cash flow generation that together create
a wide economic moat.

Economic Moat 07/12/2017

Johnson & Johnson's diverse operations are a major pillar supporting the
wide moat. The company holds a leadership role in a number of segments,
including medical devices, OTC medicines, and several drug markets.
Further, the company is not overly dependent on one particular operating
segment; the pharmaceutical business, medical device group, and consumer
products represent 45%, 35%, and 20% of total sales, respectively.
Additionally, within each segment no one product dominates sales, as
Pfizer's Lipitor did. Despite carrying some lower-margin divisions, J&J
maintains strong pricing power and has posted gross margins above 68%
during the past five years, validating its strong competitive position.
Valuation 07/12/2017
We are increasing our fair value estimate to $114 per share from $108 as a
result of increased expectations for the company's blood cancer drugs.
Based on a review of strong data for Darzalex in multiple myeloma, we
believe the drug will develop into a major blockbuster, with total peak sales
growing to over $5 billion by 2021. While the company pays royalties on
the drug to Genmab, the drug's strong pricing power still means high
profitability to Johnson and Johnson. Including the Actelion acquisition, we
expect annual earnings per share growth will average 6% during the next
three years, as strong growth in new pipeline drugs should offset some
patent losses in the pharmaceutical division. We expect flat operating
margins in the near term as a result of waning cost-remediation efforts in
the consumer group and increasing cost-containment efforts throughout the
firm offsetting margin pressure due to the loss of patent protection on
several high-margin drugs, including immunology drug

Similarly, we can look at the major indexes to see the volatility for the
market as a whole, short term and long term. Figure 3 gives a day by day
look at the volatility of the market with daily price action, while Figure 4
gives us a longer-term look using weekly price action.
Figure 3. Daily candles. A candle chart is a style of financial chart used to
describe price movements. Each bar represents four important pieces of
information: The open, close, high, and low. They are usually used to
capture trading patterns over short periods of time.

Figure 4. Weekly Candles.

You should look for news and commentary about the market in general.
Example:

Figure 5. Marketwatch.com general news site.

You can find information on many websites. Another example of market
information is:
Figure 6. Morningstar.com general market news site. (© [2018]
Morningstar, Inc. All Rights Reserved. Reproduced with permission.)

Using the VIX

The next resource that I will mention for whole-market volatility
information is an index called the VIX. This index was developed by a
company called The Chicago Board of Options Exchange, or CBOE as
commonly called in the industry (www.cboe.com). This index is related to
the S&P500 and is a "reverse indicator." In other words, when volatility is
up, the index will rise, which indicates a bearish movement. When the
indicator is down, it represents lower volatility and a bullish movement of
the S&P 500.
Figure 7. Quarterly candles for the SPX are compared to the movement of
the VIX index.
The relationship represented in Figure 7 is distorted as the scales are
mixed, but it does show that there is a relationship between the volatility
index (VIX) and the overall market (SPX, or the S&P500). The red candles
represent "bearish" periods, while the white candles represent "bullish"
periods. As you can see, during bullish periods the VIX scores are lower or
are in retraction, while in bearish periods, the VIX scores tend to spike
upward. The next two figures show the indexes separately.

Figure 8. The Standard and Poors 500 index showing a bullish market. See
Figure 9 for comparison.
Now let's take a look at the VIX. Can you see the relationships?
Figure 9. The VIX. Latest data would indicate a very bullish market. See
Figure 8 for comparison.

Using BETA
The calculation for BETA is a little more complex than we need to worry
about now. You can find the definition on www.investopedia.com. Basically,
it is a correlation indicator and was originally developed as an instrument
to help investors invest in mutual funds. The correlation is to the S&P500.
It is scored like this:
If the BETA number is 1 (one), the indication is that this issue (mutual fund
or stock) has the same statistical volatility of the S&P500. If the BETA is
0.95, then one would expect that the issue would be 95% as volatile as the
market. And a BETA of 1.3 would indicate 130% volatility.
Many utilities and similar economic core stocks demonstrate a BETA of
less than 1. Then on the other end of the spectrum, most high-tech, Nasdaq-
based stocks have a BETA of greater than 1, offering the possibility of a
higher rate of return, but also posing more risk. For example, as of May 31,
2016, the PowerShares QQQ, an ETF (Exchange Traded Fund—a security
that tracks an index, a commodity, bonds, or assets like an index fund, but
is traded like common stock) tracking the Nasdaq-100 Index, has a trailing
15-year BETA of 1.27 when measured against the S&P 500 Index, which is
the commonly used equity market benchmark. Most stock market
information resources will represent the BETA figure on their quote page,
such as Yahoo.com/finance.

You may read more about

Beta: Beta http://www.investopedia.com/terms/b/beta.asp#ixzz4uZmTLO4
S

So, in summary: As usual, we will want to use more than one method for
assessing market and specific issue volatility of a stock, fund, or ETF.
Having multiple perspectives of a particular concept should only help us. If
too much information confuses you, it would be worth taking a step back to
see the whole painting and not try to strain to see the minute brushstrokes.
Chapter 3. Fundamental Analysis—The Long-
Term View: What Am I Investing In?
As we start to talk about the long-term view, this article about Peter Lynch,
a former mutual fund rock star, is a good place to begin
(http://www.marketwatch.com/story/peter-lynch-25-years-later-its-not-
just-invest-in-what-you-know-2015-12-28). The article asks, "What’s
wrong with the popular-wisdom version of [Lynch’s] ideology, which is
usually cited as ‘invest in what you know’? It leaves out the role of serious
fundamental stock research. “People buy a stock and they know nothing
about it,” he says. “That’s gambling and it’s not good.”

Fundamental Stock Research

When Lynch speaks of fundamental stock research, what does he mean?
This article from Stockcharts.com sheds light on what fundamental stock
research should be.
"[Fundamental stock research] is the examination of the underlying
forces that affect the well-being of the economy, industry groups, and
companies. As with most analysis, the goal is to derive a forecast and
profit from future price movements. At the company level,
fundamental analysis may involve examination of financial data,
management, business concept and competition. At the industry level,
there might be an examination of supply and demand forces for the
products offered. For the national economy, fundamental analysis
might focus on economic data to assess the present and future growth
of the economy. To forecast future stock prices, fundamental
analysis combines economic, industry, and company analysis to
derive a stock's current fair value and forecast future value. If fair
value is not equal to the current stock price, analysts believe that the
stock is either over or under valued and the market price will
ultimately gravitate towards fair value. Fundamentalists do not heed
the advice of the random walkers (sic. A Random Walk Down Wall
Street, by Bertin Malkiel) and believe that markets are weak-form
efficient. By believing that prices do not accurately reflect all
available information, fundamental analysts look to capitalize on
 perceived price discrepancies." (Quoted from
www.stockcharts.com/chartschool/fundamentalanalysis.)
Fundamental stock research, then, encompasses looking at the overall
economy, the sector and industry values, as well as the individual company
underlying a particular stock.
Fundamental Stock Research in a Few Minutes per Month
This process of fundamental analysis, if one were to do in on their own, can
be extremely time consuming and would require the education of an MBA
and the skills of a forensic corporate accountant. Fortunately, however, we
have other people with that education and possessing those skills that have
done the work for us. Here is a simplified approach that can be completed,
with practice, in a few minutes per month for the general economy and
industry conditions, and in just a couple of minutes for an individual
company.
This simplified approach can help you master on a basic level the
perspectives that you may want to have as an investor. I think that investing
in a stock without doing the fundamental research is like marrying a person
that you have not met yet. Arranged marriages can work, but there's a much
higher level of success if we actually get to know our prospective spouse
BEFORE we tie the knot. Your fundamental analysis skills can be expanded
over time with more study and observation, and I encourage you to do that.
But this is a great starting point.
Overall Economic Health
First, begin by looking at a website created by the same economic analysis
company that provides data and reports to the U.S. government, and anyone
else willing to pay for the reports. We are lucky—we can check out the
charts they provide for free on their website. The name of the company is
The Conference Board. If you listen to the news on the television or radio
and economic data is cited, it is frequently accredited to The Conference
Board. Their website is www.economagic.com.
Let's take a peek.
Figure 10. Landing page for Economagic.com
Here's the home page as of today when I am writing. As you can see, we
can click on Most Requested Series.

Figure 11. Initial web page for Economagic.com for Most Requested Series
of statistics

There is just a TON of information here. Luckily, we can get a pretty quick
overview by looking at just a few key indicators. Of course, you can look at
as many indicators as you want.
We can start by looking at just the charts to eyeball a particular trend. I like
to begin with Real Gross Domestic Product which indicates the entire
universe of economic growth for the U.S.A. Other countries will have their
own statistics and resources for reporting. It is up to us as to whether we
trust the "official numbers" or not. Gratefully, in the U.S.A., we still have
high confidence in our statistics and think that they have not been
manipulated (at least not much) because the numbers are coming from a
private company and not a division of the government. The accuracy of the
information is what makes it valuable and marketable. Here is the GDP
chart.

Figure 12. GDP as graphed by The Conference Board

As we might suspect from our own personal observations, the economy has
been in a growth mode in general, with the down turn from 2008 and 2009
showing progression as expected. But we can watch for changes in
direction and that may be a factor in helping us make investment decisions.
As you can see at the bottom of the chart, you can adjust the parameters
based on personal preference. Becoming familiar with the features of this
chart may take some time in the beginning, but once mastered, only takes a
few minutes to see the perspectives wanted.
The disadvantage of most economic information is that it is updated
monthly, but more significantly, it is formally reported on a quarterly basis.
Spotting a significant trend change in advance may be more difficult, but
the historical perspective can be useful nonetheless. We are looking for
trends!
We can adjust the time frame for a more intimate look at recent years.
Figure 13. Gross Domestic Product

Another indicator of economic health is the Unemployment statistics. Here

is the most recent chart from Economagic.com.

Figure 14. Economagic: Unemployment

We can clearly see here the relationship to the GDP and Unemployment by
comparing the respective charts.
Another interesting chart that may reflect on potential economic expansion
is the Consumer Price Index (CPI), which measures the price of the same
"shopping cart" of consumer items over a long period of time. It is a good
perspective on inflation. Check with the source material on
economagic.com to see what is included (and left out) of the CPI. As of this
time, oil prices and groceries were NOT part of the "cart".

Figure 15. Economagic: Consumer Price Index.

On this screen, I selected the elective for showing true recessions. Again, a
researcher may customize the parameters of the chart. (By the way, this
kind of chart display could make you look good at work if you are in a
position to know and use this kind of data. It helped me in my previous
career.)

Sector and Industry Health

Once we have a general idea of overall economic conditions, we can then
look to sector and/or industry health. I like to use the very utilitarian
website of www.morningstar.com. It has a lot of information all the way
from economic data to sector and industry information, but also
perspectives on general market conditions, as well as excellent information
about individual stock and funds. As of today, a membership is not required
to view a treasure trove of information. For Morninsgstar.com, a
membership will give you access to more data and perspectives, as well as
some screening tools to search for stocks with specific fundamental data
and ratios. We'll talk more about this later in the chapter on "Finding Good
Investments."
Here is a screen shot of the Markets section on Morningstar.com as of this
moment.

Figure 16. www.morningstar.com/markets (© [2018] Morningstar, Inc. All

Rights Reserved. Reproduced with permission.)

Here we can see the US Indexes, Global Indexes, and Commodities. We can
also see the Market Barometer for US markets, and then some ideas for
Gainers, Losers, and Actives. The site is updated daily.
Once you have a good idea of the general market conditions, you can ask
for a fundamental quote on a particular company by inputting the company
name or ticker symbol in the oval cell next to the Morningstar name/logo at
the top of the web page. For demonstration purposes I will call up the quote
on IBM, International Business Machines, an oft-used case study in many
financial courses.
Figure 17. Morningstar "Quote" page for IBM. (© [2018] Morningstar, Inc.
All Rights Reserved. Reproduced with permission.)
As one can see, some important data can be seen here, including the current
stock prices, highs and lows, dividend yield, market cap, volume in trade
today, and some "market multiple" data, like P/E ratio, etc. You can also
access a description of the company and News and Events (as we will
discuss under the concept of Fundamental Analysis).
One of my favorite features is being able to compare the company Key
Statistics against the Industry Average, which tells how this company
stacks up compared its own industry. Just scroll down the Morningstar page
to find:

Figure 18. Key Stats on Morningstar for IBM (© [2018] Morningstar, Inc.
All Rights Reserved. Reproduced with permission.)
Under Key Stats we can find the raw numbers being compared, but also red
and green bars indicating if the statistics are better or worse than the
related industry averages. Even if I can only read red for worse and green
for better, the insight would be helpful. However, there will be few stocks
that rate in the green on all aspects. And if a stock does rate green, that may
change each quater when the 10-Q and 10-K filings are received by the
SEC. Morningstar captures the data for the reports and has the result
available within 24 hours of the postings on the SEC website.
We can also see on this page the competitors to IBM as well as a listing of
the major holders of the stock. We also see Wallstreet Recommendations.
There is a lot of wonderful data in a compact package here.
Now, let’s discuss:
Fair Value, or what is also known as Intrinsic
Value.
Warren Buffet and many major analysts use the Intrinsic, or sometimes
called, the Fair Value, method to determine what the stock price ought to be
based on the financial stability and earning power of the company. The "big
boys" use this method in conjunction with Technical Analysis techniques,
which we will explore later.
Intrinsic Value gauges the "value of a company based on an underlying
perception or calculation of corporate value. Intrinsic value includes
such hidden assets as brand-name recognition, management expertise or
hard assets carried on the balance sheet at a cost significantly below their
market value.The stock price may be compared to this intrinsic value, and
the investor may perceive an undervalued company despite full valuation
on traditional ratios." (The Street, definition of financial terms)".
So, the idea would be that if the intrinsic value of a stock is higher than the
current market price of the stock, investors will recognize this and buy the
stock, thus pushing the stock price higher. Conversely, if the intrinsic value
of a stock is lower than the market price, investors will sell, or "short", the
stock to reap their profits.
Not many places publish Intrinsic Value. One is
www.quicken.com/investment portfolio/quotes and research.
Another website is Morningstar.com. There are more than 8,000 stocks on
the American markets alone at this time. To derive what Morningstar calls
Fair Value they require that the information provided by the company being
analyzed must fit their mathematical template so that their Fair Value
calculation is reliable and consistent. Only about 1,700 stocks meet this
criteria. They are given a Fair Value price, ranges of suggested buy and sell,
and a star rating. One star (out of five) means that the stock price is
significantly greater than the Fair Value (over priced). Five stars (out of
five) indicates the the current stock price is significantly lower than the
Fair Value (underpriced). The Fair Value price is only available on paid
subscriptions, but the star rating can be seen on the stocks without having
to set up an account.
The star rating will be posted on the quote page of a stock. The quote page
for IBM on figure 17 above shows a star rating of three stars (***), which
indicates that the stock price and the Fair Value price are close to each
other.
There is a "quicky" Intrinsic Value spreadsheet in Appendix A if you would
like to attempt your own evaluation. One caveat: your valuation may be
different than the Morningstar or Quicken evaluation since they each use
their own proprietary algorithms.

Rule Number Three: Make sure that the stock that

you are considering meets your requirements for a
company that you might like to own.

It is a sad thing to get "stuck" with a stock due to unexpected market

conditions and then discover that you really don't like this company, it has
poor prospects for the future, and is basically weak and in danger of
perhaps not being able to progress. Or perhaps it is even approaching
bankruptcy (which will cause the stock to be removed from the market and
leave the stockholders with worthless paper).
An interesting insight: Companies that are very stable and long lived
generally have stock prices that are more stable. Companies that are not so
financially stable (too much debt, non-steady revenue generation, etc.) tend
to have more volatile stock prices. So we have to come to some sort of
assessment as to our own "risk tolerance" to make sure that our investments
are in the range of our tolerance. Most people want to make a lot of money
quickly, which means looking for more volatility, which means taking on
more risk of loss with a greater chance for gain.

Tip: Nothing is ever "always" when it comes to the stock market. "Usually"
is a better thought when considering the dynamics of the market. Therefore,
we occasionally see companies that have little or no debt, that have great
track records for revenue steadiness and growth, yet still have volatile
stock prices. This would be due to the popularity of the stock, like Apple
(AAPL) or Google (GOOG or GOOGL). Historically they have had little or
no debt, great revenue production and growth, but people just like to trade
them a lot to make fast money, which brings more volatility to the stock
price. Remember, volatility = risk.
Here are some quick things to look at when assessing the financial stability
of a company.
Revenue growth. This ratio should be equal to or greater than the industry
average. You may be more lenient with this requirement if you are
assessing a newer company with a fast growth potential.
For example, here is the Revenue Growth recorded for Apple (AAPL)
Revenue expressed in millions.

You can see why Apple has been a very popular stock in the past decade. So
far in 2017 the revenue is set to eclipse revenue from 2014 and may even
get to 2015 levels. They have had their challenges in 2015 and 2016, but
continue to be a stock market "darling" due to the price volatility. The year
on year growth rates are listed under the actual revenue numbers.

Figure 19. Stock price growth for Apple, Inc.

Conversely, we see more steady price growth from a more conservative
company like IBM as compared to its ability to generate revenue.

(Financial information table thanks to Morningstar.com as of the date of

this writing) (© [2018] Morningstar, Inc. All Rights Reserved. Reproduced
with permission.)

Figure 20. Price chart for IBM

Of course there are many more elements involved in a professional investor
making a decision about stock buys or sells than just revenue growth, but
you should look at revenue growth first. Compare the growth rate to the
growth rate of the related industry to which the stock belongs.
Profit Margins. This is an amount of money left over after expenses are
deducted from revenues, expressed as a percentage. Here are some
operating margin figures for AAPL and IBM as examples.

The differences in Operating (Profit) Margin may also explain the

differences in investor interest expressed as a matter of the volatility of the
stock price.
And now, a side note about:

Risk
This graph (figure 21) represents what is known as the "efficient market
theory," which in general means that all investors know all things all of the
time about all investments. We know that this is not true, so the market is
NOT efficient in terms of being able to predict with a high degree of
success the outcome of any stock price, market, or economic movement.
Based on the idea that with limited information, from which we all suffer
(not even super computers can take into account all of the variables, the
biggest of which is guessing correctly investor sentiment in advance), one
person will think that the stock price is low, so they will buy. Another, on
the other hand, will think that the prices are high, so they will sell. Buying
and selling causes the prices to go up and down, which gives us an
opportunity to make money. Our education and experience and tried and
tested tools and methods will give us the advantage in the market to make
it possible for us to make a profit and minimize losses. We will become
like surfers who watch local conditions and through experience and
education, know how to catch the next "good wave." In our case, it will be
the "wave" of stock price movement that we are trying to catch.

Figure 21. Normal bell curve of the Efficient Market Theory.

On this bell curve, the vertical axis (X) represents the rate of return (or
Return on Investment, ROI). The horizontal axis (Y) represents the rate of
risk. Where risk is zero, we would expect a ROI of 2-4%, which is the
return on the what is considered to be the safest investment in the world:
U.S. Treasury Bills. This would be considered almost zero risk.
As we see in figure 21, when we increase risk, we increase ROI. But is it
not a one-to-one relationship.
In this chart, we see that seeking returns around 30-35% takes us to about
100% risk. So, if we take even more risk, our returns will begin to decline
over the long term. This is the case in an efficient market. Of course, it is a
matter of opinion about what constitutes risk, or even the rate of return at
100% risk. Nevertheless, it is a perspective that we may maintain. Too
much risk (greed) causes eventual loss, or at least, reduction of ROI. As we
take a shot at more risk, we see that our rate of return on average will begin
to decline
Of course, in our real world, which is an inefficient market where not all
investors know all things all the time about all investments, ROI can be
incredible as well as "losing your shirt", but we must remember that
relationship between risk and return. Volatility = risk = return (or loss).
Risk tolerance. It is important to ask yourself what your risk tolerance is.
Sometimes we don't know until we start losing and how we feel about that.
So, would you rather make a little bit of money on a regular consistent
basis and take few losses, or would you rather make a lot of money only
occasionally and suffer a large percentage of trades to be losses? Can you
find your own balance? I don't know, but I would think that an 85-90%
success rate would be relatively aggresive, but doable without taking too
much risk and still getting a great rate of return. According to our graph,
that might mean 20% to 30% annualized returns. It is possible to do better
with great care, experience, and intuition. It is also possible to have
miserable losses if one does not take great care, have sufficient experience,
and has poor intuition based more on wishful thinking than correct
analysis. (See appendix B for a quicky risk tolerance quiz.)
In the stock market, risk can be associated with a couple of different
calculated factors that are easily accessed. Several factors can be looked at,
like the BETA calculation, as already described.
How to measure risk. One might also look at the Implied Volatility (IV)
when looking at an option trade. On a scale of 1 - 100, an IV score of 35 or
lower would be considered low volatility. 65 or higher would be considered
high volatility. Between 35 and 65 would be considered moderate volatility.
Of course this is a sliding scale and incremental changes in volatility
should be considered. An IV of 89 would indicate very high volatility, and
therefore more risk. A score of 23 would indicate very low volatility, and
therefore low risk. The problem here is that profits are tied to risk, as
discussed in this section (figure 21). If a person wants pretty safe "bets" on
the stock market, one would expect lower rates of return and profits. If a
person wants high profits and higher profit persenctage gains, one will have
to accept the higher risk of losing the "bet" or the trading position.
You would be wise to also check the Average True Range oscillator to get a
good idea of the market indicators (indexes like the S&P500 (SPX), the
Dow Jones index (DJI) and/or the Russel 2000 (RUT), the industry
representative ETFs and the stock chart for the individual company that is
being considered. This topic will be covered more thoroughly in later
discussions. There are other less popular indicators as well that will be
mentioned in brief later.
Chapter 4. Technical Analysis—The Short-Term
View—When To Invest
Candlestick and other forms of chart style
The study of Technical Analysis is more complex than Fundamental
Analysis. Fundamental Analysis tells which companies we can feel safe to
invest in. Technical Analysis tells us when to buy and when to sell, not
what. To me, they are both vitally important. Leaving one out in favor of
the other means that we are too lazy to be complete in our analysis process,
which means that we are setting ourselves up for higher probability of
failure.
The most popular type of Technical Analysis (reading the stock price
charts) is using Candlestick Patterns. I will also describe less popular price
chart perspectives.
Mountain Charts are one of the oldest ways of looking at price
movements. They are called mountain charts because they resemble the
peaks and precipices of a mountain range in the distance. They look like
this:

Figure 22. Mountain chart from Stockcharts.com

Or this:
Figure 23 (Thanks to Morningstar). (© [2018] Morningstar, Inc. All Rights
Reserved. Reproduced with permission.)

Another type of chart is known as a Bar Chart:

Figure 24. Bar Chart

This bar represents the full movement of the stock in one day on this chart.
The little twig in the left of the bar indicates the opening price. The twig on
the right indicates the closing price. A red candle indicates that the stock
price closed lower than the opening price, and a green candle indicates that
the price closed higher than the opening price. In this case we can see that
on the 11th of September, the Opening Price (O) was $143.54. The High
(H) for the day was $145.13. The Low for the day was $143.01, and the
Closing price for the day was $144.86. The Volume (V, for discussion later)
for this day was 4,613,381 shares traded. The Y indicator just shows at
what position on the Y axis the cursor on the cross hair is showing—in this
case $142.45.
Since the candlestick pattern is the most common and popular tool used, I
have included an appendix on Technical Analysis with a more full
description of candlestick definitions and explanations. Basically, the
candle looks like it may have a wick on the top and on the bottom. The
bottom of the candle represents the opening price of the stock for that day
(or specified period, which could be more than one day, a week, a month,
etc., with day traders using intraday charts and specifying that the candle
could represent a minute, five minutes, or any other desired time
perspective for each candle).

A green or white (hollow) candle is a BULL candle which means that the
closing price was higher than the opening price. A red candle indicates a
BEAR candle, or that the stock price closed lower than the opening price.
The candle may or may not have "wicks" or sometimes called "shadows."
You may also see black or yellow candles on your chart. The black candle
may mean that the software for the chart thinks that the stock price is in
"transition," which means it MAY change, but no guarantees. A yellow
candle may just be that color because it is today's candle and still not sure
if it should be bullish or bearish.
Here's an example of a candle with wicks. The opening price for that day
was $25. During the day the price went up to $35, but then by the end of the
day the price was only $31. Therefore, we have a wick on top. If the price
had also gone down to as low as $21, we would also have a wick on the
bottom of the candle.
Here are several different configurations or patterns that will be helpful for
you to understand, not only their names, but also, most importantly, what
they are telling us.
There are basically three types of trends: Up, Down, and Sideways. By
looking at the patterns and using some simplified tools, we may be able to
(in the stock market there is no such things as "always," but "usually" is a
more clear communication about the market) determine the "trending" of
the stock price. The best opportunities usually, but not always, revolve
around the "reversal" of a pattern to "buy low and sell high," or sell short
high and buy back low, or find an option trade that would make some
incremental profits in a sideways market.
We will explore several different patterns among the oh-so-many that can
be talked about in the market. As the education in stock market investing is
endless, so are the possible techniques and pattern studies. In this book, I
will focus on the more common types.
Note: A trend is defined as a minimum of five daily (or period) candles
in a row, running generally in the same direction. Example, you could have
two bullish candles followed by a similar sized bear candle and then
followed but two more bull candles and that would still constitute a bullish
trend, albeit a short one. Trends can continue for weeks or months or years
before there is an actually trend change. Obviously, we would look for
shorter patterns, but not too short, where we can have some predictability.
Too much volatility can also be confusing.

Bullish Patterns

Figure 25. IBM candlestick chart.

In figure 25 we seem some examples of patterns (using the chart for IBM).
A Bullish pattern may have varying degrees of slope to the line. In Figure
23 we see a strong but moderately sloped bullish pattern. This is
characterized by higher and higher high prices and higher and higher low
prices. There can be some bull and bear candles mixed together, but the
general trend is in a particular direction.
Bearish pattern may have varying degrees of slope to the line. In Figure 23
we see a strong and more pronounced bear pattern with the highs going
lower and lower and the lows also going lower and lower.
This is typical, by the way. Bear patters are usually shorter lived than
bullish patters, but the prices fall much more sharply compared to a more
moderate change in prices in a bullish pattern.
A sideways pattern may show variances in high and low prices, but they are
staying pretty much in a sideways direction for highs and lows. This may
also be called a "price channel."
Continuation Patterns

Figure 26. Continuation pattern.

In a continuation pattern we see that the stock prices seem to be continuing
in a particular direction. In candlestick parlance this would also be called
"marching soldiers. I have drawn a line above and below each pattern to
show the continuation. The downward sloping channel would indicate a
bearish continuation. The upward sloping pattern would indicate a bullish
continuation pattern. The trick here would be to determine where there
would be a change in price trend so that we can buy low and sell high, or
conversely short the market (short sell the stock at a high point and buy it
later at a lower point). See the chapter of Trading Styles under Shorting for
more detail on how that works.
We are generally looking for "reversals." It is almost impossible to know
when a stock will reverse directions from bullish to bearish or bearish to
bullish, but some of our trending indicators will help with that.
I have included a candlestick dictionary in appendix C for more
information. We can spot "potential" reversal patterns. I have listed three
here of the most common, but as you will see in Appendix C there are
many possible indicators. It is not necessary that you memorized the names
of each one, but it is necessary that you are able to recognize the
configuration and know what it is communicating.

DOJI
As you will see in appendix C there are several types of "doji" (dough -
gee), which acts as a potential "pivot point" where a trend may reverse—
usually, but not always. A doji is a very short candle with longer wicks.
Here are some examples:

This is a standard doji where the "wicks" or "tails" are about the same
length. A short, fat body or just a line forming a cross would indicate a
doji.

HARAMI
A harami is a candle that is much longer than the candles before or after
but that has no wicks. It is also a possible signal for trend change. (See the
dictionary in Appendix C for several examples.)
Figure 27 Harami (Bullish)
MARUBOZU

Figure 28. Marubozu (bearish in this case). The Marubozu candle is

indicating that the bearish trend will resume after a short bullish reversal.
Marubozu means "baldy", or no wick, on the top. It is a longer than normal
candle and can appear side by side, usually one being bullish and the other
bearish, or vice versa. This may also be an indication of possible trend
change. (See the dictionary in Appendix C for several examples.)

Multi-Candle Configurations
There are many configurations, such as "cup and handle", "cup without a
handle", "rising wedge", "falling wedge", "pennant" patterns, "flag"
patterns, "compression" patterns (like a wedge pattern), "head and
shoulders", etc. Each one has its own view to help us understand a possible
change in the trend.
Figure 29. Cup and Handle is a pattern that usually indicates that a stock
price will "break out" of its past pattern and begin a new trend, usually
bullish.

Figure 30. Cup without a handle, rarer than "with handle" can also signal
a possible breakout.

Figure 31. Rising Wedge. This is a type of "compression" pattern where the
highs don't progress as fast as the lows are progressing upward. Like a
spring when compressed, the stock price will want to "spring out" in a
different direction. A rising wedge usually indicates a possible downward
breakout or change as can be seen in the illustration.
Figure 32. Falling Wedge. This is also a type of compression pattern where
the highs are lower and lower but the lows do not decline as rapidly,
indicating a possible bullish breakout.

Figure 33. Pennant pattern is another example of a compression. Unlike

the rising or falling wedges, the pattern stays pretty symmetrical for the
decline of the highs and the increase of the low prices. It is a great
potential for trend breakout.

Figure 34. Flag pattern. The high prices and the low prices are moving in a
particular direction and have about the same range between highs and
lows. This is a bear flag, but the opposite would be true for a bull flag.
Each one signals a potential for trend change or a continuation of the
previous pattern.
Figure 35. Head and Shoulders. This pattern usually precursors a
definitive reversal. In the case of the pattern on the left, a signal is given
for a bearish reversal. On the right we seen a signal for bullish reversal.
There are many, many variations for patterns. The ones demonstrated here
would be a good start for a new investor to master. Addressing new patterns
is always a fun idea and as you continue to study the market, there seem to
be an endless supply of patterns and perspectives.
For example, many people like to focus on Fibonacci Stock Price patterns,
which we will not address in this material, but many investors see it as one
more tool or perspective to understand potential price movements.
Fibonacci patterns are statistical calculations about possible ranges of stock
price movements. I would suggest that Fibonaccis be use as a supplement
to confirm a decision after careful technical analysis and they not be use as
a primary source of information for making a decision. I had a client who
had a PhD in Fibonacci studies who came to me for help in adding
technical and fundamental analysis to his understanding as the Fibonaccis
alone were only giving him about a 50% success rate.

Figure 36. A view of a Fibonacci study.

Chapter 5. Technical Analysis: Introduction to
Upper Studies
An upper "study" is a statistical analysis of the history of the stock price
movement and is an attempt to give a better view of the stock price
trending through various means and mathematical calculations.
We will begin by talking about Simple Moving Averages (SMA). This is a
calculation that shows how the compilation of a series of stock prices may
help us see where the trend may be going. Using them in concert with
other statistical features may add some insights. For example, the 20-day
moving average will include the closing prices of each day for 20
consecutive trading days, and then reveal that value at the end of a line
drawn on the same chart (the upper chart) with the candlesticks.

Figure 37. 20 Day Simple Moving Average (SMA) In this chart we see a
blue line representing how the average of the last 20 days of prices has
changed over the period from May to October. The interpretation: When
the candlesticks are above the 20-day SMA line, we are in a bullish trend
considering the last 20 days of data. If the stock price is below the line, we
are in bearish trend. As you can see, the line lags behind the actual stock
price movements by a couple of days.
Looking for the candlestick to cross over the line from below the 20 SMA
to above would indicate a buy confirmation, or a sell confirmation when
the candlesticks go from above to below the line.
I have included a 50-day and a 200-day, along with the 20 SMA on the
next figure to show how the lines can work together.
On this chart we may use only the SMA lines to confirm buy or sell. We
see that the 20 SMA was below the 50 SMA, but crossed over, indicating a
buy or confirmation of a buy signal. In this chart we are also seeing the
200 SMA way above the current prices, which indicates that prices were
much higher a year ago and that perhaps we are in a recovery period for
this stock that has seemingly bottomed out and now may be returning to a
more bullish function. Or, there may have been a dynamic shift in the
perception of investors that for some reason this stock is valued at much
less than a year ago. Checking on the press releases and news about such a
stock might give us the additional insights as to why this may be. For
example, the stock holders may have filed a class action law suit against
the company, claiming, perhaps, that the financial reporting was incorrect
and calling for a full audit of the financials to assure accuracy, or, heaven
forbid, manipulation of the figures—or even out and out fraud.

Figure 38. Using the 20 and 50 SMAs together.

Now, just for fun, imagine that we want to see a little more close action for
a swing trade (one that lasts more than a day (day trading) to less than a
year (long term investing)). We could add the commonly used 13-day
SMA and see what it tells us.
Here we can see that we are getting "buy" crossover confirmation much
sooner than if we just used the 20 and 50 day SMAs. When the 13-day is
below the 20-day and crosses up over it, a buy signal comes much sooner
than if we are waiting for the 20 to cross up over the 50 SMA.
EMA (Exponential Moving Average) gives more weight statistically to
the more recent data than SMAs, thus causing a slight shift in the
movement of the averages and may indicate a buy signal sooner. This
advanced weighting may also give a premature false signal, so reviewing
both for perspective is a good idea.

Figure 39. Using the 13, 20, 50, and 200-day SMAs.
Drawing Support and Resistance Lines
A common practice of many investors is to draw support and resistance
lines on the graph. Many analysis tools allow you to electronically draw
on the graph.
You draw support lines under the candlesticks to signify a perceived
virtual "floor" to the stock price. In other words, unless there is a dynamic
shift in opinion on the stock, or some bad news, the stock price doesn't
appear likely to go below this support or floor line.
Conversely, when you draw a line above the candles you create a ceiling or
resistance to higher movement where the stock price seems to rise to
before it starts to go back down again in its normal "cycle." Again, this is a
ceiling in the absence of stock news to affect what investors are thinking.
We will use the same chart for IBM to look at samples of support and
resistance lines. As you can see, the stock price might go through different
trends, and each trend will have its own support and resistance. The lines
do not have to be exactly parallel or horizontal; they could be sloped
toward bullish or bearish trends.

Figure 40. Using Support and Resistance lines.

The support and resistance lines can be drawn for any interval, however,
you should probably not use them for periods of less than the 5 days
required to constitute a trend. We are looking for reversal points as well.
Multiple Time Frames
We can also get more of an eagle-eye view by not just looking at daily
candles, but also weekly or monthly candles. For example, we may think
that the stock price had bottomed out only to find that it is merely at the
low point in a higher, but shorter-term swing. Or, perhaps the opposite is
true. The stock may appear to be at a high point, but it is actually forming
a head and shoulders at the bottom of a longer-term swing.

Figure 41. Showing Weekly Candles.

Figure 42. Showing Monthly Candles. Notice the time frames associated
with figures 40, 41 and 42.
In figure 40, we think that the stock price may be at a low point. But
comparing it to figure, 41 we see that it could be seen at a higher position
in the term, and figure 42 shows that in the longer run of a decade, the
price is actually historically high. It might be an interesting exercise for
you to draw your own support and resistance line. Pick a couple of low
points in a trend and draw a support line. As seen in Figure 40, there can
be several different sets of support on a chart. Then pick a couple of high
points in the trend and draw some resistance lines, just for fun. See what
you think. There is no exact science here, so have some fun eyeballing
your own interpretation.
Note: We are more likely to make valid investment decisions using a 6-
month daily candle chart for swing trades, but the additional perspectives
may give some useful insight.
Looking at the dip in stock prices from early 2016 on the weekly chart, we
see on the monthly chart that it was really just a temporary adjustment
(what's called a "retracement") in the longer trend.
Bollinger Bands
Bollinger Bands are often used as a charting feature that allows the
computer to calculate artificial support and resistance lines for us. I won't
try to explain the statistical concept for the Bollinger Bands, but basically
the calculation results in the upper and lower bands being two standard
deviations from the 20-day mean of the stock price. For more information
on Bollinger Bands you may visit www.Investopedia.com/bollingerbands.
Here is pictorial representation for the bands (figure 43).
When the bands draw closer together it is seen as a compression cycle,
which means that the stock price may break out either direction at some
point. When the bands are far apart the indication is that there is a very
strong trend occurring after the breakout with a high volatility of price
movement, and we assume that the price volatility will eventually return
to average or normal. In some cases, that assumption may not be logical,
especially for new companies and those that are highly traded and generate
lots of news, either good of bad.

Figure 43. Bollinger bands set to 20-day moving average and 2 standard
deviations from the mean.
This particular feature is especially helpful when trying to determine the
strike prices for options trading. If you are interested, we will address
options trading in later chapters.
One last indicator that I would like to introduce that could be very helpful
in making buy and sell decisions is the Parabolic SAR (Stop And Return).
That sounds sophisticated. Again, more information can be found on
www.Investopedia.com if you want a more thorough explanation.
Basically, when the dots are ABOVE the candlesticks, we are in a
BEARISH pattern. When they are BELOW the candlesticks, we are in a
BULLISH pattern. The dots can be seen as support or resistance, but the
nice little feature here is that when the dots go from below the
candlesticks to above them, it could indicate a SELL signal, and when the
dots go from above the candlesticks to below them, it could be a BUY
confirmation.

Figure 44. Parabolic SAR.

So, just for fun, let's add all of these indicators onto one chart and see what
we get. Putting it all together:

Figure 45. Set of Upper Studies. Daily Candles, Parabolic SAR, Bollinger
Bands, SMAs 13, 50, and 200.
The 20 SMA was not added since the small dotted line the same color as
and between the Bollinger Bands shows the 20 SMA used to compute the
Bollinger Bands. Isn't that an interesting if not pretty picture? An
experienced investor can look at a chart like this and see in a short glance
if there may be an opportunity for a trade and what kind.
What is each indicator saying? What are they saying in concert?
Examples: Sell

Figure 46. Sell set up (we call it a "set up" when signals come together
and "vote" for a particular action).
In this case, we can see that on the 30th of June the Bollinger Bands were
beginning to compress. The 50 SMA crossed over the 20 SMA (the little
dotted line between the Bollinger Bands), the SAR shifted from below to
above, we had a bearish Doji that day. Yes, the stock rebounded for two
days, but as predicted, went into a bearish trend after that.
Figure 47. Buy set up.
We can see that the stock prices have seemed to bottom out on the 20th of
June. The SAR went from above to below. We waited for the other signals
to catch up, and on the 29th the 13 SMA crossed over the 20 SMA. We
could wait a little longer to be sure and enter the trade when the 20 crosses
of the 50 around the 26th of September. As you can see, the sooner you
move, the more money you can make, but also the more risk you are
taking without the additional confirmations. In this case we didn't find a
true Doji, but the candles were smaller than average around the 29th of
August. We might be safe in saying that there was a support line at 141
and that the candles broke through the support on the way down. It is more
likely that the prices would rebound and come back up as we use the SAR
and the 13 and 20 SMAs also as guides. We might also notice that the
Bollinger Bands were extremely expanded starting in the middle of June
indicating a possible consolidation of the price run in anticipation for the
eventual reversal. Patience is always key. Conversely, when Bollinger
Bands appear to be more narrow than normal, it may be signaling a
consolidation or "compression" pattern and a breakout may be pending.
Rule Number Four: Be Patient.
Don't overreact or act too soon, (or too late). It is not always easy to know
the correct time to buy or sell, but follow your rules that best that you can.
Chapter 6. Technical Analysis: Introduction to
Lower Studies
As with upper studies, there are a set of "lower studies" that are meant to
"confirm" what one is seeing in the upper studies. As explained, the upper
studies are superimposed on the candlestick graph, while the lower studies
are displayed below the candlestick graph in separate graphs. The same
time frames will be used to show the interrelationship of the studies.
The foundation for a lot of the math that we use today for analyzing stock
price movements for lower studies are founded on the work done by three
men:
Fischer Black and Myron Scholes proved in the late 1960s that a
dynamic revision of a portfolio removes the expected return of the
security, thus inventing the risk neutral argument.[4][5] In 1970, after
they attempted to apply the formula to the markets and incurred
financial losses due to lack of risk management in their trades, they
decided to focus in their domain area, the academic environment.
[6] After three years of efforts, the formula named in honor of them

for making it public, was finally published in 1973 in an article

entitled "The Pricing of Options and Corporate Liabilities", in
the Journal of Political Economy.[7][8][9] Robert C. Merton was the
first to publish a paper expanding the mathematical understanding of
the options pricing model, and coined the term "Black–
Scholes options pricing model". Merton and Scholes received the
1997 Nobel Memorial Prize in Economic Sciences for their work,
the committee citing their discovery of the risk neutral dynamic
revision as a breakthrough that separates the option from the risk of
the underlying security.[10] Though ineligible for the prize because of
his death in 1995, Black was mentioned as a contributor by the
Swedish Academy.(from Wikipedia, Black-Scholes Model)
Aberrations and adjustments to the model have led to the creation of
what's known as "confirming oscillators" and other mathematical
calculations in an attempt to track trends and even forecast them into the
future. We will look at some of the most common studies.
There are several statistical studies and mathematical tools that you have
at your disposal—many you can access for free and many that you can
access through a broker (though not all brokers have access to all of the
studies). I’ve made this point before, but it’s worth making again: None of
the studies are perfect, and none are entirely accurate in predicting the
future. They may help us spot potentials in the continuation of trends or
disruptions of trends. These studies should be used in conjunction with the
upper studies to give us as much insight as possible in making investment
decisions.
MACD
The most common of these secondary indicators would probably be
considered as the MACD, often call the Mac-D. It stands for Moving
Average Convergence Divergence. The Investopedia definition is:
"Moving average convergence divergence (MACD) is a trend-
following momentum indicator that shows the relationship between
two moving averages of prices. The MACD is calculated by
subtracting the 26-day exponential moving average (EMA) from the
12-day EMA. A nine-day EMA of the MACD, called the "signal line,"
is then plotted on top of the MACD, functioning as a trigger for buy
and sell signals.
There are three common methods used to interpret the MACD:
1. Crossovers. As shown in the chart above, when the MACD
falls below the signal line, it is a bearish signal, which
indicates that it may be time to sell. Conversely, when the
MACD rises above the signal line, the indicator gives a bullish
signal, which suggests that the price of the asset is likely to
experience upward momentum. Many traders wait for a
confirmed cross above the signal line before entering into a
position to avoid getting "faked out" or entering into a position
too early, as shown by the first arrow.
2. Divergence. When the security price diverges from the
MACD. It signals the end of the current trend.
 3. Dramatic rise. When the MACD rises dramatically—that
is, the shorter moving average pulls away from the longer-term
moving average—it is a signal that the security
is overbought and will soon return to normal levels.
Traders also watch for a move above or below the zero line because it
signals the position of the short-term average relative to the long-term
average. When the MACD is above zero, the short-term average is above
the long-term average, which signals upward momentum. The opposite is
true when the MACD is below zero. As you can see from the chart above,
the zero line often acts as an area of support and resistance for the
indicator."

Figure 48. Introducing the MACD.

There are two parts to the MACD chart. One part is the "squiggly lines," in
this case, red and black. Many analysis websites will allow you to change
the colors if you wish. They also allow you to change the default values
for the MACD, depending on the website. If you are just beginning to
learn about MACD, however, the defaults are a good place to begin.
I like to call the more jagged line (the black line) the "fast line" because it
moves more quickly. It is based on the 12-day moving average, which is
the default setting. The "slow line" is red.
Basically speaking, when the fast line (black) is above the slow line (red)
the stock movement is bullish—generally moving upward. When the fast
line is below the slow line, that price movement is bearish—generally
moving down.
Where the lines cross over, you can view that as a "confirmation" to buy or
sell.
Examples: The fast line is above the slow line and then drops, crossing
over below; you could see this as a confirmation to sell. A conservative
investor would wait for the confirmation. Conversely, let’s say that the fast
line is below the slow line and then rises, crossing over to above; you
could see this as a confirmation to buy the stock. A conservative investor
would wait for the crossover before pulling the trigger. In any case, the
study should be used with other studies to create a nuanced, big-picture of
what the market is doing. It’s like listening to an orchestra perform: if we
focus intently on the trumpet section, we may miss the unified sound of
the composition.
Sometimes the lines do what I call a "snake dance." This describes where
the two lines seem to be weaving above and below each other in rapid
intervals. This is a sign that the market does not have a definitive
direction, or is displaying "ambivalence." This may be a useful pattern for
considering an option trade (see the materials on Stock Option Contracts
for this kind of strategy).

The MACD Histogram is the set of blue bars within the graph itself.
They give a clearer view of how far apart the fast and slow lines are. When
the blue bars are below the "zero" line, the price function is bearish. When
they are above, the function is bullish. As can be seen, the bars glow
longer and shorter and may indicate that the trend is gaining or losing
strength. You can anticipate a trend change by observing the length of the
bars. If the bars are shortening, the stock price trend may be heading
towards a reversal.
As can be seen above, in many cases, the confirmation of the trend change
comes a few days AFTER the actual trend in the candlesticks may be seen.
To catch the stock price at the top or bottom of a run may be almost
impossible (how good is your crystal ball?). That’s why waiting for
confirmation is a safer way to trade. Anticipating the crossover may yield
more profit, but it’s also taking more risk.
The Stochastic Indicator (pronounced STOE-kas-tik)
This indicator may be seen as one of the few and the most commonly used
to "predict" a trend change, because—especially with the FAST Stochastic
—the signal to prepare to buy or sell may come a day or two before the
actual trend change can be seen on the candlesticks, and certainly before
the confirmation of the MACD.
When the "fast line" (the only line that we are concerned about with the
Stochastic) is above the 80 score, it indicates a market that is very bullish.
Therefore, we may anticipate a sell, since we should sell when the prices
are high and buy when the prices are low.
When the line is below the 20 score, we assume that the price is bearish
and therefore prepare to buy.
In each case, waiting for confirmation from the MACD before actually
triggering your trade would be a conservative approach.
Perhaps this could be phrased as "ready-aim-fire," with the Stochastic
telling us to fire.
According to Investopedia:
"The stochastic oscillator is a momentum indicator
comparing the closing price of a security to the
range of its prices over a certain period of time.
The sensitivity of the oscillator to market
movements is reducible by adjusting that time
period or by taking a moving average of the result.

History
The stochastic oscillator was developed in the late 1950s by George
Lane. As designed by Lane, the stochastic oscillator presents the
location of the closing price of a stock in relation to the high and low
range of the price of a stock over a period of time, typically a 14-day
period. Lane, over the course of numerous interviews, has said that
the stochastic oscillator does not follow price or volume or anything
similar. He indicates that the oscillator follows the speed or
momentum of price (italics added). Lane also reveals in interviews
that, as a rule, the momentum or speed of the price of a stock
changes before the price changes itself. In this way, the stochastic
oscillator can be used to foreshadow reversals when the indicator
reveals bullish or bearish divergences. This signal is the first, and
arguably the most important, trading signal Lane identified.
Overbought vs Oversold
Lane also expressed the important role the stochastic oscillator can
play in identifying overbought and oversold levels, because it is range
bound. This range – from 0 to 100 – will remain constant, no matter
how quickly or slowly a security advances or declines. Considering
the most traditional settings for the oscillator, 20 is typically
considered the oversold threshold and 80 is considered the
overbought threshold. However, the levels are adjustable to fit
security characteristics and analytical needs. Readings above 80
indicate a security is trading near the top of its high-low range;
readings below 20 indicate the security is trading near the bottom of
its high-low range [italics added]."

Figure 49. The Stochastic Oscillator

Here we see that the market price for this stock was in the bull territory—
that’s prepare-to-sell territory—the last two weeks of July and the first two
weeks of September. In mirror image, the oscillator was in bear territory—
or, prepare-to-buy territory—in mid-August and the first two weeks of
October.
Note: There are several variations of the Stochastic, including Full, Slow,
and Fast. Each sort of explains itself in the name. The Slow hangs back a
little to give us a more conservative confirming indicator. The Fast seems
to lean a little ahead, like the Exponential Moving Average (EMA) that
gives more weight to recent data rather than a simple average. See which
you prefer depending on our risk tolerance and which "speaks to you" more
clearly. In figure 50 I have used the Fast Stochastic as I think it gives a
little more advanced notice of a trend change.
Williams % R. A variant of the stochastic, which some people prefer since
it simplifies the image, is the Williams % R.
It basically shows us the same signals but looks like this:

Figure 50. Williams % R

You get about the same signal from the Williams % R as you do from the
stochastics. See which one you prefer through looking at many charts and
practicing doing the buy/sell analysis.
RSI
The final oscillator that we will look at is the RSI (Relative Strength
Indicator). This indicator does NOT give us a sense of direction, but a sense
of the POWER of the move. Like pointing a hose, regardless of which way
you point it, the flow gauge does NOT tell you which direction the flow is
going, but it DOES tell you how strong the flow is.

Figure 51. The RSI, or Relative Strength Indictor.

Investopedia tells us:
"The relative strength index (RSI) is a momentum indicator
developed by noted technical analyst Welles Wilder, that compares
the magnitude of recent gains and losses over a specified time period
to measure speed and change of price movements of a security. It is
primarily used to attempt to
identify overbought or oversold conditions in the trading of an asset.

Some traders, in an attempt to avoid false signals from the RSI, use
more extreme RSI values as buy or sell signals, such as RSI readings
above 80 to indicate overbought conditions and RSI readings below
20 to indicate oversold conditions.
The RSI is often used in conjunction with trend lines, as trend line
support or resistance often coincides with support or resistance levels
in the RSI reading.
Watching for divergence between price and the RSI indicator is
another means of refining its application. Divergence occurs when a
security makes a new high or low in price, but the RSI does not make
a corresponding new high or low value. Bearish divergence, when
price makes a new high but the RSI does not is taken as a sell signal.
Bullish divergence that is interpreted as a buy signal occurs when
price makes a new low, but the RSI value does not. An example of
bearish divergence can unfold as follows: A security rises in price to
$48 and the RSI makes a high reading of 65. After retracing slightly
downward, the security subsequently makes a new high of $50, but
the RSI only rises to 60. The RSI has bearishly diverged from the
movement of price.
STRATEGY 'Relative Strength Index - RSI'
The relative strength index is calculated using the following
formula:
RSI = 100 - 100 / (1 + RS)
Where RS = Average gain of up periods during the specified time
frame / Average loss of down periods during the specified time
frame.
The RSI provides a relative evaluation of the strength of a security's
recent price performance, thus making it a momentum indicator. RSI
values range from 0 to 100. The default time frame for comparing up
periods to down periods is 14, as in 14 trading days.
Traditional interpretation and usage of the RSI is that RSI values of
70 or above indicate that a security is becoming overbought or
overvalued, and therefore may be primed for a trend reversal or
corrective pullback in price. On the other side of RSI values, an RSI
reading of 30 or below is commonly interpreted as indicating an
oversold or undervalued condition that may signal a trend change or
corrective price reversal to the upside.
Tips on Using the RSI Indicator
Sudden large price movements can create false buy or sell signals in
the RSI. It is, therefore, best used with refinements to its application
or in conjunction with other, confirming technical indicators.
Some traders, in an attempt to avoid false signals from the RSI, use
more extreme RSI values as buy or sell signals, such as RSI readings
above 80 to indicate overbought conditions and RSI readings below
20 to indicate oversold conditions.
The RSI is often used in conjunction with trend lines, as trend line
support or resistance often coincides with support or resistance
levels in the RSI reading.
Watching for divergence between price and the RSI indicator is
another means of refining its application. Divergence occurs when a
security makes a new high or low in price but the RSI does not make
a corresponding new high or low value. Bearish divergence, when
price makes a new high but the RSI does not is taken as a sell signal.
Bullish divergence that is interpreted as a buy signal occurs when
price makes a new low, but the RSI value does not. An example of
bearish divergence can unfold as follows: A security rises in price to
$48 and the RSI makes a high reading of 65. After retracing slightly
downward, the security subsequently makes a new high of $50, but
the RSI only rises to 60. The RSI has bearishly diverged from the
movement of price.
Is the Investopedia definition and instruction too technical? Well, to
simplify, we can look for "set ups" or "line ups" and if, as beginners, we
insist on having the line ups, although not perfect, we may do fewer trades
but more successful trades by taking less risk.
Rule Number Five. Look for the "Set Up" Based
on Your Rules
Figure 52 shows a typical "set up." This kind of chart pattern is not
common. We will explore ways to search for set ups in chapter 7, but here
is a view of a chart that seems to have it all.

Figure 52. The Set Up

At A, we see that the candles have been following the upper Bollinger
Band but are now beginning to break away. The band expands temporarily
indicting a lot of unusual volatility. The MACD and the Fast Stochastic are
in strong bull mode, and the RSI supports that idea, although it’s not above
the 70 line, (but is touching it). Remember, this is NOT an exact science,
so "close enough" often works. Taking in all this information, you
determine that this is a pretty strong "get ready to sell" signal—but not
yet. Be patient and wait for it. The 13 SMA is well above the 20 and 50,
which still shows strong bullish function.
At B, we see that the candles have been going sideways, indicating a
consolidation pattern and several Dojis in a row. The MACD has crossed
over and the Stochastic has plummeted to Bear territory. The RSI also
indicates going from strong to weak. The strong segment of the RSI
indicates that the movement, in this case bearish, will be strong. After the
move, the strength becomes weak in preparation for the next surge, either
up or down. Remember, the RSI is non-directional, but indicates the
strength of the momentum. The 13 SMA is about to cross over the 20
SMA.
At C, the stock price has plummeted and we have a Doji before the bottom
candle, which looks like a hammer. These are both indicators for possible
change, the hammer being more bullish. The stochastic and the MACD are
indicating strong bearish function. The Bollinger Bands are very far apart
indicating the potential for retraction. The 13 SMA has crossed over the 20
and 50, indicating very strong bearish plunge.
At D, the candles have leveled out for a moment, but the 13 SMA looks
like it is recovering and indeed in a few days it crosses back over the 20
SMA confirming the bullish push that is also indicated by the MACD
bullish crossover and the Stochastic breaching into bull territory again.
C is a strong "get ready to buy" signal and D is a strong verification or
confirmation of the buy signal. A purchase anywhere in between would be
logical, and waiting for the MACD crossover the most conservative take
on this chart.
Note: Surges in volume may have also helped, but in this case, they are not
much help.
As can be seen in this chart the indicators were not giving any definitive
ideas of possible stock price movement before A, which then became quite
definitive.
You may have noticed that the Parabolic SAR was not included in the
screen shots. They were omitted to avoid an overly cluttered screen. Here
is the same chart as figure 53 but leaving out the Bollinger Bands and
including the Parabolic SAR.
Figure 53. Using the Parabolic SAR in conjunction with other indicators.
It appears that in this case the SAR confirms the signals to buy and sell.
It's OK to have multiple approaches and views to a chart. Your preliminary
chart may give you some strong ideas and your secondary checks with
additional views can give you even more confidence in your investing
decisions.
Chapter 7. Finding and Executing a Trade
There are many methods for finding ideas on potential trades. None works
better than the others. Using a plurality of these approaches will probably
help you find more trade opportunities. The following are not listed in any
specific order and may be used at your own convenience and timing.
Technical Search Engines
Almost every site that I have visited for brokers in the last while has had
some sort of tool for finding stock price patterns. It is possible to
customize searches for a variety of patterns to see if something has a "set
up" today.
Double Bottom
For example, one might search for a buy set up in what is called a "double
bottom," where the stock price has been descending for a period, hits a low,
then bounces up—but comes back down to "re-test" the support line—but
then goes back up again. The second bottom could be seen as a "buy
trigger."
Figure 54. Double bottom, double top, and head and shoulders pattern.
Double Top:
This is where the stock price seems to have hit a high, gone back down, and
come back up to that "resistance" line again, thus indicating a time to
"sell." This clearly seen in figure 52.
Head and Shoulders
In figure 54, the head and shoulders pattern is evident, although a little less
clear. As you can see, after the pattern was formed, the stock price
accelerated upward to new highs. An upside-down head and shoulders
could also indicate a sell set up.
Always double check with your other indicators to see if they are also
confirming the price action pattern.
There are many search engine parameters that you might set depending on
what you want to do. Become familiar with the search engines that your
broker or analysis website offers. Learn how they work so you can use them
to find possible trading patterns.
Adding Fundamental Analysis, Intrinsic Value or Fair Value
Endemic to the Warren Buffet methodology, if an investor can determine if
a stock is fundamentally overvalued or undervalued, this could lead to
stock investing decisions across the entire market. The theory states that a
stock that is undervalued will rise in price as investors discover it's "under-
valued-ness" and then seek to take advantage of price increases as other
investors make the same discovery. The opposite would be true of an
overvalued stock where an investor might consider "shorting" the stock or
place a bearish option trade.
There aren't many websites that take on the task of calculating and
publishing the Intrinsic value of a stock. Some investors use "book value"
to determine intrinsic value, but book value is a much simpler and less
accurate form of determining value.
Morningstar.com and Intuit.com/investors are two examples of websites
that do the calculations. For Morningstar you will need to be a premium
member to obtain that information, and they only publish the calculation of
about a third of the stocks on the open markets due to the robust nature of
the equation that they use. Many companies’ financial statements do not fit
the required format that Morningstar uses for the calculation.
Watching the News
By staying in tune with press releases about the market in general and
individual stocks may also give you an idea from time to time.
Announcements for Earnings, Dividends, change in management, mergers
and acquisitions, stock splits, bad news, good news, etc., can all affect the
stock price. This news is typically published on the analysis websites.
In fact, one evening I was watching the news and discovered that a local,
publicly traded company had announced their well respected Chief
Executive Officer (CEO) of several years had resigned. I felt that the stock
prices would go down, at least temporarily, which they did. I watched the
price chart for a few days and felt like the stock price had bottomed out, so
I bought some stock. The price went down a little more, but then leveled
off at about the price that I had paid. In less than two weeks it was
announced that the board of directors had appointed a new CEO, and within
a day the stock prices began to rise back to the previous price channel. I
watched the technical analysis of the price and was able to exit at a high
point and made a nice little profit in a short period of time.
Rule Number Six. Wait for the Setup
Chapter 8. Introduction to Stock Option Contracts
Key Term: Position
This may be a little confusing at first, but understanding that in the stock
market when entering a trade, either by buying or selling the stock to
begin the trade, this is also known as "opening a position." At the other
end of a trade, when exiting the trade either by buying or selling, we are in
"closing a position."
So, if we buy the stock, we are opening the position. If we then sell the
stock, we have closed that position. Or, if we sell the stock short to begin
with, we have "sold to open," and therefore must "buy to close" that
position. This terminology is more often used with options, but can
legitimately be used with just buying and selling stocks, or selling short
and buy to close.
Key Term: "Shorting" vs. Going Long
If a position is opened by selling, it is called "shorting." If a position is
opened by buying, it is known as "going long."
So, if a person says that they went long on a call contract, you know that
they bought the call to open the position. If they say that they went short
on a call contract, you know that they sold the contract to open.
If they say they went long on the stock, you know that they bought the
stock. If they say that they went short on the stock, you know that they
opened a position on the stock by selling it first, or "shorting the market"
on that stock.
If we buy to open, we must sell to close a position. If we sell to open, we
must buy to close the position.
Key Term: Basis Cost
This is the average price of the stock owned. Example: The investor buys
100 shares at $20. Then the stock price goes down and the investor thinks
that this is an even better price, let's say of $18 per share, so buys 100
more shares. Then the price goes up to $21 per share and the investor
thinks that this is still a great price, so buys another 100 shares. Average
price, or basis, would be $19.67 per share. So, 100 x $20 = $2000. 100 x 18
= $1800. 100 x $21 = $2100. Add them all together for a total investment
of $5900. Divide $5900 by 300 shares and we get $19.67. If the investor
then sold 3 contracts (100 shares per contract is the standard contract)
against his stock and earned $1 per share, his basis would be reduced by
$300, resulting in a basis of $5900 - $300 = $5600 / 300 shares = $19.33.
Key Terms: Bets and Plays
These words are stock market jargon for placing an Option Trade and do
not refer to direction or short or long. A "long" bet or play on an option
would be where the option is purchased.
Options: An option is a contract where the buyer of the contract has the
right to transact at the "strike" or specific value but has no obligation to do
so. The seller of the contract receives the "premium" or amount paid by
the buyer to buy the contract and has the obligation to fulfill the contract if
directed to do so by the buyer.
The contract will have an expiration date. As a general standard, the
expiration date will be the third Friday of the month. With larger more
popular stocks, the rules have been augmented to include expiration dates
in each week. These are called "weekly options" or "baby options."
In stock options, this agreement can take two forms. One is named a
CALL option contract. The other is named a PUT option contract.
These contracts can be bought or sold to begin the process. This may seem
contrary to intuition, but what we are actually doing is "opening" a
position in the market. So, I can buy to open or sell to open. Obviously
then, to close the position or conclude the contract, I would do the
opposite of what I did to open the position. If I buy the contract to open or
create the position, then I would have to sell to close the position. OR, let
the contract expire, which will also close the position.
Or, I may "sell to open" the position, and then to close it, I would "buy to
close" to terminate the contract, or let it expire to close the position.
Obviously, there must be buyers and sellers at the same time or no
transactions could take place. We will elaborate on this in the discussions
to follow about volume.
All contracts are tied to 100 shares. One contract will cause the obligation
against 100 shares. That is called the contract "lot." Odd lots are possible
and more common when buying and selling stock, but not in options. An
option contract is always 100 shares.
Note: Brokerage fees are applied to a buy and a sell. If the contract
expires, there is no brokerage fee.
CALL Contracts
A call contract, when purchased to open a position, gives the buyer the
right but not the obligation to buy a stock at the specified "strike" price on
or before the date of expiration on that contract. The amount earned is a
capital gain strategy and on a bought call, the potential for gain is
limitless, theoretically. The seller of the call is required to provide that
stock to the buyer at the agreed-on price, or strike price. The "buy" call
strategy is employed when the investor thinks that the stock price is going
to stay above the breakeven point (strike price plus premium paid).
Example: I buy a call contract on IBM with a strike price, or contract
price, of $150. The seller of the contract is required to provide the
specified number of shares to me at the strike price if I choose to exercise
my right to buy the stock any time before expiration.
So, the logic is, I buy the CALL thinking that the stock price will go above
my strike price by at least the amount that I paid for the contract. That
would be the breakeven point. Strike plus premium equals break even. So,
in this case, let’s imagine that I paid $1.00 per share for the contract. I buy
a CALL contract for $1.00 per share which means that I would pay $100
per contract which guarantees that I can buy the stock for $150 per share
should I decide to exercise my right. The breakeven point would then be
when the actual stock price reaches $151 per share.
Let's imagine that the actual stock price in the open market does not go up
above $150, but by the time the contact expires, the price may only be
$149.59. I would not exercise my right to buy the stock at $150. If I really
wanted the stock at that time, I could pay only $149.59 for the stock, not
$150 per share.
If the stock price goes up to, let's say, $154 per share, I would exercise my
right and force the seller to sell me the stock at $150. I could then sell the
stock immediately for $154 and make a $4 profit, less my premium paid,
or a net profit of $3. Since I paid $1 for the contract, and received $3 in
return, my profit margin for the transaction would be 300 percent.
Whereas if I had originally bought the stock for $150 per share and sold it
for $154, my margin of profit would only be about 3 percent ($4 / $150)
and I would have tied up all of that money in the meantime. Options can
yield an amazing return, but as you can see, there is a little less money
earned due to the premium paid.
A call contract when SOLD to open a position, gives the seller the
premium and is a cash flow strategy. The only amount that can be earned
on that type of transaction is the premium received. The strategy to sell
the option to open is the belief that the stock price will stay below the
breakeven point (the strike plus the premium).
Example: I sell a CALL contract on IBM with a strike price of $150. The
buyer has the right to call the stock from me for $150 per share at any time
before expiration. The premium for selling the call is $0.75 in this case.
I'm thinking that the stock price will go down, or at least stay below my
break-even which in this case would be $149.25. If the stock price stays
below $150 I can keep all of the premium money. Why would the buyer
exercise their right to buy the stock for $150 when then can buy it on the
open market for less? They wouldn't!!
Let's imagine that the open market price for that stock does NOT move
below my breakeven by expiration. In this case the premium received is
$0.75 per share. My breakeven would be $149.25. If the stock price is even
just one penny above $150 I should expect to be "exercised" and have the
stock called away from me. The buyer of the option would pay me $150
per share and then sell the stock on the open market for the one penny
profit. As the profit is so low this may not happen, but it must be expected.
If the stock price moves below the strike of $150, the buyer would do
nothing since they would not want to buy the stock at $150 only to sell it
at a lower price. Therefore, the option expires "worthless" to them and I
get to keep all of the premium.
Naked vs. Covered
You may have heard of "covered calls" or "naked calls." A covered call is
when we own the underlying stock and can deliver from our inventory of
stock.
If we do not own the underlying stock, we are uncovered, or "naked."
Naked is dangerous. Let's imagine that I sell the $150 strike without
owning the shares. The stock price moves up to $154. The buyer of the
option would naturally exercise the option and call my stock to him at
$150 so that he can sell it for a $4 profit. However, if I do not own the
stock and am in a "naked" position, I would be forced to deliver the stock
at $150 and the only place that I can get the stock for delivery would be
from the open market at $154, causing me to take a $4 loss on the trade.
Theoretically, the stock price could move VERY high and I would be
forced to buy the stock at the extraordinary price and then deliver it at
$150, with potentially catastrophic loss.
So, a naked call is said to have unlimited risk as the stock price could
theoretically move infinitely high. There is no theoretical ceiling on the
stock price.
I would recommend that one have this as one of their rules for investing:
NEVER SELL A NAKED CALL.
Note: You can also "cover" the position with an offsetting option without
owning the stock.
Example: You could sell the $150 strike thinking that the stock price will
stay below the breakeven point. But what if it doesn't? You could also
purchase the $145 call strike. It his case, the gain would be limited to $5
as if one was called out on the $150 strike, but the investor could also
exercise the bought call for the same number of shares to themselves at
the same time for $145, thus delivering the stock at $150, but being able to
buy it at $145.
OR, you could buy the $155 strike while selling the $150, which would
limit the loss to $5 per share. I will discuss this more later, and look at
which approach would be more profitable since the premiums paid for the
option contract will be determined by other factors.
Put Contracts
A Put contract is one when an investor BUYS the Put contract the buyer
has the right, but not the obligation, to force the seller to buy the specified
stock at the agreed upon strike price on or before the expiration date.
Profits are made when the stock price moves to be less than the strike
price plus premium.
Example: If I were to but a PUT on IBM at $150, I would be thinking that
the stock price was going to go down below the strike price based on my
technical and fundamental research. If the stock price goes to $145, for
example, I could force the seller of the contract to buy the stock for $150
while I am providing the stock either from my own inventory or from the
open market at $145. You may want to discuss how this works with your
broker.
If I were to SELL the Put contract, I would be thinking, based on my
analysis, that the stock price would stay above the strike price. That way I
am able to keep the premium and not have to transact in the stock. As
mentioned above under the buy description, if the stock price goes below
the strike, I could be forced to buy the underlying stock at the specified
price.
Here is a fun way to actually buy stocks at the price that YOU want by
selling a put option. Let's imagine that my research tells me that a
wonderfully discounted price for IBM would be $145, I would sell the put
at the strike of $145. I fully believe that the stock price will not move that
low because that would be a very low price compared to recent history.
When I sell that option, let's imagine that I would receive $1 in premium.
Now, for some strange reason, the stock price does dip below $145, I
would be forced to buy the stock at $145. I am actually pretty happy at that
price. However, an additional perspective would be that I already received
$1 per share for the contract, so my net cost on the stock is now $144,
which I think is an amazing price for that stock. If the stock price
continues to go down I am still happy because I have confidence in my
analysis that this is just a temporary "pull back" of the stock price and I
just need to wait for the price to go back up above $144 and I will have
made a profit.
To become familiar with how options are presented for sale, the following
two examples are a common way that most brokers presentation them.
Figure 55 is from CBOE.com. It shows the options available for a
particular expiration date. In this case it just displays a few option
alternatives.
Figure 56 shows all of the options available at that expiration date.
You can choose your expiration date, whether you want to trade puts or
calls, and which strike price seems most logical to you.

Figure 55. Options chain From CBOE.com (Chicago Board Options

Exchange) showing only near-the-money strikes.
Figure 56. Options chain From CBOE.com (Chicago Board Options
Exchange) showing all strikes.

Figure 57. Showing the options table or chain from Scottrade.

Every broker, as can be seen by comparing Figure 56 with 57, has a little
different format for displaying the information, but the basic information
is the same.
Volume is a key element here. You may see that some strike offerings
don't have any volume. Volume is a completed contract sale with both a
buyer and a seller. Interest, or Open Interest, is either buyers or sellers
whose contract order have not been "filled" or completed yet. Either
buyers are waiting for sellers (more likely in a bull market) of sellers are
waiting for buyers (more likely in a bear market).
If you place the order and it is not filled, it may be that the investor is
"betting against" the market and there are no takers on the other side of the
equation (purchase process). Or, there simply is no volume at all. The
option contract must have a buyer and a seller, and the transaction
completed, before it can be counted as volume. Uncompleted transactions
are considered "open interest."
Implied Volatility is the historical volatility extrapolated into a future
forecast. Since it is based on the past, it may not indicate the future, but it
is the best methodology that we can come up with, excepting a crystal ball.
Implied volatility may also play a role in your decision-making process
since it gives you an additional perspective.
High volatility (on a scale of 1-100) would be believed on a sliding scale
to be around 65 or higher and would generally indicate a bear market or at
least bear pressure. Low volatility would be around 35 or less and would
indicate generally a bull market. It is possible to have high volatility in a
bullishly surging market, and low volatility in a sluggish bear market, but
not typically so. But generally speaking based on historical data, high
volatility occurs in bear markets when prices are falling far and quickly,
whereas in bullish markets, lower volatility is generally the norm as prices
go up more slowly over time.
Tactical insight: So, it would make sense when sizing things up, if the
market has low volatility and the stock is oversold or undervalued, an
investor would assume that the stock price would be going up (if the
general market is also going up), then the investor would select to either
buy a call or sell a put.
If the volatility is high and the stock is overbought or overvalued, one
would assume that the price would be coming down and the investor would
then select either to sell a call or buy the put.
Key Terms: In the Money, Out of the Money, and At the Money
These are terms commonly used when referring to the strike price on an
option contract.
In the money means that the strike price is less than the current stock
price for calls, or more than the stock price for puts. In other words,
disregarding the premium paid, if one were to buy the CALL strike that is
less than the current stock price and transact to sell the stock immediately,
a profit would be made. Hence, "in the money." If transacting immediately
and no profit would be made, or a loss incurred, the strike would be
considered out of the money. Out of the money occurs when the strike
price is higher than the current stock price.
At the money means that it is the strike closest to the current stock price
for either puts or calls.
Out of the money means that the strike price is above the current stock
price for calls, or lower than the current strike price for puts.
Example: We might see that buying a slightly out of the money option will
be much less expensive but require a lot of volatility to become in the
money.
Once again to reiterate, out of the money means that if the option were
exercised at this moment, a profit could not be made. In the money means
that if the option were exercised right now, a profit would be made (not
considering the option premium). At the money means that not much
money, if any, would be made by exercising the option. The At the money
(ATM) option strike is the one closest to the current stock price. If the
stock price today is $25.37 and the nearest in price options available are
$20, $25 and $30, the ATM option would be the $25.
Pricing of Option Premiums
Technically speaking, the option premium is calculated by the difference
between the current stock price and the strike price (intrinsic value), plus
time and other values (extrinsic value).
Example: The current stock price is $150. The strike price being
considered is $145.Therefore, the premium (intrinsic value) should be $5
for an in-the-money strike, in this case a call, as the lower the strike price,
the higher the premium. But, we may observe that the premium is actually
$5.75. The $0.75 would be accounted to the value of the premium until the
expiration date, including the variable of implied volatility plus any
dividends that may be due before expiration. This is the added value of
time (and other considerations).
Out-of-the-money options have no intrinsic value and the prices are left to
the discretion of the market maker broker for pricing. Only a master at the
Black Scholes model could be able to give a close-to-accurate prediction
as to what that will be. So, rather than trying to second guess, we allow the
computers and the brokers to state the price.
The Time Value would be calculated as the value of the option over time
to the expiration date if we applied an interest rate, and for the USA
markets, the most commonly used rate would be the 10-year treasury bill
rate over the specified time to expire, which rate may change on a daily
basis.
Another factor not often mentioned is that the broker has the right to
adjust the premium prices to some degree. We see this in a contract asking
price that is out of sequence to its consecutive peers. In other words, let's
imagine that we are looking at an option price chart (also known as an
option chain). We see that the asking price of the at-the-money option is
true to form.
The at-the-money premium we imagine is $1. One strike in the money
(ITM), the premium we imagine is $1.15. Two strikes ITM, and the
premium is $1.30. Three strikes ITM, and the premium is $1.45. Four
strikes ITM, and the premium is $1.39. Five strikes ITM, and the premium
is $1.75. That would mean that the fourth strike is undervalued according
to our sequence. In the case of a call, we may be tempted to buy more of
the fourth strike since it is at a bargain price. But we would want to make
sure that we analyze the stock price trend and believe that the price of the
stock is definitely going to rise and that the market is also bullish and that
there is sufficient volume.
Why would a broker intentionally undervalue a stock? Perhaps because he
feels that he is not selling enough of that strike price and thinks that he
should sell more as it would be to his financial advantage to do so,
therefore he places a discounted premium on the strike. Conversely, if the
broker feels like that there is a lot of demand for a strike, he would raise
the price a bit to make some extra profits, just like the store owner who is
not selling enough beans, so he discounts the price, or that he is selling a
lot of beans and trusts that the demand will continue at a higher price.
Other Terminology
Amateurs call the price of an option, the "premium" and most brokers use
that term "bid" or "ask" prices for the option contract.
As you will discover the pricing of an option is not an exact science, and
we allow the broker/market maker function to set the prices.
Chapter 9. Calculating Bought Options Contracts
Profits
So, what happens if we buy an option? We will focus on call options first.
CALL
Let's imagine that our technical and fundamental research indicates that the
stock price will increase in the foreseeable future. For example, the stock
price for GE stock is now at $19.94. We see through our analysis that it is
beginning a steady rise from the most recent support line of the stock price
function. There is also good news about the company and the industry, and
the market is bullish in general. Our assessment further indicates logically
that we might expect that the stock price might increase by two dollars in
the next two months. The ASK price for the CALL option is $1.04 ATM,
which would indicate the time value of that option strike of $20.00 is $1.00.
The intrinsic value of the option price is $0.04.
Figure 58. Options chart showing the At-The-Money and near strikes for
two months expiration.
As each contract consists of 100 shares, the premium would be $106 to
control the shares so that they could be bought for $20 per share between
now and the expiration date. So, the option is purchased. We are now down
$106 in our profit and loss for this trade, plus commissions.
We can create a profitability chart to see what our results will be.
Figure 59. Profit results from options trade.
If the stock price goes down unexpectedly to $18, if we had bought 100
shares of the stock we would be at a loss of $200. If we had bought the
option, our loss would be $104, or the cost of the option. If the stock price
does not change, if we had bought the stock we would have no loss or gain.
If we had bought the option, our trade loss would again be $104, or the
price of the option.
If the stock price goes up as predicted to $22, our gain for buying the stock
would be $200. This would be a 10% gain or Return On Investment (ROI).
For the option, we can force the stock to be sold to us for $20 per share and
then sell it on the open market of $22 per share, netting us a gain of $200
less the price of the option of $106, or $94 equaling an 89% ROI ($95 /
$106 = 0.89 or 89%).
If the stock price goes up as predicted to $25, our gain for buying the stock
would be $500. This would be a 25% gain or Return On Investment (ROI).
For the option, we can force the stock to be sold to us for $20 per share and
then sell it on the open market of $25 per share, netting us a gain of $500,
less the price of the option of $104, or $396. This, in turn, equals a 381%
ROI ($396 / $104 = 3.81 or 381%).
So, if we trade in the stock, we have less risk of loss due to no expiration
date, but we tie up our capital of $2000 for that period and then receive the
full dollar amount of our profits.
With the option, we only tie up $104 for that period, thus reducing risk of
loss. We receive less profit dollars, but the ROI is incredibly higher. The
term in the stock market investing world is "leverage." We are leveraging
much less against a potential gain, thus taking less risk with the option. The
payoff for that is less profit, but also much higher ROI. In other words, the
price of reducing the risk is less profit in the end. But we are only risking
about 5% of the exposure with options as compared to 100% with the stock.
If the stock price goes to zero for some odd reason, we have lost all of the
$2000 with a normal purchase of the stock. If we play the option by buying
it, our maximum risk is always the premium, in this case, only $104.
Now, let's take a look at a buying PUT option.
Referring to figure 56 again, we see that to buy a PUT at the money, we
would pay the ask of $0.70.
We think that perhaps the stock price may continue its downward swing.

Figure 60. The profitability of a PUT order.

If the stock price goes up unexpectedly to $22, if we had bought 100 shares
of the stock, we would be at a profit of $200. If we had bought the option,
our loss would be $70, or the cost of the option.
If the stock price does not change, if we had bought the stock, we would
have no loss or gain. If we had bought the option, our trade loss would
again be $70, or the price of the option.
If the stock price goes down as predicted to $18, our loss for buying the
stock would be $200. This would be a 10% loss or Return On Investment
(ROI). For the option, we can buy it on the open market for $18 per share
and then force the stock to be bought from us for $20 per share, netting us a
gain of $200 less the price of the option of $70, or $130, equaling a 186%
ROI.
If the stock price goes down as predicted, but to $16, our loss for buying
the stock would be $400. This would be a 20% loss or negative ROI. For
the option, we buy the stock on the open market for $16 per share and then
force the seller of the option to buy the stock from us at $20 per share,
netting us a gain of $400 less the price of the option of $70, or $330, net
profit equaling a 471% ROI.
So, if we trade in the stock, we have less risk since there is no expiration
date, but we tie up our funds of $2000. If we buy the option, we are only
risking the amount of the premium, or ask, in this case $104 for the call and
$70 for the put. We make fewer dollars for the privilege of reducing risk
significantly. If we buy the stock, we are at 100% risk of theoretically
$2000. With the CALL option, we are risking $140/$2000, or 7%. For the
put, only $70/$2000 or 4%.
Chapter 10. Calculating Sold Options Contracts
Profits
What if we sell the options (sell to open a position)? The only benefit is
the premium received. We do not make any more money than that, but we
take on much more risk. But, if one identifies the market trend accurately,
the selling of options contracts can be a great cash flow strategy.
Calls:
Let's look at a similar chart for calculations when selling options, referring
back to Figure 56.
The BID price (which is the premium that we receive when we SELL an
option to open our position) for the $20 Call strike is $1.01. So, for taking
some risk, we receive $101 for one contract. When we sell the option, we
have no rights to exercise as the right to exercise goes to the buyer.
Therefore, we are hoping that with a Call option the stock price does not
go above our chosen strike when the option will expire worthless, or out of
the money, and therefore would not be exercised.
A calculation chart may look like this:

Figure 61. Profit on an option

We see if our strike is $20 we get to keep all of the premium if the stock
price stays at or LOWER than the strike.
If the stock price goes up, contrary to our analysis, we will be forced to
buy the stock on the open market for the current price and then sell it at
the strike. The loss is partially mitigated by the amount of the premium or
bid received. As you might have already concluded, the stock price could
unexpectedly surge or gap up astronomically, thus causing catastrophic
loss on this option play, or "bet."
So, MAXIM RULE: NEVER PLACE NAKED CALL TRADES.
A "naked" call is one that is not covered in some way. One of the safest
"plays" or "bets" is to enter a "covered call", where you are protected,
either by already owning the underlying stock, or by have an "offsetting"
option position. We will cover this more in our discussion on "spreads" in
options.
So, if I bought the stock at $22 per share and then sold the $20 call and the
price of the stock goes up past $20, I will have to sell my shares for $20
for which I paid $22. As you can see, in this case, we would make $1.01
per share on the bid, but lose $2 on the sale, for a net loss of $0.99.
A smarter way to sell a call is to "cover" the trade by buying the stock
when the price is low. Then sell the call option at a higher strike price than
our original cost, thus reducing the cost of the stock. If you analyze
properly, one would never be exercised. In this case, the investor could buy
the stock for $20, then sell the option with a strike of $20, then could keep
the premium if the stock price goes down or stays the same. So, in this
case our net cost for the stock would be only $18.99 ($20 less $1.01). One
could do that many times and continue to lower the "basis cost" of the
stock.
But if the price goes up and the buyer exercises their right to "call" the
stock on the agreed upon strike of $22 strike contract that the selling
investor sold, the worst case would be a $2 gain plus the $1.01 premium
received, so for this case, a profit of $3.01 total. The price of the stock
may have gone to $30 so the buyer of the option receives the stock at $22
and sells it at $30 making $8 per share, less the premium that he paid. For
the seller of the option, the maximum profit will be $3.01 on the covered
call no matter how high the stock price goes, but better this result than
taking an unlimited loss on a "naked" call.
As always it is important to do the calculations for any trade for
cost/profit, maximum loss potential, and maximum or probable gain.
When selling options, the downside of loss could be large, and THE ONLY
PROFIT WILL BE THE PREMIUM MADE FROM SELLING THE
CONTRACTS.
Chapter 11. Option Combinations: Spreads
Spread trading, or "spread betting," is the concept of using two contracts
together in tandem to minimize loss and still make some money.
This strategy is best used when the market is either very volatile, or not
very volatile, and when it is difficult to clearly define whether the stock
price is going to move up dynamically, or not move very far at all in either
direction.
Example: Assume that XYZ stock has had some good news and previously
the stock price had been at the "support" level. The investor would assume
that the stock price would go up but is also afraid that the stock price
could continue to go down. The fundamental analysis indicates that other
issues are still tenuous and that perhaps the analysts are divided on the
future of the stock price. So, just to be careful, minimize risk, and "buy
some insurance" in case the price does not do what the investor thinks that
it will do, the position can be protected (and can even be said, "covered").
Imagine that the current stock price is $25. It is thought that the stock
price will go up, but maybe go down. We have some choices.
TIP: We know that if the stock price is going to go up, we can either buy
calls or sell puts. If the stock price is going down, we can buy puts or sell
calls.
Option Debit "Straddle" Trade
This is also called a debit spread scenario. It’s buying a put and a call at
the same strike price with the same expiration. Because there are two
positions, it is also defined as a "spread."
So, let's imagine that the option price that we select is at the money as it is
the least expensive option not out of the money. We see that the stock price
could go up as much at $0.50 (fifty cents) per day on average. We think
that we will buy the $25 CALL strike and pay $1.00 per share. In this case,
the stock price should get past the breakeven point of $26 in just a few
days, but to be safe, we choose an expiration date two weeks from now on
a weekly options table.
But we are unsure, so, to "cover" our bet, we buy the $25 PUT strike for
$0.85. Now our breakeven point is $26.85, or, if the stock price goes down,
it would have to go below $23.15.
If the stock price goes above $26.85 to, let's imagine, $29 we can CALL
the stock to us at $25 and then sell it immediately for $29 making a $4
profit less our ask costs of $1.85, netting us $2.15 per share. If this takes
two weeks to happen, then our return on the trade would be $2.15/1.85 =
116%.
As there are 26 two-week periods in the year, our fictional and theoretical
annualized return would be 26 x 116 = 3,016 % annualized. If we had
merely bought the stock and waited for the price to go up, we would have
made $4 per share, and our trade return would be $4/25 = 16%.
Annualized, that would be 16% x 26 = 416%. These calculations do NOT
include the value of the funds over time. The other perspective is that we
made $215 dollars on our 100-share contract, but only risked $185. We
would have made $400 on 100 shares traded, but would have "risked"
$2500 to get it.
Figure 62. Straddle Debit Spread
As you can see, the stock price must be VERY volatile to take us beyond
our break-even points in order to make money, then once past those
breakeven points in the Straddle Debit Spread, our profits are theoretically
unlimited.
NOTE: The kinds of spreads that end up costing us money to begin with
are called "debit" spreads. The kind that puts money back into our account
at inception is called a "credit spread."

Credit Straddle Spread

This happens when one position is purchased and another sold in
combination for a spread, but the money received for selling one strike is
more than the cost of the other strike. This creates a credit to our account.
Or, both positions being sold for an even bigger "credit."
The stock current price is $25. So, let's imagine that the option strike price
that we select is out of the money, because it is the less expensive option
now. We see that the stock price could go up as much at $0.50 per day on
average. We think that we if buy the $25 CALL strike and pay $1.00 per
share it is too expensive. Therefore, we buy the $26 strike and only pay
$0.45 per share. In this case, the stock price should go beyond the
breakeven point of $26.45 in just a few days. To be safe, however, we
choose an expiration date two weeks from now on a weekly options table.
But, we are still unsure, so, to "cover" our bet and to make a little money
up front, we sell the $25 CALL strike for $0.85. Our "credit" would be
$.45 less $0.85, or $0.40 per share x 100, or $40 per contract. Now our
breakeven point is $24.15 on the sold '"leg." If the stock price stays below
the strike of $25, we will not be "exercised" (where the buyer calls the
stock to him at $25) and we get to keep our money.
Now, let’s say that the stock price goes above $24.60 (our bought call
breakeven) to $29. We can CALL the stock to us at $25 and then sell it
immediately for $29 making a $4 profit, plus our credit of $0.40, netting
us $4.40 per share. If this takes two weeks to happen, then our return on
the trade would be infinite as we made money without having to invest
anything, if fact, we were paid to invest.
Here's the risk that we take with a credit spread, using this case as an
example.
Figure 63. Credit Straddle Spread
As you can see from this example, our stock price must have very LOW
volatility and we want the price to stay within the narrow boundaries of
our break even points for both the call and the put, and the maximum
profit will be the combination of the premiums received.
I have included a recipe book of more possible strategies in Appendix D.
Chapter 12. More Combinations: Butterfly and
Condor
Butterflies and Condors take advantage of combining different variations
of spreads. For example, a strangle debit put spread can be combined with
a strangle credit call spread. With the addition of positions, or "legs,"
your probability for success can be increased, but profits will be reduced
due to additional premiums and brokerage fees. Also, these types of trades
must be matched well with market conditions.
They are best used when—
stock prices are hovering around their intrinsic value
the stock price has low or high volatility

Appendix D has more explorations into styles and types of combinations.

The Butterfly
A butterfly, or iron butterfly, has four positions but only three strike prices.
Example: You see that a stock price is hovering around its intrinsic value
price, but has high volatility. You are not sure which direction the stock
price will move next. You suspect that the price may make a bullish move.

The current price is $97.99. So, we select the 100 strike as the one closest
to the stock price (ATM). You "leg into" this trade by entering one position
at a time.

You stand to earn maximum profit if the stock price goes above the
breakeven point of 104 (105 - 1). Unlimited profits are available as the
stock rises above 104. Or, if the stock price falls lower than 96 (95 + 1)
your gain will be the difference between 95 and how low the stock price
goes, with the max price movement being to 0 for a 95 gain (very
unlikely).
If the stock price is at 100 by expiration we get to keep the 1. Your
maximum loss is $4 if the stock price stays within the spread of 5 (in
either direction), less the $1 we receive in premium.
This strategy requires HIGH volatility for the stock price to move beyond
our breakeven points.
Chapter 13. Finding good investment
opportunities: Option Contracts
Probability of Outcome vs. Price Wedge
How do I find an opportunity for an option?
Mispriced stocks or options
How to Find
i. Watchlist stocks, tracked over time, long acquaintance (keep your
research!), comparing current stock price to intrinsic value
A great way to begin investing is to just look at a lot of different
companies on a fundamental basis. A new investor could focus on
studying the Dow Industrial 30, or find a sector within the S&P 500 that
the investor is familiar with. The companies can be found merely by doing
a Google search or working through a website like Morningstar, Yahoo
Finance, Google Finance, or a broker. These are just a few of many, many
sources.
As you look at companies, apply the Fundamental Analysis techniques
already explored in Chapter 3 of this text. As you discover interesting
companies, you can place them on a "Watchlist." Most larger brokerages
and analysis websites have a page or tool to store your selections for
further watching. A quick calculation for Intrinsic Value can help you see
if the stock is overvalued or undervalued on a fundamental basis.
Confirming this thought with Technical Analysis is the next step. It might
be that the stock price is fundamentally undervalued, but is not in a
technical position for a trade. Or, it could be overvalued and in a position
to be traded due to market conditions (quite a common situation at the end
of bull market run ups).
ii. Serendipitous discoveries: something we found while looking at
something else
It is not unusual to be analyzing a stock only to discover that one of its
peer companies is actually a better company and also in a better price
position technically. You might discover this when looking at the peers
reported for a company as is done on some analysis websites, like
Morningstar.com.
A peer company may be mentioned in a news or press release about the
industry or a similar stock.
iii. News media
It's a good idea to subscribe to more than one or two news sources. Most
financially oriented websites will have email newsletters. Some may have
several depending on the subject. Most of these subscriptions are free, but
some sources may charge. My finding is that the free websites, when
reviewed properly, will have the same information available (albeit in a
condensed format) as the subscription websites. You should be a little
wary, because the website or newsletter may actually be trying to stimulate
purchase of a particular stock rather just reporting on it. It may not be a
bad investment, but my experience is that the ideal time to invest in a
sponsored stock has already passed and a lot of hype is being used to show
past performance, when what we are interested in is a set up for future
performance.

One "screener" that I like to use is to look for good companies with bad
news. The bad news will usually send the stock price down, but it will then
recover over time. Some bad news is just "window rattling"—like when a
big truck passes your house and rattles the windows, but no damage
occurs. Other types of news can send a stock price down and it may take
time to recover. For example, there was a news flash that GE corporation
was being investigated for falsifying financial information to investors.
That news added to some divesting of some of their less productive
divisions, seemed to cause the price to decline over a long period of
several months.
Another example was with a company that had been sued in the health care
industry. The stock price had been unnecessarily low. The news came out
after a few months that the law suit had been dropped, and within a day or
two the stock price began to recover.
Being familiar with the life events of the companies on our watch list can
help us be prepared to take advantage of the change in market opinion of a
stock.
Occasionally, through a newsletter or other source of information, you
may notice that a company previously unknown has had a dynamic event
occur. There is nothing wrong with checking into that company, but it can
be dangerous to immediately invest based only on the announcement alone
(been there, done that) without doing the fundamentals and background
checks and a proper technical analysis.
iv. Conversations
As in the topic of News Media above, you may overhear a conversation
from other investors, or wannabes, of something happening with a
company or some profits or losses occurring with a company. As we
discussed, don’t take that conversation at face value. Seek to do your own
unilateral study before making a decision.
v. Stock searches or “screeners” for undervalued or overvalued issues
vi. Screens for additional uncertainty
1. Find discrepancies between expected fair value and
actual value
2. Find discrepancies between implied vs. historical
volatility

vii. “Fat Tails,” or high probability trades—these are stocks identified by

their volatility combined with their "valuedness" pointing toward a bull or
bear movement
viii. Abnormal variations in price to book, price to sales, etc., compared to
historical
ix. High operating or financial leverage not reflected in the price
x. Undervalued volatility
xi. Market fear or uncertainty
xii. Discrepancies in the stock price movement vs. industry movement
xiii. Political manipulation or influence (taxes, regulations, statutes)

-Identify the conditions of the opportunity and match up the appropriate

trading strategy
-Situation vs. Tenor:
1. Short (sell) for 3 months to 1-year tenors
2. Long (buy) for 1 to 2 years
3. Long term analysis can give us a heads up for a coming
change not yet fathomed by the market
4. Look at option returns 2-3 years out for best calculations
for price (that doesn't mean that we will hold the option
contract for that long—as soon as it reaches an acceptable
profit within the expiration period we can exit any time
with a profit)

-Only do a “deeper dive” into the financials when one of the above exists
(unless already part of the watch list).
Just because we select an option contract expiration date that may be in
the distant future it does not mean that we will continue to own that
contract for the whole period.
American Style options trading allow for the reversing of a trade, or
exercising of the trade, any time before the expiration date.
European Style options contracts require that the contract be held until
expiration.
IT IS IMPORTANT BE SURE WHICH TYPE OF OPTION IS BEING
OFFERED. Most brokerages worldwide offer American Style contracts,
but it would be good to ask the question of the broker just to be sure. The
nationality of the offeror does not necessarily determine if the option is
American style or European.
Chapter 14. Trading skills and Tactics: Options
In this section we will explore a couple of ideas that may help you find the
option strike prices that have the highest probability of success. I
emphasize the word “probability.” We will use some statistical calculations
to help us determine "probability" based on some such mathematical
calculations. Unfortunately, the math that we use is a poor tool for
predicting the future, but it is the only tool that we have, aside from our
own just good intuition and plain old "luck."
We are going to use some ideas that correlate to the Black-Scholes-Merton
(BSM) model. To understand fully how this works would require a PhD
degree in mathematics—as applied to the functions of the stock market for
volatility and trend analysis (parabolic equations using higher calculus). If
it sounds amazingly daunting, it is.
We will attempt to simplify the approach without getting into the inner
workings of the math, but by using the measures and statistics available to
us. To do this we will focus on the mathematical concepts known as Delta
and Implied volatility. We will also look at the highest probability trades
using trend analysis.
The highest probability option trades are going to occur in the center of
probability. If we focus on the 66% center of all the options available, we
can increase our possibilities.
First, let's calculate what the "forward" price of the stock might be. To
begin, we calculate the "drift" rate" of the stock price. Let's imagine that
the current stock price is $26.73.
We see from our option chain our implied volatility (IV). We will then
allow for dividend "drag" on the stock price. We also include the interest
rate for the price of money based on the Federal 10-year bond rate (the
risk-free rate). So, if the rate is 2% we can create a simple equation
including the dividend rate.
Drift rate for a 4% dividend paying company would look like this:
Drift Rate = (.02) - (.04/26.73) = approximately .02
Therefore, we can look at an annual forward price (ignoring market
dynamics) of—
$26.73 * (1 + .02) = $27.26
As you can see, with lower priced stock the difference can be negligible.
With a higher priced stock, for example $250, the forward price gives us a
little more perspective, in this case: $250 * (1.02) = 255.
Now, to get a better feel, let’s adjust this number based on days to
expiration for an option. Since Variance is part of the theory, we won't take
time to dig into this math. But to help us see how this can work, our
implied volatility is based on Standard Deviation calculations, which uses
square roots. The equation is simple. Our Adjusted for time IV will look
like this:
Adjusted IV = Annual IV * the √ days/365 (the square root of the
days to expiration divided by the annual number of days).
So, if our option expires in 45 days, our Adjusted IV would be the Implied
Volatility times the Drift Rate + √45/365 = 3.6056 * .02 = .07, or 7%
Now we take a look at BOUNDS, or boundaries of where our stock price
may be in 45 days.
To get the Lower Bound, we calculate 26.74 * (1-.07) = 24.87
To get the Upper bound, we calculate 26.74 * (1+.07) = 26.61
These forecasted future prices do NOT include market function, on the time
value of money ideas multiplied by the Historical Volatility of the stock
price extrapolated into the future for Implied volatility.
But wait! There is a better way that is not so math heavy!!!
We can increase our probability of success through a process of
elimination. If you want a 60% probability of successfully gauging future
stock prices, we can deduct 20% of the trades from the bottom of the list,
and 20% of the strikes from the top of the list, leaving us with a core of
strikes hovering around the center of the price chart.
Example:

Figure 64. J. C. Penney (JCP) options "chain" or chart. (from

Scottrade.com)
There are 15 strikes available. So, 15 times 20% = 3 strikes. We can
eliminate 3 strikes from the top and 3 from the bottom. Leaving with the
60% of the strikes in the middle with the highest probability. We can then
do the math to select the strikes and outcomes from this reduced set.
And, an even more sophisticated way is using an efficiency calculation.
The Strike Efficiency Calculator: Efficiency Leverage Ratio
But first we should discuss the "Greeks." They are called the Greeks
because Greek letters are used as designators. They are specifically: Delta,
Gamma, Theta, Vega, and Row. (I know; Vega is not a
Greek letter. See the appendix E for more conversation on Greeks.)
We will use $ Delta and the spread for bid/ask to help us determine where
we have the most leverage.
The equation is simple and can be plugged into a spread sheet.
(Ask - bid)/Bid ask mid-point)/$ Delta = Efficiency Leverage Ratio
(what I call the ELR, AKA the MOE, Morningstar Options Expense
ratio, no longer in use at Morningstar).
This idea was proposed by Eric Kobayashi-Soloman and Philip Guzniec of
Morningstar investments.

Figure 65. Two fictitious companies with the most efficient trades marked.
Which would be the better company to go with based on ELR? (© [2018]
Morningstar, Inc. All Rights Reserved. Reproduced with permission.)
The higher the ratio the more expensive the option trade.
Here’s an even easier way
Easier does not always mean better, but here is another little insight.
Many investors will use the Bollinger Bands to help guide them to most
probable strikes (refer to the section on Technical Analysis). If the investor
does not want the stock price to go beyond the selected strikes, these strikes
may be found one or two strikes outside the bands.
If an investor DOES want the stock prices to go beyond the strikes, very
close strikes, or equivalent strikes could be used ATM or close to ATM
strikes, as in a Straddle trade.
Combining all of the above techniques for analysis may give the investor a
more reliable view of potentials for trades.
Also, it must be remembered that if you "open a position" by buying the
contract, at any time before expiration, that contract can be sold back to the
broker. Conversely, if a contract is sold, it may be reversed by buying the
option contract back from the broker.
Example:
If an option contract is purchased for $1 per share ask price, and we later
find that the stock price has moved dynamically, and now the option bid
value is $1.50. That contract may be sold and the difference of $0.50 per
share kept as profit. This may be a way of reducing risk rather than waiting
for the stock itself to be purchased and then resold for a profit, or for the
option contract to expire. In this case, there would be a 50% return on
investment. If the underlying stock were trading for $25 and moved to $30
in price and were traded as a regular buy and sell, the profit would be $5, or
a 20% gain. With the option, only $1 was put at risk. With the trade in the
actual shares, $25 would be put at risk. You have the privilege of deciding
which strategy you think would work for you.
Or, one could sell the option to open the position. Let's imagine that the bid
premium was $1 per share. Then, the stock price moves in such a way that
the option now has an ask price is now $0.50. One could buy the option
back from the broker and receive the $0.50 profit (less brokerage fees, of
course) thus minimizing risk of the stock price moving in such a way to
diminish or even negate profitability before expiration.
A great tool was developed some years ago by a man named Kelly (See
appendix G for more explanation). The Kelly calculation helps us to choose
the optimum strike prices using two variables: Expected return (using
technical analysis to see where the stock price may go) and Probability of
being right (implied volatility, or by using Delta).
The chart below, figure 62, takes the pain out of doing all of the
calculations by using a matrix. The chart shows the calculations multiplied
by half the Kelly factor just to increase safety and minimize risk.

Figure 66. Half Kelly Chart

Example: If you think that you may have a return of 35% and you are
choosing the ATM strike, or the one with a Delta of 50%, or close to 50%,
based on this chart, you would not put more than 8.3% of your available
money into this trade (bet). So, if $100,000 were available, no more than
$8,300 should be put at risk. If you only had $5,000 to invest, then no more
than $415 should be put at risk.
Shifting Your Perspective on Becoming a Full-Time Trader
A complaint that I often hear is that, "I only have $10,000 to invest, so if I
expect a reward of 35% with an ATM strike, will can only "bet" $830. That
only give me a return on $290.50. It will "take forever" to get to my goal of
trading for a living."
My response is, How much to you really want to lose? And how much time
did it take you to determine that this was a "good trade" for you? Twenty
minutes perhaps? Where can you receive $290.50 for only twenty minutes
work?

Here’s another way to look at it. Let’s say you’re driving on a road with a
lot of unexpected twists and turns. Your destination is 10 miles away. By
going 50 miles per hour, your assurance of arriving safely is almost 90%. If
you push it to 70 miles per hour, your assurance of arriving safely is now
only 40%. If you are running really late and you decide to drive at 80 miles
per hour, then your assurance of arriving safely is now only 20%.
Which speed would you choose?
Let’s analyze this more closely. For a 10-mile drive going 50 miles per
hour, it would take you 12 minutes to arrive with a 90% chance of safe
arrival. If you go 70 miles per hour, you would arrive in 8.5 minutes, but to
do so you would risk a 60% chance of not arriving at all with great damage
or serious injury being a 40% probability. Or, you could speed forward at
80 miles per hour and supposedly reach your destination in only 7.5
minutes, but with a 90% chance of severe damage and probable death. So,
you are thinking that you want to taking a chance to save 5 minutes by
driving in a way that is likely to kill you?
If you are investing, wouldn't it be better to make assured increments of
capital over a longer period, but not that much longer, building your
available capital so that at some point risking 8% of your money would
now be netting you $16,000 per trade from a $200,000 account? And,
perhaps you could do that $16,000 trade 8 or 10 times per year. Assuming
that 8 out of 10 trades are successful, and the other 2 are not, that would
give you an income in one year of $128,000 minus $32,000, for a total of
$96,000. Would that be acceptable for you—as opposed to 8 fails and 2
successes, which would give you a $96,000 LOSS?
Be patient, work the systems for higher probability—albeit lower rates of
return—to find ultimate safety and profitability. A mansion is built one
small brick at a time. Be willing to carefully lay many bricks, and you will
indeed create a mansion in due time, one that you can be proud of with a
method that will carry you more safely into the future.
Chapter 15. Selecting a Broker
What should you look for when you select a stock broker? Not all brokers
are created equal. As the saying goes, you usually get what you pay for.
Some of the "cheap" brokers don't provide the tools and services you need
to conduct a deeper analysis. They appeal to the investor who has one or
two strategies that they have mastered and don't require any of the other
tools and services offered by other brokers. Their appeal is that they offer
less expensive trades. There is nothing wrong with that idea if it works for
you.
Here are some issues to be aware of when you are comparison shopping.
(See appendix F for a spreadsheet example that may help you compare
brokers side by side.)
Cost
This aspect of option investing cannot be overstated. We pay enough for
the privilege of investing in less-liquid markets, and so there is no reason
to pay more for trade execution than you have to. Find out particularly the
answer to such question as:

What does the broker charge as a commission fee for making

an option transaction?
Are there volume discounts, and will you transact enough to
take advantage of these?
Are there any discounts if you transfer other accounts (e.g.,
stocks, bonds, IRAs, etc.) so that they are under the same roof?

Transaction Availability
Some brokers have restrictions on the types of transactions that can be
conducted in accounts. Here are some questions to ask:

How long does it take to complete a trade once placed?

Can one transact options in the type of account that you want
to set up (note that some brokerages will not allow you to
make option trades in an IRA in particular)?
Can one sell options in the account?
 What is the margin rule for selling puts? (Note that "cash-
secured puts" are those in which you have to have an amount
equal to the strike price less the premium in the margin
balance whenever you write a put.)
What is the margin rule for selling calls? Note that generally
selling "naked" calls (i.e., calls not backed by the simultaneous
ownership of the underlying stock) is a risky idea, but that
some brokerages will allow it.
Can non-cash securities be used as margin collateral? If so,
what is the face value "haircut"? In other words, if you need
$100 in your margin account, does your $100 of Microsoft
shares count toward margin requirements? (Note that some
brokerages will count securities but will say that they are
worth only some percentage of market value.)

Extras
The brokerage business is very competitive, and many shops offer various
“freebies” to entice people to open an account with them rather than a
competitor. Here are some “goodies” you might hope to find:

Good brokerage research. Some people regard the concept of

“good brokerage research” as an oxymoron, but others may be
interested. In all seriousness, brokerages often will publish
"initiation of coverage" reports on individual companies with a
great deal of background information that is helpful for
quickly “getting up to speed” on a new company. Also, many
of the brokerage’s industry or sector reports tend to be of high
quality. In addition, it can be interesting to see what the
investment bank analysts are talking about, and for obtaining
their upgrade and downgrade comments. In general, it is best
to use the analyst's information regarding companies and
industries and then to make your own conclusions regarding a
fair value.
Good software. Look for historical data availability, good
charting capabilities, the ability to view the order book, etc.
 Good data packages. Look for the quality of the brokerage’s
news services, cheap data charges for non-institutional
investors, discounts on data packages with certain levels of
assets and/or trade volume, etc.

There is a good guide to brokerages published periodically by the

newspaper Barron's, which serves as a kind of a Consumer Reports for
brokerage firms. Having a read through the latest such report will give you
some other ideas—and, perhaps, a head start on choosing a broker.
Chapter 16: Portfolio Management (Modern
Portfolio Theory)
Portfolio theory has two opposing but mutually beneficial concepts that need
to work in harmony. Many of the models used for rebalancing refer better to
mutual funds, but can also be applied to stocks
1. How do I minimize risk to protect my assets and not damage my ability to
reach my goals? How do I preserve my money?
2. How do I maximize my rate of return to reach my goals? How do I make
money?
Notice that the number-one idea is to preserve capital since generating
capital for investing is difficult and time consuming. Maybe you have
enough income to absorb and maybe not even care about losses in the
hundreds or even thousands of dollars, but I have seen wannabe investors
throw large amounts of cash into poorly researched trades seeking after the
promise of large returns, and not seem to care about risk or losses. They are
looking for the grand slam that will take them to near instant wealth. The
market is unpredictable, and everyone takes unexpected losses from time to
time. But seeking such get-rich-quick opportunities seems very high risk and
seems destined for more failure than success. If you wants that kind of
opportunity, perhaps gambling in Las Vegas would be a better approach.
Goal setting is vitally important! Referring to the risk verses return graph
from Figure 21:

See figure 21.

The problem with this graph is that it is called the Efficient Market Theory,
which assumes that all investors know all things about all investments at all
times. We know that this is not true. There is no perfect approach, and no
investors know all things at any time about all possible investments.
Therefore, it is possible to have great returns, but as we can see from the
theoretical graph, as we seek more return, our risk goes up. Therefore, it is
important to understand the risk potential for any investment to assure
returns. I have never found a low risk investment with high returns, however.
Not even Warren Buffet would say that such a thing is available.
By setting goals and knowing the required rate of return to achieve our goals
will help us avoid too much risk and be able to protect our capital.
Example
Investor A, who is 30 years old, has $10,000 to invest and can contribute
another $5,000 per year towards a retirement goal of having $2,000,000 at
the age of 65 years old, giving A enough to enjoy retirement. This would
require roughly a 10.8% rate of return.
If investor B is 40 years old, has $10,000 to invest, and will invest an
additional $5,000 per year towards retirement and has a goal of $2,000,000,
the rate of return required would be 17.1%
Investor C has just 15 years to retire with the same goal of $2,000,000. The
rate of return would need be 34.12%.
Investor A could minimize risk by investing in large cap, blue chip stocks
with some dividends, and perhaps have more of a buy and hold strategy.
Investor B would need to trade, in addition to holding some stocks.
Investor C might need to invest some portion of their money in large cap,
blue chip stocks for long terms, do some trading, and perhaps also get
involved in stock options to increase their rate of return.
As an investor, our responsibility is to determine the rates of return required
and then determine the safest strategy to get the required goals. By
minimizing rates of return required we can reduce risk. Why would we desire
a 30% rate of return for greed's sake, when 20% would be sufficient? The
exponential additional risk would not be just a 33% difference, but more like
a 60% difference of additional risk for the 30% return, as is reflected in the
risk vs. return graph. Look at the slope!!
Here are examples of these three figuring out how to allocate their
investment capital to achieve their desired goals.
Investor A As a group, large cap blue chip stocks tend to go up in value
around 7 or 8% per year long term by just the increase in the stock value. But
A still needs another 2 to 3% more return, so many of the choices would
have to also included dividends that have the 2 to 3% yield required. Investor
A could focus on these kinds of stocks.
Investor B would have some money in large cap blue chip stocks, but
requires an additional 7% return. So, they not only purchase the same stock
type as investor A for long-term hold, but also need to actively trade some
stocks to achieve the extra return. Let's then imagine that B invests 60% of
available funds in large cap blue chip stocks with no dividend. The
remaining 40% would need to earn 21.04% to achieve their goal.
We’ll talk about Investor C in just a moment.
The following chart may help visualize each of the cases in comparison.

Figure 67. Note, the risk numbers are only an estimate.

This separation of investment strategies is called "asset allocation." In other
words, the available assets are distributed or allocated to different
investment strategies to minimize risk.
The problem with Investor C is that there is too little time to minimize risk,
so additional risk is required to achieve their goals. You might say, "Why not
just go for the 50% rate of return for all investments to reach the goal
faster?" My reply would be to ask why would anyone want that kind of risk
for all of their money? Wouldn't we want to be safer with some of our money
just in case our higher risk investments don't go as planned?
Investor C does have options, however. True, the time is short and they need
to make exceptional gains to their goal.
In this case, it is recommended that the investor selects high volatility
stocks, then applies a meticulous analysis for when to buy and when to sell—
BUT ONLY CHOOSES EXCEPTIONALLY RELIABLE COMPANIES THAT
HAVE A VERY LOW PROBABILITY OF BANKRUPTCY AND THAT CAN
RECOVER WELL AFTER BAD NEWS IN THE MARKET, OR FROM
GENERAL MARKET MALAISE.
I’ve included some articles in their entirety about this topic to shed more
light on this concept.

How to Do an Investment Portfolio Analysis

by Sheyna Steiner

Tuesday, May 3, 2011

Each of your investments won't be a home run, but your portfolio's
performance should at least be in line with your expectations. If the gap
between your expectations and reality is consistently the size of the
Grand Canyon, it's time to re-evaluate your portfolio.
"If you're managing your returns and your strategy, and for all of '09 and
2010 your portfolio was way under-performing by 8 (percent) or 10 percent
each year," it's time to find out what's going wrong and why, says financial
adviser Mike Masiello, president of Masiello and Associates in Rochester,
N.Y. To assess your investments' performance, you need to begin with your
original investment plan and a process.
"The keyword is the 'process,'" says Drummond Osborn, a Certified Financial
Planner at Osborn Wealth Management in LaPorte, Ind. "You truly need to
have a process in place for how you're buying, how you're re-evaluating and
how to make the changes. Those three things create the process."
Ideally, investors would assess the health of their portfolios at least once a
year and after significant life changes such as marriage, having kids, losing a
job or coming into an inheritance.
To get to that point, you have to start at the beginning.
What's Working, What's Not
Your original investment plan is really the blueprint for assessing what's
working. If your portfolio was assembled willy-nilly, consulting a financial
professional can help you put together a comprehensive investment strategy.
To determine if your plan is working, review your investments. These should
be contained in a diversified portfolio that was constructed based on the
parameters established by your risk tolerance, time horizon and goals. In
simpler terms, your investment plan should be based on how much risk
you're willing to take, how long it will be until you need the money and your
goals for that money.
If your investments are in accord with those three considerations, it's time to
start digging.
Begin by looking at your allocation and weightings.
Many investment advisers recommend re-balancing your portfolio to stay
within the allocation established at the outset of your plan.
"Say I'm 51, my allocation is 60 percent equities, 40 percent bonds. At the
end of the year if my equity portfolio has done particularly well and it's now
70 percent equities and 30 percent bonds, I'm going to reallocate," says
Herbert Hopwood, CFP and president of Hopwood Financial Services in
Great Falls, Va.
"And that's what you have to do -- have that discipline," he says.
Check Individual Holdings
Before re-balancing, take a look at the performance of the individual
investments that make up your asset allocation plan.
Investors should understand why each asset is in the portfolio and what they
expect from it.
Asset classes perform differently and have varying roles within a portfolio.
One sector, style or class might have a great year while other parts of the
portfolio may turn in only a middling performance. Together they mitigate
volatile swings in the portfolio's value.
"There are going to be parts of a portfolio that are going to zig when others
zag. You want securities that, under other circumstances, will protect the
portfolio," says Hopwood.
The important thing to consider is how an investment performs compared to
its benchmark or similar securities. Was it a bad year for all small-cap
growth companies, or just your small-cap fund? If small companies in
general underperformed, then selling it or switching it for a hot fund in
another sector could be a bad move.
"It could be just what's happening at the moment. Then you make the change
and you whipsaw yourself," says Hopwood.
"I see too many people do that, one day value, then growth, then bond funds,
then stocks. ... You have to look forward," he says.
What About Income?
Evaluating investments isn't always about return. A large portion of investors
need more than capital gains, they need income from their investments.
Eking out a living from fixed-income investments has become progressively
more difficult over the past few years as the Fed ratcheted down interest
rates.
Sustained low interest rates have forced retirees to get creative when it
comes to living off their investments. Simply rolling over CDs may have cut
it in 2007, back when the average five-year CD was yielding around 4
percent. Now that the average yield on a five-year CD is less than 2 percent,
according to Bankrate's most recent interest rate survey, stretching for yield
has compelled many investors to take on more risk.
Unfortunately for income investors, principal preservation as well as risk has
to be considered in the search for yield.
"There is no free lunch. See how (the investment) did in 2008. That is the
litmus test for me. If you can stomach what these things did in 2008, then
you know that you can probably stomach the investment," Hopwood says.
Instead of jumping for the highest yield, go down the spectrum of risk from
the very safest investments to the more risky. Hopwood provides the
following example:
• Federally insured money markets.
• Short- to intermediate-term CDs for laddering.
• Short- to medium-term bond funds.
• Corporate bonds.
• Balanced or hybrid funds containing stocks, bonds and convertibles.
• Dividend-paying equity fund or individual stocks.
Whatever the investing goals, investors should have an investment plan in
place, as well as a plan for evaluating individual investments. Rather than
making changes willy-nilly based on desperation or the latest hot asset class,
keep your original plan in mind, systematically evaluate investments and
make changes in moments of lucidity -- not out of emotion.
Copyrighted, Bankrate.com. All rights reserved.

Tune Up Your Portfolio in Six Easy Steps

by Christine Benz | 02-01-05 | 06:00 AM
Let's face it: Investing well requires you to get your head around some pretty
counterintuitive concepts. Strong past performance rarely predicts strong
future performance. Rising interest rates, a boon to those shopping for new
certificates of deposit and other short-term savings accounts, are actually bad
news for most bond funds. And for those of us consumers schooled in the
maxim that "you get what you pay for" (there's a good bet a BMW is a better
car than a Kia, after all), it may be hard to comprehend that the cheapest
mutual funds are usually the best performers.
Similarly off-putting is the concept that you improve your portfolio's overall
risk/reward profile if you regularly reduce your holdings in those
investments that have performed best while sending more to your laggards.
Although counterintuitive, this practice, called rebalancing, is straight out of
Investing 101—the importance of buying low and selling high. That's
because when you rebalance, you put money into those securities that have
held steady or dropped in value (your losers) while paring back on those
investments that have grown more expensive (your winners).
To illustrate the merits of rebalancing, financial writers often hark back to
the second half of the 1990s, when risky tech shares consumed a
disproportionate share of many investors' portfolios. When the tech market
sank, so did their portfolios. That's not apt to be a risk for most investors
right now; many of you learned, the hard way, the risk of loading up on a
single risky sector. But the market trends of the past five years have still been
quite pronounced, with bonds trumping stocks and small caps beating large.
If you haven't actively cut back on your winners recently—or perhaps you
lightened up on stocks during the bear market and never fully got back in—
it's possible that your portfolio is out of sync with where it needs to be.
Here's how to find out if your portfolio needs a tuneup, as well as the steps
you should take to get the job done.
1) Find Out Where You Are Now
Okay, regular readers—get ready. I'm about to sing the praises of
Morningstar's Instant X-Ray tool. Again. But the fact is, if you're tackling
any task at the portfolio level, you need to be able to look at all of your
accounts--your 401(k) and that of your spouse, your IRAs, and any taxable
accounts that you hold, including cash holdings--as a unified whole. Instant
X-Ray helps you get the job done.
To use X-Ray, simply enter the tickers for each of your holdings and your
holding amount, then click "Show Instant X-Ray." You'll not only see your
portfolio's breakdown among stocks, bonds, and cash, but you'll also see how
it shakes out across Morningstar's investment style box and view how your
sector weightings compare with those of the S&P 500 Index. Before closing
out of your X-Rayed portfolio, click "Save Instant X-Ray Holdings as a
Portfolio." Follow the prompts and name your portfolio—you'll need to refer
back to it later.
2) Find Out Where You Need to Be
To determine whether you need to make any changes to your current mix, it's
essential that you have an idea of how much you should have in stocks,
bonds, and cash given your goals, time horizon, and savings rate. Bear in
mind that your optimal stock/bond/cash mix—or asset allocation—will be a
moving target, as most of us need to tilt our portfolios toward conservative
investments as we get closer to retirement or any other savings goals. If you
haven't revisited your own asset allocation in a few years, it's a good idea to
do so before you undertake any rebalancing.
To help simplify the task, check out Morningstar's Asset Allocator tool.
(Asset Allocator is available to Morningstar.com's Premium subscribers.)
3) Compare Your Target Allocations with Where You Are Now
Now it's time to evaluate if you need to make any changes. Start with your
current asset allocation. Is it dramatically out of whack with your targets? I
wouldn't get too worked up about minor divergences—if your stock
weighting is, say, 2 percentage points less than your optimal allocation, you
probably don't need to make any changes at all. (The most successful
investors are usually those who trade the least, particularly where taxable
accounts are concerned.) But if your current allocations differ from your
target allocations by 5 percentage points or more, that's something you'll
want to address.
4) Be on the Lookout for Investment-Style Bets
Secondarily, you'll want to size up whether your portfolio's fortunes are
riding on certain parts of the market. Using Instant X-Ray again, check out
your portfolio's sector positioning relative to the S&P 500 Index. Are you
heavy on tech shares? Financial stocks? Again, we're looking for big
inadvertent bets here. If your portfolio is heavily tilted toward a given sector
and you're comfortable with that positioning, fine. Just know what types of
bets you're making.
While you're at it, check out your portfolio's positioning in Morningstar's
style box; after a five-year runup in smaller-cap value stocks, you may find
your portfolio is skewed toward the lower left-hand corner of the style grid.
As a reference point, compare your portfolio's style-box positioning with that
of the Wilshire 5000 Index (as represented by Vanguard Total Stock
Market Index VTSMX). As of the end of September, that fund had 22% of its
assets in large-value stocks, 29% in large-blend stocks, 20% in large-growth
stocks, 6% in mid-value stocks, 7% in mid-blend stocks, 6% in mid-growth
stocks, and 3% in each of the small-cap boxes. I'm not saying that your
portfolio needs to be a mirror image of the index, mind you. Instead, you're
looking for big scary bets you didn't know you were making.
5) Tinker, Starting with Your Tax-Sheltered Accounts
If your portfolio is in line with your target asset allocation and you're not
making any inadvertent sector or style bets, your work is done. But if you
determine you need to make some changes, you'll want to go back to your
saved portfolio and do some tinkering.
In some cases, the alterations you need to make might be obvious—if you're
heavy on bonds, for example, trimming your bond funds should resolve the
problem. Getting to the bottom of other bets might take a little more
research. For example, if your portfolio has more cash than you want it to,
that could be because one of your stock-fund managers is holding a lot of
cash. You could decide to live with it, and reduce your designated cash
holdings accordingly, or else pare back your holdings in the cash-heavy stock
fund.
Rebalancing often requires that you sell, so it's essential that you focus your
rebalancing efforts on your tax-sheltered accounts to reduce tax costs. If you
need to sell, do so in your IRA or 401(k), if at all possible. Alternatively, you
could try to correct your portfolio's imbalances not by selling but by
directing a bigger share of future contributions to those holdings that need
beefing up. In so doing, you'll save on tax and transaction costs.
6) Plan to Make a Habit of It
Conventional wisdom holds that there are two ways to rebalance—either you
can rebalance on a set schedule, say, every December, or you can rebalance
whenever your portfolio gets dramatically out of whack with your targets.
My advice is to split the difference. While I think it makes sense to give your
portfolio a thorough review once a year, you don't want to get into the habit
of trading too frequently. Schedule a top-to-bottom portfolio review at a
fixed time each year. (My colleague Gregg Wolper noted in a recent column
that the holiday crunch time—which many pundits recommend for
rebalancing—may actually be less than ideal). But rebalance only if your
portfolio's allocations have gotten dramatically out of whack with your
targets. (© [2018] Morningstar, Inc. All Rights Reserved. Reproduced with
permission.)
Chapter 17. Stock Buying Strategies
"Buy low, sell high" is the age-old maxim for any investment. But how can
we do this and reduce risk? Several methods may be applied. Here are a
few among many.
Place Market and Stop Orders
You can place a market order to buy when you think that the price is low
and probably won't go any lower, or that the price seems to hit bottom and
is rising again. Placing a MARKET ORDER will get you into the position
the most efficient way. Refer back to the chapters of Technical Analysis to
help you as you consider the timing of your market order.
You can read or hear of reports indicating that a stock seems to be at a low
point and that the open interest to go long on call options is increasing.
This is "news" and may influence many investors to buy the stock—and
thus push the price up.
But if there is some uncertainty about the price rising at a certain point,
you may choose to have a little more complex strategy. Let's imagine that
the stock price is falling and you think that the price will bottom out soon
but are not sure when or if it has.
I call this the one percent trade rule.
You would be following the stock price down, thinking that it could
reverse at any time, but are unsure when to place the market order. An
alternate strategy would be to place a "stop" order to buy the stock at 1%
above the high price of today's candle (or use the Average True Range as
the defining distance). If that high of the day were, for example, $25, a
stop order to buy could be placed at one percent above that high at $25.25.
If the ATR indicated an average daily movement of $0.23, then again, with
a little margin of safety, the additional price of $0.25 might be added to
the high-of-the-day price. If the stock goes up the next day it will trigger
the buy and the investor will enter the trade as the price rises.
If the stock price continues to go down, the order will not be filled and can
be cancelled and re-entered at the newer lower price of one percent (or one
ATR) above the high of the following day.
Using Options to Buy Low
Another little trick that I like is using options to buy stocks at a low price.
Let's imagine that you have analyzed the stock price chart and you see that
the long-term support price is around $25. You think that this is a good
company and that if you could buy the stock for less than $25 it would be
great. So, we sell the Put option at the strike of $24 and receive $1 on the
bid. If the stock price goes down to $23 and your sold Put is exercised
against you, you would be forced to buy the stock at $24 per share. But,
since you received a dollar premium on the bid for your sold PUT, your net
cost is actually only $23. If the stock price indeed goes to perhaps $22,
you still have a great price of $23 as the new low price of $22 is so
unusual that the likelihood of it going back up is quite high, unless, of
course, you haven't done your fundamental analysis properly and didn't see
bad news that was driving the price down. Shame on you for being less
than thorough. Either way, we are now in a waiting game for the stock
price to go back up to its normal price range (channel).
Another strategy using options would be to buy a Call option on the stock
at a strike price above the current stock price by, perhaps, one or two
strikes OTM (out of the money). If the stock price does indeed go up as
you predict, you may exercise your option and buy the stock at your
selected price. If the price of the stock continues to decline, the value of
your Call contract may also decline, but you may re-purchase that contract
at a much lower loss than you would have had if you had purchased the
stock and held on to it in the decline and later sold it at a loss just to get
out of the trade. (This is not a recommended strategy, by the way. This
would violate your "buy low, sell high" rule, thus causing you to lose
money.)
As the stock price goes above your breakeven point for your bought Call
(strike price plus Ask premium paid), you would then consider your
reasonable price target for selling the stock, or watch it carefully for signs
of reversal, to then exit the trade.
INSIGHT: Any money made on the stock market should be considered a
great thing and that even small gains or profits are a good thing and much
better than any loss. You should never feel bad about exiting a trade in a
profitable position, albeit minor, if the conditions look like they are
beginning to reverse.
Intrinsic Value
Using intrinsic value as the basis for calculating buy price is another
approach based mostly on Fundamental Analysis.
Example: The investor may have made a habit of following a particular
stock and has determined that the intrinsic value of the stock is $25 per
share. The investor also sees from technical studies that the price channel,
or normal trading range, is $23 per share at the low end (support), roughly,
and at the high end, the stock has a perceived resistance at about $35 per
share, with the stock rarely going below its 50-day moving average of $30.
Nevertheless, the investor might say to themselves that they require at
least a 20% gain on this kind of stock. So, they may determine to place a
"limit" order to buy the stock at $24, this being 20% less than the 50-day
moving average. This price seems reasonable since it does not require the
stock to go down to the support level, which it seldom does, but also
allows for a 20% gain when the stock rises back to its 50 SMA.
The limit order would be placed as "good until expires," which is usually
60 days. If the stock price goes down to or lower than $24, the order will
be filled. If the price does not go down to or lower than $24 by expiration,
the order can be cancelled at any time without penalty or fee (the
brokerage fee and/or commissions are only due on completed
transactions). Or the order can be renewed and the limit price changed at
any time. After the order is filled, then a limit order to sell could be place
at the desired gain of 20%, or $30 per share. Then the stock will be sold at
or above the limit price and the 20% gain realized. You could also just
follow the stock on the technical charts from day to day to determine if
there is a possible trend in the bullish movement. If so, exit the trade at
will to avoid any retraction of profit if the stock price does not make it to
the limit-to-sell price and seems to be turning bullish again. Better to
make, for example, 18% on a trade than stick it out for the desired 20%
only to have a sell opportunity pass—perhaps for a long while to come.
Stop Orders
Stop orders can be used in a similar way to buy and sell. With a Stop order
you are most likely to get the price designated, but with a limit order there
may be a greater advantage since the stock price may actually be lower
than the specified limit price on the purchase side, or higher on the sale
side.
Example: You place a limit order on the above described stock at $24.
Overnight, or over the weekend, the stock price dips to $23.54 by the
opening of the next trading day. With a Limit order the stock would then
be purchased for $23.54 rather than the specified $24. With a stop order,
the stock price would have to rise to $24 per share before it would be
purchased.
Then, let's imagine that totally out of character and expectations for this
stock, the price suddenly increases overnight or over a weekend and is now
trading at $53 per share at opening. If a limit order had been placed to sell
at $30, the order would still fill; the stock will be sold at $53 per share.
Whereas with a Stop order to sell, the broker would have to wait until the
stock price was again at $30.
See appendix I for more information on Stop and Limit orders.
Chapter 18. Stock Selling Strategies
Selling strategies can, in many ways, be just a mirror image of a buying
strategies.
You can place a market order to sell when you think that the price is high
and probably won't go any higher, or that the price seems to hit a ceiling
(resistance) and is beginning to show signs of a bearish reversal. Placing a
MARKET ORDER to sell will get you out of the position in a most
efficient way. Refer back to the chapters of Technical Analysis.
You can read or hear of analyst or media reports indicating that this stock
seems to be at a high point and that the open interest to go short on call
options is increasing. This is news and may influence many investors to
sell the stock, pushing the price down.
But if there is some uncertainty about the price declining at a certain
point, you may choose to have a little more complex strategy. Let's
imagine that the stock price has been rising and the investor thinks that the
price will peak soon but is not sure when or if it has.
Again, I call this the one percent trade rule.
You would be following the stock price up, thinking that it could reverse at
any time, but are unsure when to place the market order. An alternate
strategy would be to place a Stop order to sell the stock at 1% below the
low price of today's candle (or use the Average True Range as the defining
distance). If that low of the day were, for example, $25, a Stop order to
sell could be placed at 1% below that low at $24.75. If the ATR indicated
an average daily movement of $0.23, then again, with a little margin of
safety, the amount of $0.25 might be subtracted from the low-of-the-day
price. If the stock goes down the next day, it will trigger the sell and you
will exit the position as the price declines.
If the stock price continues to go up, the order will not be filled and can be
cancelled and re-entered at the newer higher price of 1% (or one ATR)
below the low of the following day. This action, in essence, is a "manually
adjusted trailing stop order.”
Use Options to Sell Stocks at a High
Another little trick that I like is using options to sell stocks at a high price.
Let's imagine that you have analyzed the stock price chart and you see that
the long-term resistance price is around $25. You think that this is a good
company but is overvalued, and that if you sell the stock for more than $25
it would be great. So, we could sell the Call option at the strike of $26 and
receive $1 on the bid. This transaction is named a "covered call" because
you already own the underlying stock. If the stock price goes up to $27 and
your sold Call is exercised against you at $26, you would be forced to sell
the stock at $26 per share. But, since you received a $1 premium on the
bid for your sold Call, your net price is actually $27. If the stock price
indeed goes to perhaps $28, you still have a great price of $27 as the new
high price of $27 is so unusual that the likelihood of it going back down is
quite high. Unless, of course, you haven't done your Fundamental Analysis
properly and didn't see good news that was driving the price up. Shame on
you for being less than thorough. Either way, we have made an excellent
profit and should never mourn for the profits that we didn't receive.
Put Options with Strikes
Another strategy using options would be to buy a Put option on the stock
at a strike price above the current stock price by, perhaps, one or two
strikes OTM (out of the money). If the stock price does indeed go down as
you predict, you may exercise your option and force the sale of the stock
at your selected strike price.
If the price of the stock continues to decline, the value of your Put may
also rise, but you may re-purchase that contract at a much lower loss than
if you had purchased the stock and held it in the decline, later selling it at
a loss just to get out of the trade. (This is not a recommended strategy, by
the way. This would violate your "sell high, buy low" rule, thus causing
you to lose money.)
As the stock price goes beyond your break-even point for your option
(strike price plus ASK paid (less BID received), you would then consider
your reasonable price target for selling the stock, or watch it carefully for
signs of reversal, to then exit the option trade.
Selling Short
This is an unusual method available on the stock market. It is possible to
sell a stock position before buying it.
Let's imagine that you have done an excellent job analyzing the stock price
and feel like it is high and overvalued and pending a downturn. You could
then "sell short" to open a position at the selected stock price fully
believing that the market and stock will decline. Then, at a later date,
usually sooner than later, you could then close the sold position by buying
back that position.
Example: The stock price at resistance is $25. You see definite signs of a
market reversal and decline in the price. You could sell short the stock at
$25. Having deduced the support line to be around $18, you would watch
the decline of the stock for signs of a bullish reversal.
When you see those signs of reversal, you would then buy-to-close the
position. A conservative approach might be to calculate what a portion of
the total potential profit would be if the stock went down to support, and
then design to take perhaps 80% of that profit to minimize risk.
SHORTING IS RISKY BECAUSE BEAR FUNCTIONS ON THE
MARKET ARE MUCH SHORTER IN TIME LENGTH THAN BULL
MARKETS and move much faster.
So, in this case, if support is $18 and resistance is $25, the profit potential
is $7. Therefore, 80% of $7 is $5.60. If you set a stop limit order to sell at
$25.00 - $5.60 = $19.40, and had sold short at $25, the margin of profit
would be 29%. Not a bad profit in any market. Going for the full $7 profit
may add additional risk of the stock reversing before it actually gets down
to $18 —you would lose an opportunity when a bullish reversal hits. The
prices often move rapidly, and you may not be monitoring the stock when
it actually reverses, or overnight trading could reverse unbeknownst to the
investor.
Remember our first responsibility as investors is to "not lose money" and
to minimize risk.
The following chart demonstrates the technical signals to look for in a
short sell strategy.
Figure 68. "Shorting" technical signals.

On the 21st of October, you can see that the candles have formed a bullish
Marubozu. Plus, other indicators are showing a move toward bull action.
Then, the following day, a Harami forms. You should be watching closely
at this point.
The following day on the 24th of October, the price takes a dive to a new
low. The RSI, along with the MACD and Fast Stochastic, now indicates
bear. Watching the negative news and the development of declining
revenues and earnings per share, the market finally gives up on GE and
starts selling off in a dramatic pattern.
You could have entered the trade at that point by selling short the stock
using the 1% rule and finding success on any day after the 24th with high
confidence of success. Knowing that this kind of thing can reverse quickly,
by using a manually adjusted trailing stop each day to buy the stock at 1%
higher than the previous day, you would have had a run of selling the stock
(let's say at $21.38, 1% lower than the low $21.60 on October 24), then
using that same rule, buying the stock back on November 3rd for $20.14.
But, with a little more insight by looking at the continued bear trends of
the MACD and Fast Stochastics, you may have stayed in the trade until
true signs of reversal occurred on the 27th of November. At that point the
fast line on the MACD had crossed back up over the slow line, the Fast
Stochastic had bounced above the 20 line a couple of times, and the
histogram on the MACD showed transition from bear to bull by crossing
over the zero line. The RSI also showed a move up from bear territory.
For the nervous investor, a profit of $21.38 minus $20.14, or $1.24 in just
about 8 trading days is not an acceptable return. Or, expressed as a
percentage, 6%. That’s not bad for a week's trade. Annualized, that would
be 6% times 52 weeks or 320%. Of course, the annualized figure would be
mythical as you would have to do that same kind of action every week for
the year, but it does show you the possibilities. Trading 1,000 shares
would have netted $1,240 in 8 days.
But following the Oscillators indications, the buy would have come later
on the 27th of November when 1% above the high of that day when the
indicators showed transition for bear to bull. The high was $18.37, so that
plus 1% would give you a buy-back price of $18.55, netting a profit of
$21.38 minus $18.55, or $2.83. This would be a profit of 15% in a 31-day
period, or one month. So, 12 times 15% is 183% annualized.
But I think that I would rather have more frequent money with a lower
return. But still, that would have been a great trade. Now, of course, you
could have gone short twice by seeing a sell signal on the 10th of
November and had two trades instead of one with good success. In this
case a trade to sell short at 1% less than the low of $19.76, or $19.56, and
then buying again on the 27th of November at $18.55 would allow us to
combine that profit of $1.01 and the previous trade of $1.24 for a total of
2.25. This approach would have yielded less profit but perhaps been more
soothing to our nerves than trying to stick it out until the 27th of
November when very clear signals of reversal occurred.
Chapter 19. And Then There Are Mutual Funds
There is an easy way out for most investors who want to avoid having to
learn all that we have discussed so far. (Or perhaps, many don’t even know
that any of the investing skills we’ve learned about exist.) I’m speaking of
investing in mutual funds.
What Is a Mutual Fund?
A mutual fund is a fund investing instrument comprised of moneys pooled
from many investors. That pooled money is used to buy securities such
as stocks, bonds, money market instruments, and other assets. Mutual
funds are operated by professional money managers and/or committees,
who allocate the fund's moneys into different acquisitions of many
different assets and seek to produce capital gains and/or income for the
fund's shareholders. A mutual fund's portfolio is structured and maintained
to match the investment strategies as published in its prospectus.
Breaking Down a Mutual Fund
Mutual funds give small or individual investors access to professionally
managed portfolios of equities, bonds, and other securities.
Each shareholder, therefore, participates proportionally in the gains or
losses of the fund and not the individual stocks or holdings within the
fund.
For example, 5% of the fund value may be held in Apple (AAPL) stocks.
When AAPL rises in price, the investor would expect to make money.
However, the other holdings in the fund may not do so well and it is
possible that net asset value (NAV) of that fund actually goes down due to
other poor-performing stocks.
Mutual funds may invest in a wide amount of securities, and returns are
usually expressed as the change in the total market cap of the fund,
derived by aggregating performance of the underlying investments.
Mutual fund units, or shares, can typically be purchased or redeemed as
needed at the fund's current NAV per share, which is sometimes expressed
as NAVPS. A fund's NAV is derived by dividing the total value of the
securities in the portfolio by the total amount of fund shares outstanding.
More on Mutual Funds
From Investopedia.com: "A mutual fund is both an investment and an
actual company. This may seem strange, but it is actually no different than
how a share of AAPL is a representation of Apple, Inc. When an investor
buys Apple stock, he is buying part ownership of the company and its
assets. Similarly, a mutual fund investor is buying part ownership of the
mutual fund company and its assets. The difference is Apple is in the
business of making smartphones and tablets, while a mutual fund company
is in the business of making investments."
Most mutual funds hold hundreds of different securities, which means
mutual fund shareholders gain important diversification at a very
advantageous value.
Example: an investor who buys AAPL stock before the company has
a bad quarter. He could lose a great deal of value because all his invested
dollars are tied to the one issue. Conversely, another investor may buy
shares of a mutual fund that happens to own some Google stock. When
Google has a bad quarter, they only lose a fraction as much because
Google is just a small part of the fund's portfolio. The NAV of the mutual
fund may actually go up, despite Google going down, because of the other
issues held are performing well.
Most mutual funds are part of a much larger investment fund "family" or
company apparatus. The larger fund families have many separate
individual mutual funds. Companies of fund families like Fidelity
Investments, Oppenheimer, T. Rowe Price and Funds, and
the Vanguard Group are examples of these large fund companies.
Mutual Fund Types
Mutual funds are segregated into several categories representing the kinds
of securities the mutual fund invests in.
Fixed income mutual fund: Focuses on investments that pay a fixed rate of
return, such as corporate bonds, government bonds, or other debt
instruments. As the fund portfolio generates a lot of interest income, it
then passes that income on to shareholders.
Index funds: The investment strategy here is based on the belief that it is
very hard to try to consistently beat the general market. So the index fund
manager simply buys stocks that correspond with a major market
index such as the Dow Jones Industrial Average, the S&P 500, Russell
2000, or any of the industry specific indexes. Requiring less research from
analysts, there are fewer expenses, so the shareholders receive more of the
benefits of the index performance. These funds are often designed with
cost-sensitive investors in mind.
If an investor seeks to gain diversified exposure to the Canadian equity
market, he can invest in the S&P/TSX Composite Index, which is a mutual
fund that covers 95% of the Canadian equity market. The index is
designed to provide investors with a broad benchmark index that has the
liquidity characteristics of a narrower index.
Money market funds: These funds consist of many different offerings in
the money market industry and seek to find an advantage of individual
investment by pooling the risk/reward over many individual issues.
Balanced funds: This is an attempt to balance performance using small
cap, mid cap, and large cap companies, including dividend-paying stocks
and growth stocks.
Sector funds: As mentioned above, the fund manager may have an
expertise in a particular industry or sector. They will seek to maximize
returns while minimizing risk through diversification in a more narrowly
defined approach in an industry, like the gold mining sector.
Equity funds: The focus here is strictly on stock and does not include any
other type of security.
Funds of funds: Mutual funds that buy shares of a variety of other mutual
funds.
Fund Fees
In mutual funds, fees are classified into two categories:
1. Annual operating fees: The annual fund operating fees are charged as an
annual percentage of funds under management, usually ranging from 1-
3%.
2. Shareholder fees: The shareholder fees, which come in the form
of commissions and redemption fees, are paid directly by shareholders
when purchasing or selling the funds. These fees are often called "loads."
Front end loads are additional commissions paid by the buyer of the fund
shares for the privilege of buying into the fund. Back end loads are paid
when shares of the fund are redeemed or sold by the investor.
Expense ratio: A fund's expense ratio is the summation of its advisory
fee or management fee and its administrative costs. Loads are generally
around 1% or less. Fees are generally no higher than 3%, with 1% being
most common, but could be lower, including 0%.
There are investment companies that offer a no-load, no fee mutual fund,
which doesn't carry any commission or sales charge. These funds are
distributed directly to the shareholder of the fund and not through a third-
party broker. You may have a brokerage account with T.D. Ameritrade, for
example, and buy shares of a mutual fund through them, at which time
there will probably be a load attached. Or, you might go directly to the
mutual fund itself and buy the shares in the same fund and experience no
additional commissions or fees.
Example: You might buy shares in the Magellan fund, part of the Fidelity
fund family. If you do it through a brokerage account, like T.D.
Ameritrade, there will be commissions paid to T.D. Ameritrade as well as
the loads for the Magellan Fund. But you might search diligently within
the Fidelity fund offerings and find a fund that has similar performance
without the fame and hype of the Magellan fund, and be able to buy it
directly though Fidelity and pay no loads of fees, thus enhancing your
return on that little known but equally effective investment.
Penalties: Some funds also charge fees and penalties for early
withdrawals.
Example—loads, fees, and penalties: If the fund returns are categorized as
8% per year, but have a front load of 1% and a back load of 1%, your net
return on that fund after you buy and later sell your shares in the fund,
would be only 6% after loads. If there is an additional 1% management
fee, your return would then be only 5%. If there were an early withdrawal
fee required and if you held the fund shares for less than the required time,
and the early withdrawal fee were added of 1%, for example, your net
return would only be 4%.
Clean Share Mutual Funds
If you want to get the biggest return on your investment, you may want to
consider mutual funds with 'clean shares,' a relatively new class of mutual
fund shares developed in response to the U.S. Department of
Labor’s fiduciary rule.
According to a recent Morningstar Inc. report, "...clean shares could save
investors at least 0.50% in returns as compared to other mutual fund
offerings. Even better, investors could enjoy an extra 0.20% in savings, as
their advisors will now be tasked with recommending funds that are in
investors' best interests, according to the report.
Clean shares were designed, along with low-load T shares and a handful of
other new share classes, to meet fiduciary-rule goals by addressing
problems of conflicts of interest and questionable behavior among
financial advisors. In the past some financial advisors have been tempted
to recommend more expensive fund options to clients to bring in bigger
commissions. Currently, most individual investors purchase mutual funds
with A shares through a broker. This purchase includes a front-end load of
up to 5% or more, plus management fees and ongoing fees
for distributions, also known as 12b-1 fees. To top it off, loads on A shares
vary quite a bit, which can create a conflict of interest. In other words,
advisors selling these products may encourage clients to buy the higher-
load offerings.
Clean shares and the other new classes eliminate this problem, by
standardizing fees and loads, enhancing transparency for mutual fund
investors. “As the Conflict-of-Interest Rule goes into effect, most advisors
will likely offer T shares of traditional mutual funds … in place of the A
shares they would have offered before,” write report co-authors Aron
Szapiro, Morningstar director of policy research, and Paul Ellenbogen,
head of global regulatory solutions. “This will likely save some investors
money immediately, and it helps align advisors’ interests with those of
their clients.”
For example, an investor who rolls $10,000 from his 401k or other
qualified account into an individual retirement account (IRA) using a T
share could earn nearly $1,800 more over a 30-year period as compared to
an average A-share fund, according to the analysis. The Morningstar
report also states that the T shares and clean shares compare favorably
with “level load” C shares, which generally don’t have a front-end load but
carry a 1% 12b-1 annual distribution fee.
Good as the T shares are, clean shares are even better: They provide one
uniform price across the board and do not charge sales loads or annual
12b-1 fees for fund services. American Funds, Janus, and MFS are all fund
companies currently offering clean shares." (Morningstar.com)
Advantages of Mutual Funds
Diversification: The mixing of investments and assets within a portfolio is
designed to reduce risk, and is one of the advantages to investing in
mutual funds. If an investor were to buy individual company stocks in
retail and offsetting them with industrial sector stocks, for example, would
provide some diversification. However, a truly diversified portfolio has
securities with different capitalizations and industries, and may contain
bonds with varying maturities and issuers, as well as other securities.
Buying a mutual fund may achieve diversification more cheaply and faster
than just buying individual securities.
Economies of scale: Buying into a fund spares the investor of the
numerous commission charges needed to create a diversified portfolio.
Buying only one security at a time leads to large transaction fees which
could eat up a good chunk of the investment return. Also, the $100 to $200
an individual investor might be able to afford is usually not enough to buy
a round lot of a stock (100 shares), but it could buy many mutual fund
shares. The smaller prices of NAV for mutual funds could allow investors
to take better advantage of dollar cost averaging.
Easy access: Mutual funds can be bought and sold on the open market
with relative ease, making them highly liquid investments. And, assuming
that the investor wants to participate in more exotic types of investments
that would normally not be available to the smaller investor, like foreign
equities or exotic commodities, mutual funds may be the most feasible
way, sometimes the only way, for individual smaller investors to be
involved.
Professional management: Most private, non-institutional money
managers deal only with high net worth individuals – people with six
figures (at least) to invest. But mutual funds are run by managers, who
spend their days researching securities and devising investment strategies.
These funds provide a low-cost way for individual investors to experience
(and hopefully benefit from) professional money management.
Individual-oriented: All these factors make mutual funds an attractive
option for younger, novice, and other individual investors who don't want
to actively manage their money. They offer high liquidity, are relatively
easy to understand, provide good diversification even if you do not have a
lot of money to spread around, and have the potential for acceptable
growth. Many people, especially in the U.S.A, already invest in mutual
funds through their 401(k) or 403(b) plans. The majority of money
in employer-sponsored retirement plans are available only to mutual fund
investing. The qualified account management company (the 401k
manager) will probably have a limited stable of mutual funds available to
invest in.
Disadvantages of Mutual Funds
Fluctuating returns: There is always the possibility that the value of your
mutual fund may go down, or depreciate instead of go up. Equity mutual
funds experience price fluctuations based on the movement of price of the
individual stocks that make up the fund.
FDIC: The Federal Deposit Insurance Corporation does not insure mutual
fund investments. There is no guarantee of performance with any fund.
Any investment carries some form of risk. But it's especially important for
investors in money market funds to know that, unlike their bank
counterparts, these will not be insured by the FDIC.
I think that a long history of steady performance may be more comforting
and profitable for the investor that just wants to park their money and not
have to worry about it, over an occasional "flash in the pan" fund that has
great returns now and again, but also tends to have off years for gains in
the NAV. Otherwise, the investor would want to monitor the funds and do
some shifting around, aka rebalancing, of the portfolio periodically,
perhaps more than once a year, to try to maximize gains. This method only
works with no-fee and no-load funds.
Cash: Mutual funds pool money from thousands of investors, so money in
continuously going into the fund as well as leaving it. To maintain the
capacity to accommodate withdrawals, funds typically have to keep a large
portion of their holdings in cash. This is great for liquidity, but money kept
as cash is not growing for you and thus does not add to the growth of the
fund.
Costs: Mutual funds provide investors with professional management, but
it comes at a cost—those expense ratios mentioned earlier. These fees will
reduce the fund's overall performance, and they're assessed regardless of
the performance of the fund, good or bad. In years when the fund doesn't
perform well, or even have a declining NAV, these fees still apply and can
magnify losses.
Diworsification: Many mutual fund investors tend to overcomplicate
matters. They acquire too many funds that are highly related and, as a
result, don't get the risk-reducing benefits of diversification. In fact, they
have made their portfolio more exposed, a syndrome called
"diworsification." At the other extreme, just because you own mutual
funds doesn't mean you are automatically diversified. For example, a fund
that invests only in a particular industry, sector, or region is still relatively
undiversified and therefore more risky.
Lack of transparency: One thing that can lead to diworsification is the fact
that a fund's purpose or makeup isn't always clear. Fund advertisements
may not fully represent the objective or even the holdings in the fund.
The Securities and Exchange Commission (SEC) requires that funds have
at least 80% of assets in the particular type of investment implied in their
names; how the remaining assets are invested is up to the fund manager.
However, the different categories that qualify for the required 80% of the
assets may be vague and wide-ranging. A fund can therefore manipulate
prospective investors via its title: A fund that focuses narrowly on the
Congo stock exchange, for example, could be sold with the grander title
"International High-Tech Fund."
Evaluating funds: Researching and comparing funds can be difficult.
Unlike stocks, mutual funds do not offer investors the opportunity to
compare the P/E ratio, sales growth, earnings per share, etc. A mutual
fund's net asset value gives investors the total value of the fund's portfolio,
minus liabilities, but how do you know if one fund is better than another?
There are many agencies that seek to classify and rate mutual funds, the
foremost of which is Morningstar.com, which started its value in the
market by rating funds. They have since expanded into rating stocks as
well. There is a simple explanation on their website the describes their
rating system. Even with this tool, it is not a good predictor of future
performance, but is much better than no tool at all. All ratings are
backward looking. Forward-looking investors would need a good crystal
ball. So, the ratings assume a certain amount of trend continuation.
As sample of a rating chart from Morningstar looks like this:
Figure 69. The Morningstar home page for mutual funds. Arrows point to
the free "screener" and other descriptions of fund performance helps and
descriptions. (© [2018] Morningstar, Inc. All Rights Reserved.
Reproduced with permission.)

Figure 70. An example result of the Morningstar screener. (© [2018]

Morningstar, Inc. All Rights Reserved. Reproduced with permission.)
Read more: Mutual
Fund https://www.investopedia.com/terms/m/mutualfund.asp#ixzz54a2TA
XeU, www.morningstar.com, or any one of the major fund families, the
three largest of which are The American Funds group, Fidelity funds, and
Vanguard. There are many more excellent fund families, like Wasatch, but
the noted first three are the largest.

ETFs
Exchange-traded funds (ETFs) take the benefits of mutual fund investing
to the next level. ETFs can offer lower operating costs than traditional
open-end funds, flexible trading, greater transparency, and better tax
efficiency in taxable accounts. There are drawbacks, however, including
trading costs and learning complexities of the product. Most informed
financial experts agree that the pluses of ETFs overshadow the minuses by
a sizable margin. ETFs have several advantages over traditional open-end
funds. The four most prominent advantages are trading flexibility, low
cost, operational transparency, and tax benefits.
Trading flexibility: Traditional open-end mutual fund shares are traded
only once per day after the markets close. All trading is done with the
mutual fund company that issues the shares. Investors must wait until the
end of the day when the fund net asset value (NAV) is announced before
knowing what price they paid for new shares when buying that day and the
price they will receive for shares they sold that day. Once-per-day trading
is fine for most long-term investors, but some people require greater
flexibility.
ETFs are bought and sold during the day when the markets are open. The
pricing of ETF shares is continuous during normal exchange hours. Share
prices vary throughout the day, based mainly on the changing intraday
value of the underlying assets in the fund. ETF investors know within
moments how much they paid to buy shares and how much they received
after selling.
The nearly instantaneous trading of ETF shares makes intraday
management of a portfolio a snap. It is easy to move money between
specific asset classes, such as stocks, bonds, or commodities. Investors can
efficiently get their allocation into the investments they want in an hour
and then change their allocation in the next hour. That is not something I
recommend, but it can be done.
Making changes to traditional open-end mutual funds is more challenging
and can take several days. First, there is typically a 2:00 pm Eastern
Standard Time cutoff for placing open-end share trades. That means you
do not know what the NAV price will be at the end of the day. It is
impossible to know exactly how much you will receive when selling
shares of one open-end fund or know how much you should buy of another
open-end fund.
The trade order flexibility of ETFs also gives investors the benefit of
making timely investment decisions and placing orders in a variety of
ways. Investing in ETF shares has all the trade combinations of investing
in common stocks, including limit orders and stop-limit orders. ETFs can
also be purchased on margin by borrowing money from a broker. Every
brokerage firm has tutorials on trade order types and requirements for
borrowing on margin.
Short selling is also available to ETF investors. Shorting entails borrowing
securities from your brokerage firm and simultaneously selling those
securities on the market. The hope is that the price of the borrowed
securities will drop, and you can buy them back at a lower price at a later
time.
Portfolio diversification and risk management: Investors may wish to
quickly gain portfolio exposure to specific sectors, styles, industries, or
countries but do not have expertise in those areas. Given the wide variety
of sector, style, industry, and country categories available, ETF shares may
be able to provide an investor easy exposure to a specific desired market
segment.
ETFs are now traded on virtually every major asset class, commodity, and
currency in the world. Moreover, innovative new ETF structures embody a
particular investment or trading strategy. For example, through ETFs an
investor can buy or sell stock market volatility or invest on a continuous
basis in the highest yielding currencies in the world.
In certain situations, an investor may have significant risk in a particular
sector but cannot diversify that risk because of restrictions or taxes. In that
case, the person can short an industry-sector ETF or buy an ETF that
shorts an industry for him or her.
For example, an investor may have a large number of restricted shares in
the semiconductor industry. In that situation, the person may want to short
shares of the Standard & Poor’s (S&P) SPDR Semiconductor (symbol:
XSD). That would reduce one’s overall risk exposure to a downturn in that
sector. XSD is an equal-weighted market cap index of semiconductor
stocks listed on the New York Stock Exchange, American Stock Exchange,
NASDAQ National Market, and NASDAQ Small Cap exchanges.
Lower costs: Operating expenses are incurred by all managed funds
regardless of the structure. Those costs include, but are not limited to,
portfolio management fees, custody costs, administrative expenses,
marketing expenses, and distribution. Costs historically have been very
important in forecasting returns. In general, the lower the cost of investing
in a fund, the higher the expected return for that fund.
ETF operation costs can be streamlined compared to open-end mutual
funds. Lower costs are a result of client service-related expenses being
passed on to the brokerage firms that hold the exchange-traded securities
in customer accounts. Fund administrative costs can go down for ETFs
when a firm does not have to staff a call center to answer questions from
thousands of individual investors.
ETFs also have lower expenses in the area of monthly statements,
notifications, and transfers. Traditional open-end fund companies are
required to send statements and reports to shareholders on a regular basis.
Not so with ETFs. Fund sponsors are responsible for providing that
information only to authorized participants who are the direct owners of
creation units. Individual investors buy and sell individual shares of like
stocks through brokerage firms, and the brokerage firm becomes
responsible for servicing those investors, not the ETF companies.
Brokerage companies issue monthly statements, annual tax reports,
quarterly reports, and 1099s. The reduced administrative burden of service
and record keeping for thousands of individual clients means ETF
companies have a lower overhead, and at least part of that savings is
passed on to individual investors in the form of lower fund expenses.
Another cost savings for ETF shares is the absence of mutual fund
redemption fees. Shareholders in ETFs avoid the short-term redemption
fees that are charged on some open-end funds. For example, the Vanguard
REIT Index Fund Investor Shares (symbol: VGSIX) has a redemption fee
of 1% if held for less than one year. The Vanguard REIT ETF (symbol:
VNQ) is the exact same portfolio and has no redemption fee.
Tax benefits: ETFs have two major tax advantages compared to mutual
funds. Due to structural differences, mutual funds typically incur more
capital gains taxes than ETFs. Moreover, capital gains tax on an ETF is
incurred only upon the sale of the ETF by the investor, whereas mutual
funds pass on capital gains taxes to investors through the life of the
investment. In short, ETFs have lower capital gains and they are payable
only upon sales of the ETF.
The tax situation regarding dividends is less advantageous for ETFs. There
are two kinds of dividends issued by ETFs, qualified and unqualified. In
order for a dividend to be classified as qualified, the ETF needs to be held
by an investor for at least 60 days prior to the dividend payout date. The
tax rate for qualified dividends varies from 5%-15% depending on the
investor’s income tax rate. Unqualified dividends are taxed at the
investor’s income tax rate.
Exchange Traded Notes (ETNs), which are a subset of ETFs, are structured
to avoid dividend taxation. Dividends are not issued by ETNs. However,
the value of dividends is reflected in the price of the ETN.
Investors may wish to quickly gain portfolio exposure to specific sectors,
styles, industries, or countries but do not have expertise in those areas.
Given the wide variety of sector, style, industry, and country categories
available, ETF shares may be able to provide an investor easy exposure to
a specific desired market segment.
ETFs are now traded on virtually every major asset class, commodity, and
currency in the world. Moreover, innovative new ETF structures embody a
particular investment or trading strategy. For example, through ETFs an
investor can buy or sell stock market volatility or invest on a continuous
basis in the highest yielding currencies in the world.
In certain situations, an investor may have significant risk in a particular
sector but cannot diversify that risk because of restrictions or taxes. In that
case, the person can short an industry-sector ETF or buy an ETF that
shorts an industry for him or her.
For example, you may have a large number of restricted shares in the
semiconductor industry. In that situation, you may want to short shares of
the Standard & Poor’s (S&P) SPDR Semiconductor (symbol: XSD). That
would reduce your overall risk exposure to a downturn in that sector. XSD
is an equal-weighted market cap index of semiconductor stocks listed on
the New York Stock Exchange, American Stock Exchange, NASDAQ
National Market, and NASDAQ Small Cap exchanges. (ETF section is
from the Fidelity.com website)
Searches to find ETFs can be done within the fund family, through your
brokerage website, through Morningstar (as above) or many other sources.
Chapter 20. The Case for Dividends
Historically, an investor in the stock market was more interested in
dividend payouts than in the volatility of the stock price. In fact, some
investors back then shied away from volatile stocks. The main focus then
was to receive consistent and growing dividend payments over time. This
is truly passive income. Please note also that dividends are taxed at a
different rate than capital gains. The bull market and access to online
brokers in the 1980's started to make dividend investing less and less
important and has become somewhat of a lost art. We will resurrect the
science behind that art in case you have an interest in dividends, albeit if
only for part of your portfolio allocation matrix.
So, what is a dividend? A dividend is a payment made to an individual
investor by a corporation with each share receiving the declared amount.
Typically, the Board of Directors for the company will meet before the
dividend date arrives and determine how much of company earnings will
be allocated back to the shareholders. This amount is then divided by the
number of shares outstanding on the "ex-dividend date," then a check of an
electronic transfer will be sent to the investor or the broker that is holding
the shares on behalf of the investor.
Dividends can be paid at any time, but most companies like to have an
expected schedule. It could annual, semiannual, quarterly, and I suppose, if
desired by the company, even monthly, although I have not found any
company doing that. In addition, a company may declare a "special
dividend" at any time in addition to the normal payouts. The amount of the
dividend may vary from payout to payout, but a wise company will seek to
have steadily growing dividends over time, which is more likely to assure
investor loyalty and give a sense of consistent performance.
Buying dividend producing stocks is not a loan to the company, as would
be the case in buying a corporate bond. When you buy the stock, you
actually have an equity stake in the company, and with common shares,
you would also have rights to give input to management for operational
suggestions, and to vote for who you would like to represent you on the
board of directors.
There are two types of shares most commonly offered to investors:
common stock and preferred shares.
Common stock, gives you the right, but not the guarantee, to receive
dividends. Common shares also allow you to have input to management
and the right to vote for the members of the board of directors. Common
stock trades on the open market, and you can take advantage of price
changes for extra profits in buying and selling shares. Common shares are
not usually convertible. Even though you have the right to receive
dividends, it is possible that the board of directors does NOT decide to
share profits with the shareholders, therefore there is no dividend paid.
Preferred shares DO have a guaranteed dividend, but do not have voting
rights. Preferred shares are usually offered to initial and large investors
and other large stake holders in the company. Preferred shares are not
commonly traded on the market, although it is becoming a little more
common. Preferred shares are also usually convertible to common shares.
Yield
Another common term that we should understand is the concept of "yield"
or "dividend yield." This is the amount of dividends issued in the past 12
months divided by the current stock price.
Example: ABC company issues dividends on a quarterly basis. For the last
several years the dividend has been 12 cents per share. For the year the
dividend payout would be 48 cents.
At the beginning of the year the stock is trading for $20 per share. You can
determine the dividend yield by dividing $0.48/$20 = .024, or a 2.4%
yield. Let's then imagine that for a short period of time the price of the
stock declines to $15 per share merely due to waning investor interest. The
yield when the stock price is $15 would be $0.48 / $15 = .032, or 3.2%.
Then later in the year, investors take more of an interest in this stock, and
the price goes up to $23 per share. We can do the same math for yield:
$0.48 / $23 = .0209. or 2.09%.
If you are patient and savvy enough to watch this stock, you might say to
yourself, "If the dividend has stayed the same over many years, even with
the stock price fluctuating, and I want a 4% yield, I would set my sites to
buy this stock at $0.48 / .04 = $12 per share.” You could set a limit order
with the broker to buy the stock at $12 per share. If it happens, we then
have our 4% yield. If it doesn't happen, we are no worse off as the order
was never filled.
Total Return
A scenario that’s more exciting to me is this. Let’s say I buy the shares at
$12 per share and then ride the stock out over time because I know that the
stock price could go as high at $23. I could benefit from the stock price
move for capital gains, and also collect a dividend in the meantime.
Let's imagine that it takes one year for the stock price to make that
dynamic move, and I purchased 1,000 shares. My outlay in the beginning
would be $12,000. I would then collect the four dividend payments over
time to the amount of $0.48 per shares, or in this case, $480. Tthe stock
price has risen to $23 per share, at which time I sell the shares for a
$11,000 gain. That would give me a 91.67% gain in one year, and I could
add the $480 to it for a $11,480 total profit of 95.67% margin. This
example is very realistic.
Here’s another example: Stock XYZ is trading at $100 per share. It has a
yield of 4%, or $4 per share. I am able to get it at a bargain price of $100
per share knowing that is below its normal support level. I see that there
has been a lot of good news about this company lately, with great
prospects for the future.
At the end of 12 months, the stock is now selling for $130 per share. I had
purchased 500 shares, so my initial outlay was $50,000. I have now arrived
at a 30% gain in the stock price and a 4% yield, so my profit margin on
this stock is 34 percent, or $34 per share. Not spectacular, but nevertheless
enhanced by the dividend.
What would be considered a reasonable dividend? In my opinion, anything
over the inflation rate, which at this writing is around 3%, would be a good
idea.
Finding Extraordinary Stocks
It is possible to find stocks with extraordinary advertised dividends. I
found one once touting a 20% promised dividend. It sounded too good to
be true.
On further research, I discovered that this was a South American company
trading on the New York Stock Exchange. This alone told me that they had
passed the strict scrutiny of the Securities and Exchange Commission
(SEC).
However, I was also aware of the economic and political instability of this
company's mother country. So, I wasn’t all in for this one. (We will do a
little demonstration later to show what an appropriate dividend payout
would be for a company.)
I dug deeper in my analysis. I determined that this company was not only
at risk to NOT make the promised payout, but they were at risk of
bankruptcy if their forecast for increased oil prices didn't happen.
Their estimates for oil prices were done at a high in the market and they
assumed that the prices would continue to rise. As it turned out, they
didn’t. Oil prices began to decline, and in less than one year this company
declared bankruptcy. In cases like this, an investor would want to be a
student of the company, the underlying economics of oil prices, and the
political situation of the mother country.
The Legal Bribe
Why do companies pay a dividend? I call it a legal "bribe," or enticement,
to investors. It encourages investors to buy shares, which maintains the
share price, which maintains the capitalization of the company.
(Remember, capitalization is the number of shares outstanding multiplied
by the current stock price.) Banks will look at capitalization as a serious
factor in approving loans to a company. Maintaining the capitalization
value is critical.
If a company’s stock price is a little volatile and the management of the
company sees that investors can buy other shares and get a better gain due
to stock price movements, the company may offer a dividend to help
"level the playing field." It’s designed so that the additional dividend can
boost the attractiveness of a stock and hopefully keep investors from
selling off, causing the stock price to sink.
Calculating Total Percentage Return on investment (ROI)
Let’s say that you buy 100 shares of XYZ for $29.11 per share, or $2,911
total investment. In five years the market price of the stock rises to $35.23
or $3522.30. Your capital gain would be $611 or 20.99% in five years. The
dividend was constant every quarter for five years of $0.32 per share for
20 quarters or $640 total dividends in the five years, or 21.99%.
An easy way to calculate total return would be to merely take the total
gains of $611 + $640 = $1251/5 (years) = $250.20 per year. Then $250.20 /
$2911 (original investment) = 8.59%. This is not exactly correct but close
enough to give you a valuable perspective.

Key terms:
Dividend rate: A forecasted number based on the dividend the company
projects that it will be able to pay in the coming year.
Dividend yield: The historical yield of the dividends in the last fiscal year
divided by the current stock price.
Dividend Increase: The dollar amount that a company feels like it can
offer over time, or the historical increase of dividends over time.
Dividend growth rate: As the dividend is increased over time, the growth
rate will show what percentage the dividend has increased over time.
Bigger is better.
Example: Let's imagine that ABC company paid out $0.48 in dividends
last year. Now this year they have increased dividends due to increased
profitability that management is willing to pass back to the investors, and
the dividend paid out is $0.50 per share. So, the dividend increase was
$0.02 per share, resulting in a growth rate of $0.02 / $0.48 = .0417, or a
4.17% growth in the dividend yield.
Payout ratio: The amount of money paid back to the investors compared
to the actual net profit that company was able to keep after all other
expenses were paid.
Example: Tupperware Brands (TUP) is trading at $54.54 at this moment.
An annual dividend of $2.72 has been paid for the last four years and
counting. This amounts to $0.68 per share each quarter. The Earnings per
share in 2016 was $4.41. The dividend paid was $2.72. Now we calculate
$2.72 / $4.42 = .615 or a 61.5% payout ratio. That means that for every
dollar of net profit the company made, $0.615 was sent back to the
investors.
The danger of an excessively high a payout ratio is that it may not leave
enough money back in the treasury of the company to finance growth or
other projects (like expanded marketing campaigns, etc.). It is possible to
have too high a payout which cannot be sustained long term. We will
explore later what a mathematically acceptable payout ratio would be.
Declaration date: The date on which the board of directors announces
what the dividend will be.
Record date: This is usually several weeks before the actual pay date. You
must be a shareholder of record on this date in order to receive the
dividend. It is two days AFTER the ex-dividend date, giving the company
two days to determine just exactly how many shares qualify for the
dividend.
Ex-dividend date: This is two days before the record date. You must own
your shares on or before this date to qualify to receive the shares. If you
own the shares on this date you will receive the dividends for every share
that you own on this date, even if you sell some or all of your shares
before the payout date. It takes three days for stock purchases to "settle"
and the brokerages need time to square the accounts.
You might think that you could buy the shares at the last minute of the
trading day on the day before the ex-dividend date, then sell the shares the
next day and collect the dividend and make a quick profit without tying up
capital for more than a day. The fallacy here is that the shareholders are
now richer, but the company is poorer by the amount of the dividend paid
out. Why would an investor on the very next day value the stock the same
AFTER the depletion of cash fund value from the company as they did the
day before the depletion? They wouldn't, so the intrinsic value of the share
goes down to about the amount of the dividend paid out. In most cases, the
price of the stock on the open market also takes a dip shortly after
dividends are to be paid after the ex-dividend date. This is an arbitrary
amount and is based on market perception and supply and demand, but it
would be much riskier to assume that the price of the stock would stay the
same. Could the stock price actually go up? Yes, but not likely. As we have
said in the past, conditions in the market are "usually, but not always."
Payment date: This is actual date on which funds will be distributed to
the shareholders (or brokerage accounts). This date is usually a couple of
weeks after the ex-dividend date.
Dividend re-investing programs (DRIP):
It is assumed that the dividends in your brokerage accounts are received in
cash. But many publicly traded companies may offer a DRIP program for
you. These companies have their own internal brokerage accounts and you
are able to buy their stock directly from them, and in many cases, buying
directly reduces or eliminates the broker commissions and fees. You may
also be able to request that your dividends be used immediately to buy
more shares. In this case, it is possible to buy fractions of shares and then
in turn receive fractions of dividends.
Example: Let's imagine that you own 1,000 shares of ABC company, and
this year they are paying a 4% dividend. You paid $20 per share. At
dividend time, you would receive $0.20 for your quarterly dividend, giving
you $200.
Instead of keeping that cash in cash, you have enrolled in the DRIP
program and the money is used to buy more shares. At the moment that
the account receives the $200, the active share price is then at $19.13.
Your dividend money is used to buy shares and you are credited with an
additional 10.4548 shares.
Now you own 1,010.4548 shares. So, next dividend period the dividend is
the same $0.20 per share, so your dividend allocated to you is $202.0910.
That money is used to buy more shares, which are trading at $20.93 per
share. You have an additional 9.6556 shares allocated to your account for a
new total share count of 1,020.1104 shares.
On the next dividend date, the dividend is still $0.20, so you receive a
dividend allocation of $204.0221. Again, new shares are purchased. You
are a little sad that share prices are down to $18.98 per share, but since you
are in the investment for the long term, you are happy to have purchased
an additional 10.7493 shares, taking your total up to 1030.8597 shares.
Now, with one last dividend payment for the year, you receive $206.1719
in dividends. Share prices are now $22.11. You have an additional 9.3248
shares purchased for you, totaling now 1,040.1845 shares.
You think that you'd like to move on and sell your shares at $22.11 and
reap $22,998.48 which results in a $2,998.48 profit, or, $2,998.48 /
$20,000 (your original investment) 14.99% gain. Since you were smart to
do this in a ROTH IRA account, the total profit is non-taxable.
This kind of strategy is common for those who want excellent gains, but
don't want the responsibility of constantly trading stocks. This previous
scenario is a reasonable expectation of a stock with mid-range dividends
and mid-range price volatility.
Evaluating Stocks for Safe Dividend Investments
Look for "Safe" dividend paying companies (cash available and
history of consistent dividends)
Look for dividend growth
Look for an attractive potential for total return
“Safe” companies will—
Have a real or perceived product or service differentiation (this
is called "Moat" by author Pat Dorsey in The Little Book That
Builds Wealth)
Drive costs down and be a low-cost provider
Lock in customers with high switching costs (you can only get it
here)
Have high barriers to entry or high barriers to success for
competitors
Possess intangible assets (Coca Cola formula, for example)
Weigh the quality of management (ROE & ROA compared to
industry average)
 Employ good financial controls and reporting (timely SEC
filing without subsequent revisions due to errors or omissions)
Exhibit earnings stability (few revenue fluctuations)
Enjoy high operating leverage (how is operating income
affected by revenue growth/loss)
Wield strong financial leverage (interest/income coverage,
debt/capital (debt + equity))
Demonstrate earnings durability
Dividend Growth
Reliability of dividends (continuation and growth over time)
Steadiness and growth of payout ratio (no dividend cuts)
Total Return
Adding stock price growth to dividend yield
Sustainable growth rate = (1- pay ratio) x Return on Equity =
Sustainable Growth Rate. This ratio can be used when
comparing two companies that may look the same otherwise.
Optimal payout (how much should be paid out in dividends?)
100% - Core Growth Rate / Return on Equity
Cost of Growth per Share = Core Growth / ROE x EPS
Forecasting
Using the above concepts and putting them into a spreadsheet calculator,
we can do some forecasting about total return for a dividend stock. See the
spreadsheet section for an interactive spreadsheet, but basically, if you
would like to create your own, it could look something like this:
Dividend Rate ($)
Current Share Price
Dividend Yield = Dividend Rate / Current Share Price

Core Growth Estimate (%)

Divided by Return on Equity (ROE)
Multiplied by Earnings per Share (EPS)
Cost of Growth ($)
Earnings per Share (EPS)
Minus Dividend
Minus Cost of Growth
Funding Gap ($)

Funding Gap ($)

Divided by Share Price
Share Change (%)

Core Growth (%)

Plus Share Change (%)
Total Dividend Growth (%)
Plus Dividend Yield (%)
Projected Total Return (%)

The spreadsheet looks like this:

General Electric GE
name ticker
Year 2016
$
Dividend Rate $ 0.48
$
Share Price $ 14.79
Current Yield (%) 3.25%

Core Growth Est

(%) -3.33%
Return on Equity
(ROE,%) 9.39%
Earnings per Share $
(EPS,$) 0.89
$
Cost of Growth ($) (0.32)
 Earnings per Share $
(EPS,($) 0.89
$
Dividend ($) 0.48
$
Cost of Growth ($) (0.32)
$
Funding Gap ($) 0.73

$
Funding Gap ($) 0.73
$
Share Price ($) 14.79
Share Change (%) 4.91%

Core Growth (%) -3.33%

Share Change (%) 4.91%
Total Dividend
Growth (%) 1.58%

Total Dividend
Growth (%) 1.58%
Dividend Yield (%) 3.25%
Projected Total
Return (%) 4.82%

Figure. 71. Total Return Calculator forecaster for dividend plus stock
price gain.
You could set up your own spreadsheet or borrow the one on the related
website (Formula List for Dividends)
Limitations of This Model
Like any model, the underlying elements are not static. Stock prices
change from moment to moment and the dividend rate may go up or down
at any time. Also, revenues and expenses are not static going into the
future. To have some assurance, you must assume that the dividend rate
will continue into the future and that the dividend growth rate and core
growth rates will similarly continue into the future. Like anything else,
constant monitoring from quarter to quarter to assure that things are
continuing as projected would be a wise practice. Unreliable data entry
will obviously result in unreliable forecasting.
Also, we are reluctant to use ROEs of greater than 25 or 30 as these are not
"normal" in terms of general market averages. These kinds of numbers
would indicate a fast-growing company, therefore less predictable share
price.
You may also look for possible variants in values and see a range of
possibilities rather than looking for a solid figure. The following chart
shows normalized projections:
Revenue
Growth
ROE % 7% 8% 9%
14% 10.00% 10.80% 11.10%
16% 10.40% 11.00% 11.60%
18% 10.80% 11.30% 12.00%
Estimated Core Growth
Rates

Figure. 72. Chart of normal long-term performance of the whole market.

In the above chart, we are assuming that the general market will appreciate
between 7 and 9 percent per year long term, giving us a likely long-term
average of 8%.
When researching companies with low volatility in the past, the likelihood
or our projections to be reasonable is quite high. However, the more
volatility on the core statistics makes for less reliable forecasts. As
always, we would rely on the stability of our trending for past performance
to give us more assurance of the accuracy of our future forecasting. In the
absence of clear trending, we must resort to merely hoping that things will
work out the way that we want. We have found that hope is not a very good
or reliable tool for investing—reality often catches up to us in a negative
way. The real world does not often conform out ideas for mathematical
trending. So, as with any investing idea, we should have a healthy respect
and allowance for a "margin of safety" and a sound exit philosophy.
Even with dividend investing, you should not lose sight of this: you can
take advantage of large capital gain advances that the stock may make
from time to time. It wouldn't be rational to avoid taking a 15% capital
gain by selling off the stock when that kind of movement has occurred
rather than simply waiting around for a 5% dividend, no matter how good
and reliable it seems.
If you use a flexible strategy to hold on to a stock while the share prices
remain relatively steady to reap the benefits of the dividend, and are not
being afraid to take advantage of a significant price movement in a short
period allows you to compound your returns with both gains and dividends
combined. For example, if you have held a stock that has had steady prices
over time and reaped a nice little dividend of, let's say, 5% in a year, and
then sell the stock with a 15% gain in that same year, it would actually
yield a 20% total combined return.
Portfolio for Dividends
Just for fun, here is an example spreadsheet for monitoring your dividend
portfolio.

Figure 73. Sample dividend portfolio.

It may be important to you to have some diversification among different
economic sectors or industries. Or, you may prefer to select companies
within a couple of industries that you understand. Most advisors that
DON'T make a commission on their advice would lean toward focusing on
the industries that you know and understand.
Also, focusing on fewer stocks with reliable returns and growing dividends
might also be more efficient and more effective, but you get to choose
what you want to do. I know of one investor that just loved to buy newly
found issues. She had probably almost 30 issues in her portfolio. She
would buy and hold for the long term. She truly enjoyed finding a few new
issues each year.
A more successful investor that I knew actually had a better return by
focusing on a few stocks, buying and selling for the capital gain when
appropriate, and collecting dividends in the meantime between trades.
So, based your personality and following correct principles, you should
choose your own style of investing.
Final Summary
After you acquire the skills to invest, you discover that investing is more
like an art.
It’s like surfing. First, you learn how to paddle, then you balance on the
board. You have to get the hang of reading the wind and the waves and the
currents. These combine as the science of surfing—the technical know-
how. From there, however, you have practice over and over. Your muscle
memory develops. You learn and internalize each movement. You begin to
see how the ocean moves, the winds shift, and the sky portends. Your
movements become as fluid and artistic as the waves you ride. You cut
across each curl with your own style. You turn it into art, not just the
mechanical application of basic rules.
Your first step in investing it to master the concepts, jargon, and culture of
the market. You know that investors should buy low and sell high. So why
are you surprised when your pet stock reaches an all-time high—just
before the price drops. Wouldn't you sell it off if you had made your target
profit?
The exciting new is that yes, you can ultimately be very successful in
trading in the market, whether for the long term (buy and hold more than
one year), swing trading (holding the stock for a few days, a few weeks, a
few months, etc., but less than a year), or "day trading" (opening and
closing our positions within the same trading day).
Learning how the market works and how to negotiate the turbulent waters
is just the beginning. Having a solid plan and using your practiced skills
and your unique artistic approach will lead to the ability to create wealth
and minimize risk.
The tale is told of a boy who stepped off the train in New York City
carrying a violin case. He asked an older man at the depot how to get to
Carnegie Hall. The old man replied, "Practice, practice, practice."
I would strongly recommend studying the concepts in depth so you can
apply them. Then, set up a practice account on your brokerage website
where you can trade in real stocks using real time tools, but with pretend
money, until you feel at least 80% confident in your practice trades before
putting real money at risk in the market. Choose an arbitrary number of
trades to do and then keep track of your success.
One of my colleagues suggested to his clients that they place and track one
hundred trades before considering real world trades. But that wasn’t all; he
suggested that they achieve at least an 80% success rate on their trades
before they take the plunge with real money.
One of my studied gurus that taught me a lot about options suggested that
he looks for option trades with at least a 95% probability of success. He,
like me, hates to lose money in the market. He spends a lot of time looking
for the trade that fits his parameters. There are many days that he does not
find a reasonable trade. NOT trading on a particular day or time is also an
investing strategy.
Remember, preserving capital is the first rule of the savvy investor.
Appendix A
(1) Calculating Intrinsic Value of a Stock
(WIKIPEDIA)
Stock

There are many ways to calculate the intrinsic value. The most common is
the PE (Price to Earnings) stock valuation method to calculate the intrinsic
value. Price/earnings ratio is the most common measure of how expensive
a stock is.

P/E ratio = P / EPS P = Current Market Price EPS = Earnings per

Share

The higher the P/E ratio, the more the market is willing to pay for each
dollar of annual earnings. Companies that are currently unprofitable (that
is, ones which have negative earnings) don't have a P/E ratio at all. In
general, the P/E ratio is higher for a company with a higher growth rate.
The P/E ratio of any company that's fairly priced will be equal to its growth
rate.

If we know a stock P/E ratio and its EPS, we can calculate its value by the
following formula:

Value = P/E * EPS

For example, if stock ABC’s long term EPS growth rate is 15%; and next
year EPS estimation is $1.8, we can suppose its next year fair PE equal to
15, and its next year’s fair value is 15 * 1.8 = 27. Now that you know what
the stock is "worth," you can compare its current stock price with its value
to decide if it is worth it to buy, sell, or hold. For example, if ABC was
trading at $20, you would consider it undervalued because it’s trading at a
price that is less than its value of $27. However, if it was trading at $35 per
share, it would be considered overvalued.
A more complex way, the Warren Buffet way, is also called the Discounted
Cash Flow (DCF) model, which is a mathematical expression based on the
company’s ability to generate cash flow. The P/E method is subject to
changes in earnings, growth of revenue, or the stock market price itself,
while the DCF model is based on the growth rate of revenue and the
amount of revenue itself, uninfluenced by the market value of the stock.

value of firm =
where
FCFF is the Free Cash Flow to the Firm (i.e. Operating cash flow
minus capital expenditures)
WACC is the Weighted Average Cost of Capital
t is the time period
n is the number of time periods
g is the growth rate
value of firm is enterprise value

As you can see, this value may be difficult to derive, and therefore is less
popular, but carries a strong perspective as the true value of the stock
(enterprise value / number of shares outstanding). This number is published
on Morningstar.com, premium service as “Fair Value,” and on Quicken.com
as “Intrinsic Value” (for account holders that own the Quicken software).

Options
Intrinsic value of options is the value of its underlying stock that is built
into the price of the option. In fact, options traders buy stock options for
the sake of those options gaining intrinsic value (long call or long
put options trading strategy).
Changes with the Underlying Stock Impacting the Value of the Option
Intrinsic value for the value of the option changes when the underlying
stock moves. Intrinsic value of the option increases as the underlying stock
goes more and more in the money and intrinsic value becomes zero when
the underlying stock moves out of the money.
When you buy call options, you do so because you want to profit when the
stock goes up. When the stock moves higher and higher, more and more of
the stock's value gets built into the price of the option in the form of
intrinsic value.
For example, AAPL is trading at $100 today and you bought AAPL's
$100 strike price call options. If AAPL rises to $150 at expiration of the
call options, your $100 strike call options will be worth $50 because they
allow you to buy AAPL at $100 when it is trading at $150. That $50 is
intrinsic value.
Similarly, if you own AAPL's $200 strike price put options when AAPL is
trading at $150, those put options would also have a $50 intrinsic value
because they allow you to sell AAPL's shares at $200 when it is trading at
only $150.
Basically, intrinsic value is the value that you will receive
from exercising your in-the-money options.
Changes with the Underlying Stock
Intrinsic value changes when the underlying stock moves. Intrinsic value
increases as the underlying stock goes more and more in the money and
intrinsic value becomes zero when the underlying stock moves out of the
money.
Intrinsic Value of Call Options and Put Options
Intrinsic value of call options increases as a stock rises above the strike
price of the call options. Intrinsic value of put options increases as the
stock falls below the strike price of the put options.
Stock Valuation
In The Intelligent Investor, Benjamin Graham describes a formula he used
to value stocks. He eschewed the more esoteric calculations and kept his
formula pretty simple. In his words: "Our study of the various methods has
led us to suggest a foreshortened and quite simple formula for the valuation
of growth stocks, which is intended to produce figures fairly close to those
resulting from the more refined mathematical calculations."
The formula as described by Graham, is as follows:
Value = Current (Normal) Earnings [EPS] x (8.5 + (2 x Expected Annual
Growth Rate) x (AAA bond Rate / AA bond rate)
Where the Expected Annual Growth Rate "should be that expected over the
next seven to ten years."
The value of 8.5 appears to be the P/E ratio of a stock that has zero growth.
It is not clear from the text how Graham arrived at this figure, but it is
likely it represents the y-intercept of a normal distribution of a series of
various P/E values plotted against corresponding growth figures.
Graham's formula takes no account of prevailing interest rates; at the time
he last updated the chapter, around 1962, the yield on AAA Corporate
Bonds was around 4.4%. We can adjust the formula by normalizing it for
current bond yields by multiplying by a factor of 4.40/{AAA Corporate
Bond Yield}. Bond yields can be found on Yahoo: Finance! (The
assumption is that the price of money is the rate being paid on highly stable
and reliable bond issuers).
Let’s take a real-life example using IBM. According to Yahoo!, the
expected growth rate for IBM over the next 5 years is 10% per annum (note
data is only available for 5 years ahead rather than the 7-10 years Graham
states, but this should not make a significant difference). EPS for IBM over
the last 12 months is $4.95. Taking these values and plugging in the 20 year
AA Corporate bond yield of 5.76% (AA Bond yields are higher than AAA
so will give a more conservative estimate of IV) in our adjustment gives:
Intrinsic Value = 4.95 x (8.5 + (2 x 10) x (4.40/5.76) = $107.77
IBM is currently trading at around $91, so it is currently slightly
undervalued.
We can also do the same calculation for IBM's average expected 2005
earnings of $5.62 in order to give some idea of what IBM's price should be
if it meets those earnings estimates:
Intrinsic Value = 5.62 x (8.5 + (2 x 10) x (4.40/5.76) = $122.36
Of course this calculation is somewhat subjective when considered on its
own. It should never be used in isolation; we must always take into account
other factors such as debt/equity, cash flow, management effectiveness,
prevailing economic conditions, etc. Investors should seek some qualifying
criteria such as a PEG (Price Earnings Growth) ratio of less than 1 in
addition to the stock being undervalued based on trailing and forward
intrinsic value. Be aware that PEG itself is also based on future
expectations, so we have to have some degree of certainty that the company
will meet those expectations. We can do this by looking at the last 5 years
growth rate and Earnings figures.

(2) Approximate valuation approaches

Average growth approximation: Assuming that two stocks have the same
earnings growth, the one with a lower P/E is a better value. The P/E method
is perhaps the most commonly used valuation method in the stock
brokerage industry.[2][3][citation needed] By using comparison firms, a target
price/earnings (or P/E) ratio is selected for the company, and then the
future earnings of the company are estimated. The valuation's fair price is
simply estimated earnings times target P/E. This model is essentially the
same model as Gordon's model, if k-g is estimated as the dividend payout
ratio (D/E) divided by the target P/E ratio.
Constant growth approximation: The Gordon model or Gordon's growth
model[4] is the best known of a class of discounted dividend models. It
assumes that dividends will increase at a constant growth rate (less than the
discount rate) forever. The valuation is given by the formula:

and the following table defines each symbol:

Symbol Meaning Units
P estimated stock price $ or € or £
D last dividend paid $ or € or £
k discount rate %
g the growth rate of the dividends %
[1]
Limited high-growth period approximation: When a stock has a
significantly higher growth rate than its peers, it is sometimes assumed that
the earnings growth rate will be sustained for a short time (say, 5 years),
and then the growth rate will revert to the mean. This is probably the most
rigorous approximation that is practical.[5]
While these DCF models are commonly used, the uncertainty in these
values is hardly ever discussed. Note that the models diverge for k = g and
hence are extremely sensitive to the difference of dividend growth to
discount factor. One might argue that an analyst can justify any value (and
that would usually be one close to the current price supporting his call) by
fine-tuning the growth/discount assumptions.
Implied growth models: One can use the Gordon model or the limited
high-growth period approximation model to impute an implied growth
estimate. To do this, one takes the average P/E and average growth for a
comparison index, uses the current (or forward) P/E of the stock in
question, and calculates what growth rate would be needed for the two
valuation equations to be equal. This gives you an estimate of the "break-
even" growth rate for the stock's current P/E ratio. (Note: we are using
earnings not dividends here because dividend policies vary and may be
influenced by many factors including tax treatment).
Imputed growth acceleration ratio: Subsequently, one can divide this
imputed growth estimate by recent historical growth rates. If the resulting
ratio is greater than one, it implies that the stock would need to experience
accelerated growth relative to its prior recent historical growth to justify its
current P/E (higher values suggest potential overvaluation). If the resulting
ratio is less than one, it implies that either the market expects growth to
slow for this stock or that the stock could sustain its current P/E with lower
than historical growth (lower values suggest potential undervaluation).
Comparison of the IGAR across stocks in the same industry may give
estimates of relative value. IGAR averages across an industry may give
estimates of relative expected changes in industry growth (e.g. the market's
imputed expectation that an industry is about to "take-off" or stagnate).
Naturally, any differences in IGAR between stocks in the same industry
may be due to differences in fundamentals and would require further
specific analysis.

Market criteria (potential price)

Some feel that if the stock is listed in a well organized stock market, with a
large volume of transactions, the listed price will be close to the estimated
fair value. CBOE.com This is called the efficient market hypothesis (see
appendix
On the other hand, studies made in the field of behavioral finance tend to
show that deviations from the fair price are rather common, and sometimes
quite large.CBOE.com/vix
Thus, in addition to fundamental economic criteria, market criteria also
have to be taken into account market-based valuation. Valuing a stock is
not only to estimate its fair value, but also to determine its potential price
range, taking into account market behavior aspects. One of the behavioral
valuation tools is the stock image, a coefficient that bridges the theoretical
fair value and the market price.
References:
http://research.stlouisfed.org/fred2/data/AAA.txt
http://en.wikipedia.org/wiki/Benjamin_Graham_formula

(3) Intrinsic Value Formula (my extraction from the above

aritcle)
To determine stock “value”
(Benjamin Graham, quick version)
Value = Current (normal) earnings X (8.5 + (2 x Annual EPS growth rate))
Current Earnings = EPS
8.5 is a middle of the road, conservative P/E ratio. The higher the P/E used
here, the higher the Value number will be, which may not be realistic. The
DCF model is more accurate, but this model can give us a quick idea.

Example: $1 per share earnings last year

Expected (based on historical) growth rate 5%
P/E 8.5
Value = $1 (8.5 + (2 x 5)) = $1 (8.5 + 10)) = $1 x 18.6 = $19.60.
(4)

(from www.wealthacademy.com)
Appendix B
The Many Faces of Risk
By Eric Jacobson | 05-26-11 | 06:00 AM | E-mail Article
Sometimes it seems as though all we ever discuss and write about is risk.
In talking with investors who were burned during the most recent crisis
and are now worried about the next one over the horizon, however, it's
clearly never a bad time to rekindle some old flames of the discussion.
Unfortunately, the very definition of risk is elusive, as it can take on
different shades of meaning depending on who's using the word. Here's a
framework to think about it. These aren't widely accepted academic terms
—just some labels to try and make the case.
True Risk
Sheesh. Where to even start? One of my colleagues invoked Justice Potter
Stewart's famous declaration (about obscenity): "I shall not today attempt
further to define ... [it]; and perhaps I could never succeed in intelligibly
doing so. But I know it when I see it." Think of "True Risk" as the
hypothetical, inherent risk in an investment—in other words, a Platonic
ideal: The risk that exists, whether it's ever actually realized or not, and
which any of us could only be certain of if we had perfect, godlike
knowledge. Put another way, we're talking about risk that can never be
truly and completely known or measured unless it rears its head and comes
to fruition.
Some elements of True Risk are so ephemeral—such as whether a CEO
will decide to perpetuate a fraud—that we're unlikely to ever have the
capacity to measure them. Others are much more concrete and
theoretically discoverable but can be very difficult to identify, especially
in very complex or immature markets. It's not clear that the Federal
Reserve or other regulators would have acted differently before the
financial crisis, for example; but there has been some reason to think that
they probably did not have a full and complete picture of just how much
financial liability there was in the system (not only actual debt, but also
obligations from derivatives and other contracts). Even down at more
granular levels, such as the dangers that developed among investment
banks, their mortgage exposures, and their off-balance sheet exposures, it
appears that regulators were unable to actually observe or understand
certain risks. They were there, though--whether anyone could or couldn't
see them.
If that's still not clear enough, think of it in another realm. If a
thunderstorm passes over your office, there's a True Risk that lightning
may strike its roof. You know that, but you probably can't say too much
about its severity or likelihood of occurring. At this point, meanwhile, the
scientific tools and resources necessary to perfectly describe that risk
either don't exist or aren't practical to deploy.
A large portion of the work put into academic and applied finance,
however, is devoted to coming up with ways to observe, predict, and
measure investment risks. Those efforts fall mainly into the following two
camps.
Fundamental Risk Estimates
This is arguably the closest we actually come to knowing True Risk
(unless it's realized). It's what we estimate True Risk to be based on what
most refer to as "fundamental" measures. Critically, though, even though
many of these metrics can be calculated to measure things with great
precision, they are ultimately measurements of those "things," and really
are only estimates of True Risk.
When looking at the stocks of companies—or portfolios of stocks—for
example, investors often look at accounting measures, such as the ratio of
debt to shareholder equity, to gauge how highly leveraged they are. And
while market capitalization may be a little further removed, it, too, is the
kind of basic factor that we often use to classify and think about how risky
different stocks are.
For corporate bonds it might be debt coverage ratios that suggest how
much cash or income an issuer will have available to pay its obligations.
For mortgage bonds, one might look at any number of items such as
homeowners' credit scores or their loan-to-value ratios. For bonds and
portfolios of bonds (including mortgage bonds), we often use measures
such as duration to predict how they will move, given changes in interest
rates. The bottom line is that these are all different ways that we try to
zero in on an investment's risk, based and built upon its fundamental
characteristics.
Price Volatility as Risk
This awkward label is just an attempt to translate the uber-jargony term
"empirical volatility." Put another way, it's a reflection of how much an
investment's price moves over time. It gets more complicated when
academics layer on calculations, but most of modern finance is based on
the following: Given that we can't really know True Risk, and that data for
measuring Fundamental Risk can be really difficult to gather and can't
usually be compared across different investments, the best proxy for "risk"
is what we can observe through price fluctuations.
One can spend a lot of time picking and choosing time periods, but there is
a limit to the usefulness of data gleaned from an investment's price
movements. It can tell you what the "market" has perceived an
investment's risk to be over time—which is certainly useful—but even
that information can be muddied up by any number of factors.
Take U.S. Treasury bonds, for example. Putting aside speculation about
Uncle Sam's economic situation and focusing just on the basic risk of
whether or not bondholders will get paid, it's pretty well accepted that
Treasury bonds are about the safest option around. By contrast, the
likelihood that owners of high-yield corporate—or junk—bonds might fail
to get some money back is generally a lot higher. Whatever precision we
lack in being able to assess the True Risk of those sectors, we at least have
good estimates of Fundamental Risk that tell us it's much greater for high
yield.
The problem is, however, that for long stretches of time, broad swings in
Treasury bond prices can create the perception that they're a lot riskier
than high-yield bonds. If you use a typical tool for measuring Price
Volatility, such as the standard deviation, for Treasuries and high-yield
bonds over the past 12 months, you'd find the former to be nearly twice as
volatile as the latter. There are a few reasons for that (including the fact
that Treasuries are much more liquid and actively traded), but the fact is
that during unremarkable times for the market, high-yield bonds often just
chug along, with their prices changing just a little bit every day, even if
they're marching upward over time. In other words, unless serious risk
actually materializes in high-yield prices—that is, bad things actually
happen—then the statistics can actually send the wrong message.
The only way that "Price Observed Risk" would help you see the bigger
True Risk in the high-yield bond sector is if you were to include a period
during which high-yield bonds actually "blew up," as they did in 2008.
Before that, though, you would have had to go all the way back to 2002.
That means that high-yield risk remained relatively well hidden for a
roughly five-year stretch (2003 through 2007). During that period high-
yield bonds looked less risky as determined by Price Volatility than U.S.
Treasuries.
The point here isn't to completely dismiss the value of academic research
or the use of statistical tools to try and measure risk. Each method has
some advantages and utility, and Morningstar makes liberal use of both in
order to help investors understand risks, both hidden and visible. In fact,
the only way to get really close to understanding True Risk, as we've
labeled it here, is to combine many different indicators of risk. Of course,
sifting among them and using the results to make wise and profitable
investment decisions is an exercise even the best among us spend a
lifetime trying to perfect.
Eric Jacobson is Morningstar's director of fixed-income research and an
editorial director for mutual fund content.

Risk Tolerance Test Score: ______ Name:

_____________________

1. When it comes to investing, my luck has been:

1. Rotten
2. Average
3. Better than average
4. Terrific
2. Most of the good things that have happened to me have been
because:
1. I planned them
2. I was able to exploit opportunities that arose
3. I was in the right place at the right time
4. God looks out for me

3. If a stock doubled in price five months after I bought it, I would:

1. Sell all my shares
2. Sell half my shares
3. Sit tight
4. Buy more shares

4. Making investment decisions on my own is something I:

1. Never do
2. Do occasionally
3. Often do
4. Almost always do

5. At work, when my boss tells me to do something that I know is

a bad idea, I usually:
1. Tell him or her that it is a mistake
2. Get co-workers to join me in opposing the idea
3. Do nothing unless the boss brings it up again
4. Do it anyway

6. In order for me to invest 10% of my net worth in a venture that

has at least a 75% chance of success, the potential profit would
have to be at least:
1. The same as the amount invested
2. Three times the amount invested
3. Five times the amount invested
4. No amount would be worth the risk
7. When I watch television and see people involved in such sports
as hang gliding or bungee jumping:
1. I think they are idiots
2. I admire them but would never participate
3. I wish I could try such sports once just to see what
they are like.
4. I think seriously about participating myself

8. If I held a finalist ticket in a lottery with a one-in-three chance

of winning a $50,000 prize, the smallest amount I would be
willing to sell my ticket for before the drawings is:
1. $30,000
2. $17,000
3. $13,000
4. $10,00

9. In the past, I have spent $100 on one or more of the following

activities: gambling in a casino; betting on my own recreational
activities, such as golf or poker; betting on professional sports
(Circle the item that best applies).
1. I have done two or more of these in the past year
2. I have done one of these in the past year
3. I have done one of these a few times in my life
4. I have never done any of these.

10. If I had to make a critical decision that involved a large amount

of money, I would probably do one or more of the following
things.
1. Delay the decision
2. Delegate the decision to someone else
3. Ask others to share in the decision
4. Plan strategies that would minimize any loss
SCORING
For questions 1,3,4: If you answered (a) give yourself one point, (b) two
points, (c) three points, and (d) four points.
For questions 2, 6, 8, and 9: If you answered (a) give yourself four points,
(b) three points, (c) two points and (d) one point.
For questions 5 & 7: No matter what you chose, don’t give yourself any
points. Moral courage and physical bravery don’t have anything to do with
your tolerance for investment risk.
For question 10: Subtract from five the number of answers you circled and
give yourself the rest.

What Your Score Means

8-16: You’re a conservative investor, willing to take few risks.
17-24: You’re a moderate investor, willing to take moderate risks.
25-32: You’re an aggressive investor, willing to take greater-than-average
risks.

From: The Money Book of Personal Finance, Eisenberg, 1966,

Money magazine.
Appendix C
Candlestick Basics
Bull Candlestick

Bear Candlestick

In the following black-and-white representations, the white candlesticks

are the bulls and the black candlesticks are the bears.

Abandoned Baby: A rare reversal pattern characterized by a gap followed

by a Doji, which is then followed by another gap in the opposite direction.
The shadows on the Doji must completely gap below or above the shadows
of the first and third day.

Dark Cloud Cover: A bearish reversal pattern that continues the uptrend
with a long white body. The next day opens at a new high then closes
below the midpoint of the body of the first day.
Doji: Doji form when a security's open and close are virtually equal. The
length of the upper and lower shadows can vary, and the resulting
candlestick looks like, either, a cross, inverted cross, or plus sign. Doji
convey a sense of indecision or tug-of-war between buyers and sellers.
Prices move above and below the opening level during the session, but
close at or near the opening level.

Downside Tasuki Gap: A continuation pattern with a long, black body

followed by another black body that has gapped below the first one. The
third day is white and opens within the body of the second day, then closes
in the gap between the first two days, but does not close the gap.

Dragonfly Doji: A Doji where the open and close price are at the high of
the day. Like other Doji days, this one normally appears at market turning
points.

Engulfing Pattern: A reversal pattern that can be bearish or bullish,

depending upon whether it appears at the end of an uptrend (bearish
engulfing pattern) or a downtrend (bullish engulfing pattern). The first day
is characterized by a small body, followed by a day whose body
completely engulfs the previous day's body.

Evening Doji Star: A three day bearish reversal pattern similar to the
Evening Star. The uptrend continues with a large white body. The next day
opens higher, trades in a small range, then closes at its open (Doji). The
next day closes below the midpoint of the body of the first day.

Evening Star: A bearish reversal pattern that continues an uptrend with a

long white body day followed by a gapped up small body day, then a down
close with the close below the midpoint of the first day.
Falling Three Methods: A bearish continuation pattern. A long black body
is followed by three small body days, each fully contained within the
range of the high and low of the first day. The fifth day closes at a new
low.

Gravestone Doji: A Doji line that develops when the Doji is at, or very
near, the low of the day.

Hammer: Hammer candlesticks form when a security moves significantly

lower after the open, but rallies to close well above the intraday low. The
resulting candlestick looks like a square lollipop with a long stick. If this
candlestick forms during an advance, then it is called a Hanging Man.

Hanging Man: Hanging Man candlesticks form when a security moves

significantly lower after the open, but rallies to close well above the
intraday low. The resulting candlestick looks like a square lollipop with a
long stick. If this candlestick forms during a decline, then it is called a
Hammer.

Harami: A two-day pattern that has a small body day completely contained
within the range of the previous body, and is the opposite color.

Harami Cross: A two-day pattern similar to the Harami. The difference is

that the last day is a Doji.
Inverted Hammer: A one day bullish reversal pattern. In a downtrend, the
open is lower, then it trades higher, but closes near its open, therefore
looking like an inverted lollipop.

Long Day: A long day represents a large price move from open to close,
where the length of the candle body is long.

Long-Legged Doji: This candlestick has long upper and lower shadows
with the Doji in the middle of the day's trading range, clearly reflecting
the indecision of traders.

Long Shadows: Candlesticks with a long upper shadow and short lower
shadow indicate that buyers dominated during the session and bid prices
higher. Conversely, candlesticks with long lower shadows and short upper
shadows indicate that sellers dominated during the session and drove
prices lower.

Marubozo: A candlestick with no shadow extending from the body at

either the open, the close or at both. The name means close-cropped or
close-cut in Japanese, though other interpretations refer to it as Bald or
Shaven Head.

Morning Doji Star: A three day bullish reversal pattern that is very similar
to the Morning Star. The first day is in a downtrend with a long black body.
The next day opens lower with a Doji that has a small trading range. The
last day closes above the midpoint of the first day.

Morning Star: A three day bullish reversal pattern consisting of three

candlesticks—a long-bodied black candle extending the current
downtrend, a short middle candle that gapped down on the open, and a
long-bodied white candle that gapped up on the open and closed above the
midpoint of the body of the first day.

Piercing Line: A bullish two day reversal pattern. The first day, in a
downtrend, is a long black day. The next day opens at a new low, then
closes above the midpoint of the body of the first day.

Rising Three Methods: A bullish continuation pattern in which a long

white body is followed by three small body days, each fully contained
within the range of the high and low of the first day. The fifth day closes at
a new high.

Shooting Star: A single day pattern that can appear in an uptrend. It opens
higher, trades much higher, then closes near its open. It looks just like the
Inverted Hammer except that it is bearish.

Short Day: A short day represents a small price move from open to close,
where the length of the candle body is short.

Spinning Top: Candlestick lines that have small bodies with upper and
lower shadows that exceed the length of the body. Spinning tops signal
indecision.

Stars: A candlestick that gaps away from the previous candlestick is said
to be in star position. Depending on the previous candlestick, the star
position candlestick gaps up or down and appears isolated from previous
price action.

Stick Sandwich: A bullish reversal pattern with two black bodies

surrounding a white body. The closing prices of the two black bodies must
be equal. A support prices is apparent and the opportunity for prices to
reverse is quite good.

Three Black Crows: A bearish reversal pattern consisting of three

consecutive black bodies where each day closes near below the previous
low and opens within the body of the previous day.

Three White Soldiers: A bullish reversal pattern consisting of three

consecutive white bodies, each with a higher close. Each should open
within the previous body and the close should be near the high of the day.

Upside Gap Two Crows: A three day bearish pattern that only happens in
an uptrend. The first day is a long white body followed by a gapped open
with the small black body remaining gapped above the first day. The third
day is also a black day whose body is larger than the second day and
engulfs it. The close of the last day is still above the first long white day.

Upside Tasuki Gap: A continuation pattern with a long white body

followed by another white body that has gapped above the first one. The
third day is black and opens within the body of the second day, then closes
in the gap between the first two days, but does not close the gap.

From: Chart School, StockCharts.com

DOJI: Indecisiveness
Long-legged DOJI: Tremendous Indecisiveness

Dragon Fly DOJI: Strong indication of bullish sentiment,

sometimes in the midst of a downward trend.

Gravestone DOJI: Typical bearish indication

LONG CANDLESTICKS: The longer the body, the more

buying or selling sentiment is present.
SHORT CANDLESTICKS: Less buying or selling pressure,
indicating pointing to consolidation periods.

MARUBOZU Candle: Bulls or bears were in full control of

the session, may indicate a change in direction or strong
indicator of continuation.

SPINNING TOP: Shows indecision and that trend could

change.

SHADOWS: Indicates that the majority of trading took place

well beyond the open and the close of the session and is
pointing in the direction of the trend. Longer shadows on the
bottom indicate potential turn towards up. Longer shadows on
the top may indicate more movement downward.

HAMMER: Indicates trend may be at the bottom of a run.

 HANGING MAN: may indicate trend may be at the top of a
run.

Inverted HAMMER: Bullish reversal pattern. Sellers are

losing momentum (bottom of run).

SHOOTING STAR: Forms after an advance (top of a run).

(see WIKIPEDIA for more definitions)

Appendix D
Option Strategy Map
There are many ways to create combinations for placing
"option bets." The following "map" may give you some
ideas for types of trades and how to determine what type
of trade to construct based on the underlying
"valuedness" (overvalued, undervalued, or appropriately
valued i.e. fair or intrinsic value of the stock price) and
the "implied volatility" (implied volatility being
historical volatility forecasted into the future). Here is a
Trade Recipe Table to act as a guide. The Volatility
Structure Investments are for experienced investors and
the meaning will become plain as the other concepts are
mastered.
 Figure D.1 Options strategy table.

So, if the market in general is bullish, and the stock is at its longer term
support line, or below its intrinsic value, and the implied volatility of the
option for a given expiration date is low, then we can choose to just by a
CALL, or buy a protective PUT, or do a combination of the two. I like to
always add the idea of checking the news for the market and the news for
the stock to assure that our "bet" has a high degree of probability in
success.
If the market in general is bearish and our stock price is overvalued or
running higher than normal (at resistance?), we would then check out just
selling the call or other more complex ideas.
We recommend that you stick to the four corners of the trade recipe table
to begin with by mastering the buying and selling of PUTS and CALLS,
the mastering Spreads, before venturing into the more exotic trades.

How to Select Strikes

It is also important to understand how to use the "Greeks" in selecting
option strikes. See the Appendix E for more information on Greeks.
Basically, for longer term trades we have more time for the stock to move
in our direction.
Example: XYZ company stock is now trading at $49.93. Therefore, the
$50 strike, the closest to the actual stock price, is the "at the money"
(ATM) strike. The Greek ratio known as Delta will always be close to 50
when the strike is ATM. Delta will increase as we go deeper In The Money
(ITM). The further Out of the Money (OTM) the lower the Delta.
Example:

Figure D.2 showing Delta and IV.

As you can see the Delta is greater the deeper ITM. Lower as we go OTM.
Delta is also seen as a "probability" indicator, but only assuming that the
stock price does not move. Delta for each strike is calculated
independently from every other strike. So, the likelihood of GE stock
strike of being ITM at expiration for the $16.50 strike is 92.76%, if the
stock price does not change much by expiration.
Interestingly, the farther out the expiration date the more the Delta will
migrate to a figure of 1 (one) as even with the best implied volatility
calculations, the probability of a stock price to be at a given level in the
future merges to either 0 or 1. For shorter term trades, Delta can be very
helpful. We can also convert Delta from Dollar Delta, as displayed in D.1
to %/% Delta. The higher the %/% Delta number the more leverage we
have in the trade. So, it turns out, the OTM trades on a long-term scale
have more leverage as the %/% delta gets higher and higher.
Tip 1
For the small investor, if we have a tie in strikes with the same Delta (very
unusual), the we break the tie by using the Gamma figure. The higher
Gamma wins. We are not too concerned about Vega or Rho as they
measure differences in the other Greeks. Theta is the measure of the
amount of money eroded from the value of the contract over the next day
IF STOCK PRICES DO NOT MOVE.
So, we will probably place out strikes closes to ATM in general for doing a
direction trade as the efficiency of the trade is best for short term trades. If
the Delta is 0.50, we assume that we have a 50$ chance of success as the
stock price could go up or down. Deeper ITM trades will have higher
probabilities as the likelihood of the stock price going to our deep in the
money strike is quite low, therefore, the probability of our trade being ITM
is high.
Tip 2
Always use the calculation boxes as demonstrated above to see what your
profitability is. Don't ever enter a trade without knowing the upside of the
trade, as well as the worst-case result for you using tables as demonstrated
in figures 57 through 59 of the text.
Implied Volatility (IV)
We can also see the Implied Volatility of the individual strikes. On some
options chains or charts, the IV is not calculated for each strike, but only
for the expiration date. You will want to work with your broker or analysis
service to be able to be able to set your view to see the Greeks and the
Implied Volatility (IV).
Volume
Another issue to keep in mind is Volume. You may find a strike that you
think is excellent for your purposes, only to find out that when you try to
transact, your order is not filled. It will probably be because there is not
sufficient volume in that strike. So be aware of volume. You may not agree
with the other investors as to the strike with the most volume, but you will
be filled on those strikes, and they may have a point, so see if you can
think through why that strike is being chosen. It may be the strike just
inside or outside of the support and resistance levels, or the Bollinger
Bands, which many investors use as guides.
Intrinstic Value
Using Intrinsic Value, or Fair Value, for guessing future stock price: Most
analysts will use a 3-year time horizon for prognosticating what the stock
price ought to be. So, if the stock is trading at $25 per share, and the
Intrinsic Value is gauged at $45, we would expect the price to migrate
there sometime in the next three years. So, if you are looking at
expirations out just two years, we can do a little simple math:
$45 x 2/3 = $29.97
The stock price should not be expected to rise about $30 in two years. This
is a mathematically simplified approach and may not hold true in reality
due to many factors, but it is the only reasonable method that we have.
Anything else is too complicated and probably less accurate. There are too
many variables in forecasting the future of a company, so let's keep it
simple.
Other Trade Terms
Here are some clarifying concepts for placing trades:
BUY BEARISH
Buy Put
We would adopt this strategy when the stock price is seen as high and
the volatility is low, thus giving pressure for the stock price to continue
to fall. Picking a strike "at the money" makes the most sense for
economic pricing of the option, or one just out of the money, for a
cheaper option but less profit.

Buying (Going Long) Bear Puts

The selection Buy a put contract at a given strike
price for a given expiration.
Shorter term trades should have
higher Deltas. For very long trades,
the Delta is less significant. Look
to Intrinsic Value to see where that
stock price might go over the long
term. Use Technical analysis for
shorter term trades to forecast
stock price movements.
Maximum Gain The put strike price less the
premium paid.
Maximum Loss The premium paid.
Margining Not required.
Advantages • Straightforward access to a
stock’s downside.
• Limited, perfectly predictable
position expense.
Drawbacks • The premium payment is never
recoverable.
• Can earn only the difference
between the strike and zero (i.e., no
“unlimited profit potential,” as
with a similarly structured long
call).

Long Put Spread

Buying Bearish Put Spreads
The Selection Buy a put contract at a given strike
price for a given expiration. Sell a
put contract at a lower strike price
for the same expiration as the
bought put. (Note: see below for a
description of the “Buying Bearish
Calendar Put Spreads” strategy, in
which puts of different expirations
are transacted.)
Maximum Gain The total value between the two
put strikes, less the premium paid.
Maximum Loss The premium paid.
Margining Not required.
What Is a “Bear Put Spread?”
A bear put spread is a type of options strategy used when an
option trader expects a decline in the price of the underlying asset. Bear
put spread is achieved by purchasing put options at a specific strike
price while also selling the same number of puts at a lower strike price.
The maximum profit to be gained using this strategy is equal to the
difference between the two strike prices, minus the net cost of the options.
Strategy for a Bear Put Spread
For example, let's assume that a stock is trading at $30. An option trader
can use a bear put spread by purchasing one put option contract with a
strike price of $35 for a cost of $475 ($4.75 * 100 shares/contract) and
selling one put option contract with a strike price of $30 for $175 ($1.75 *
100 shares/contract). In this case, the investor will need to pay a total of
$300 to set up this strategy ($475 - $175). If the price of the underlying
asset closes below $30 upon expiration, then the investor will realize a
total profit of $200 (($35 - $30 * 100 shares/contract) - ($475 - $175)).
How do we know which price to pick for our offsetting trade to maximize
profits? Here's a fun way to look at the profitability of the spread choices.
Let's imagine that you see a stock and you think that selling the $270
strike is a good idea. Then, to buy the offsetting strike, we see that we will
be giving up some of the premium. This table may help us make that
decision.

This kind of table can be used for any kind of spread, credit or debit, to
determine the most efficient offsetting strike price to select.
What Is a “Bull Put Spread?”
A bull put spread is an options strategy that is used when
the investor expects a moderate rise in the price of the underlying asset.
This strategy is constructed by purchasing one put option while
simultaneously selling another put option with a higher strike price. The
goal of this strategy is realized when the price of the underlying stays
above the higher strike price, which causes the short option to expire
worthless, resulting in the trader keeping the premium.
Strategy for a Bull Put Spread
In a bull put spread, the investor is obligated to purchase the underlying
stock at the higher strike price if the short put option is exercised.
Additionally, if exercising the long put option is favorable, the investor
has the right to sell the underlying stock at the lower strike price. This
type of strategy (buying one option and selling another with a higher strike
price) is known as a credit spread, because the amount received by selling
the put option with a higher strike is more than enough to cover the cost of
purchasing the put with the lower strike.
Profit and Loss
The bull put spread strategy has limited risk, but it has a limited profit
potential. Investors who are bullish on an underlying stock could use a bull
put spread to generate income with limited downside. The maximum
possible profit using this strategy is equal to the difference between the
amount received from the short put and the amount used to pay for
the long put. The maximum loss a trader can incur when using this
strategy is equal to the difference between the strike prices and the
net credit received. Bull put spreads can be created with in-the-money or
out-of-the-money put options, all with the same expiration date.
Bull Put Spread Example
Assume an investor is bullish on hypothetical stock TJM over the next two
weeks, but the investor does not have enough capital to purchase shares of
the stock. The stock is currently trading at $60 per share. Consequently,
the investor implements a bull put spread by writing five put options with
a strike price of $65 for $8.25 and purchasing five put options with a strike
price of $55 for $1.50, which are expire in two weeks.
Therefore, the investor's maximum profit is limited to $3,375, or ($8.25 -
$1.50) * 5 * 100, since equity options typically have a multiplier of 100.
The investor's maximum loss is capped at $1,625, or ($65 - $55 - ($8.25 -
$1.50)) * 5 * 100. Therefore, the investor is looking for the stock to close
above $65 per share on the expiration, which would be the point the
maximum profit is achieved.

Protective Put
Let's imagine that you bought a stock and you are pretty sure that the price
of the stock will rise. But you are not sure how far. You fear that it might
go out of control and fly upwards and then, as is usually the case, fall off
just as rapidly if not more so.
You would like to lock in your profits. You are completely satisfied with
your profit target. Assume that your target is a 10% gain in a short period
of time. You bought the stock at $25 per share, to so protect your profit,
you buy the PUT for the same number of shares (or closest 100 lot) with
the strike of $25 plus 10%, giving us a strike of $27.50, or something close
to that. You will pay a little premium, but you will lock in your required
profits. The downside would be the addition capital gain past $27.50 if that
price goes higher.
OR, perhaps you are ok with the $25 price, but think that if the price goes
down, you'd like to "double down" your investment by being able to buy
the shares at a lower price to give you a lower dollar cost average of your
stock. So, you may consider selling the PUT at a suspected strike lower
than your current basis cost, thus assuring the acquisition of that stock at a
lower price without tying up your money until the stock does go to that
level.
The benefit here is that you also receive the premium, so if you think that
your strike should be $23 and you sell the option for $.50 and you are put
the stock, your cost on this transaction would be $22.50. If you bought
equal lots, your average stock price would now be $25 + $22.50 / 2 =
$23.75. If you are not put the stock, your basis cost on your original
purchase would be $24.50, still giving you an advantage as you were able
to keep the premium. In this way, but continuing to sell puts against your
stock, you can reduce the cost of your stock incrementally over time.
The Selection Sell a put contract at a higher
strike price than current stock
price.
Maximum Gain The total value between the cost
and the put strike, less the
premium paid.
Maximum Loss The premium paid.
Margining Not required on cash transaction

OR, to Double Down

The Selection Sell a put contract at a given strike

price for a given expiration at a
suspected or desired strike.
Maximum Gain The total value between the put
strikes and any gain in the stock
price, plus the premium received.
Maximum Loss The difference between the strike
and any price decline after the
stock is PUT to you.
Margining Not required on cash transaction
Sell Put (Bullish Sentiment)
We would adopt this strategy when the stock price is seen as low and the
volatility is high, thus giving pressure for the stock price to rise. Picking a
strike "at the money" makes the most sense for economic pricing of the
option, or one just out of the money, for a cheaper option but less profit.
You should realize that first and foremost, when selling puts, you are
agreeing to buy a stock at a the strike price. If you have any misgivings at
all about holding a stock at your chosen strike price, you should not think
about selling the puts on it at that price! At what price would you like to
own the stock? Be reasonable; what would be a realistic price after having
done your research?
This stock should be from a company that you would not mind owning at
the strike price. In other words, you think that this price would be a "really
good deal" at that price. AND, you think that the stock price is on the rise
and will continue to be so before your expiration date. How do you know?
Perhaps the intrinsic value of the stock is $45, and the support level for the
stock is $35, and the stock is now just above support and rising on some
good news for the company. So, you sell the $35 strike for a $2 premium
that expires in 4 months, making your net cost, if the unlikely event of
being exercised or "put" the stock to you, of $33.
Wow, what a great price for this stock, and it gives us a little more
advantage. Or, perhaps you want more advantage, so you look at a longer
expiration date with a $5 premium, thus making your basis cost $30,
which might be an unheard of price for this stock.

The Selection Sell a put contract at a given strike

price for a given expiration at a
suspected or desired strike at
which you would not mind owning
the stock.
Maximum Gain The total value between the put
 strike and any gain in the stock
price, plus the premium received.
Maximum Loss The difference between the strike
and any price decline after the
stock is PUT to you minus the
premium received.
Margining Not required on cash transaction.
Bear Call Spread
A bear call spread is a type of options strategy used when a decline in the
price of the underlying asset is expected. It is achieved by selling call
options at a specific strike price while also buying the same number of
calls, but at a higher strike price. The maximum profit to be gained using
this strategy is equal to the difference between the price paid for the long
option and the amount collected on the short option.
Strategy “Bear Call Spread”
For example, let's assume that a stock is trading at $30. You have
purchased one call option with a strike price of $35 for a premium of
$0.50 and sold one call option with a strike price of $30 for a premium of
$2.50. If the price of the underlying asset closes below $30 upon
expiration, then you collect $200 (($2.50 - $0.50) * 100 shares/contract).
What does “Buy-Write” Mean
Buy-write is a trading strategy that consists of writing call options on an
underlying position to generate income from option premiums. Because
the options position is covered by the underlying position, the downside
risk of writing the option is minimized.
Strategy “Buy-Write”
For example, suppose you have a 100-share position in XYZ stock and
purchased the shares for $10 each. Soon after, you decide to write a call
option for XYZ stock at an exercise price of $12.50, selling the option
contract for a small premium. As long as the price of XYZ stays below
$12.50 until maturity, you will keep the premium. If the price rises above
the $12.50 level and is exercised, you will be required to sell the shares at
$12.50 to the option holder. The trade will only lose out on the difference
between the exercise price and the market price.
“Collar” Spread
A collar is a protective options strategy that is implemented after a long
position in a stock has experienced substantial gains. An investor can
create a collar position by purchasing an out-of-the-money put option
while he simultaneously writes an out-of-the-money call option. A collar
is also known as hedge wrapper.
Collar Strategy Mechanics
The purchase of an out-of-the-money put option is what protects the
underlying shares from a large downward move and locks in the profit.
The price paid to buy the puts is lowered by amount of premium that is
collected by selling the out-of-the-money call. The ultimate goal of this
position is that the underlying stock continues to rise until the written
strike is reached. Collars can protect investors against massive losses, but
collars also prevent massive gains.
The protective collar strategy involves two strategies known as a
protective put and covered call. A protective put, or married put, involves
being long a put option and long the underlying security. A covered call, or
buy/write, involves being long the underlying security and short a call
option.
Maximum Profit and Loss
If the strategy is implemented for a debit, the maximum profit of a collar
is equivalent to the call option's strike price less the underlying stock's
purchase price per share less the net premium paid. Conversely, if the
trade is implemented for a credit, the maximum profit could also be
equivalent to the call strike, minus the underlying stock's purchase price
plus the net credit received.
The maximum loss is equivalent to the purchase price of the underlying
stock minus the put option's strike price and the net premium paid. It may
also be equivalent to the stock purchase price minus the put option's strike
price plus the net credit received.
Collar Example
Assume you are long 1,000 shares of stock ABC at a price of $50 per
share, and the stock is currently trading at $47 per share. You want to
temporarily hedge the position due to the increase in the overall market's
volatility. Therefore, you purchase 10 put options with a strike price of $45
and write 10 call options with a strike price of $60. Assume you option
positions that are implemented for a debit of $1.50. The maximum profit
is $11,500, or 10 * 100 * ($60 - $50 + $1.50). Conversely, the maximum
loss is $6,500, or 10 * 100 * ($50 - $45 + $1.50).
What Is a “Straddle”
A straddle is an options strategy in which the investor holds a position in
both a call and put with the same strike price and expiration date, paying
both premiums. This strategy allows the investor to make a profit
regardless of whether the price of the security goes up or down, assuming
the stock price changes somewhat significantly.
Straddle Strategy
Straddles are a good strategy to pursue if an investor believes that a stock's
price will move significantly but is unsure as to which direction. Thus, this
is a neutral strategy, as the investor is indifferent whether the stock goes
up or down, as long as the price moves enough for the strategy to earn a
profit.
Straddle Mechanics and Characteristics
The key to creating a long straddle position is to purchase one call
option and one put option. Both options must have the same strike price
and expiration date. If non-matching strike prices are purchased, the
position is then considered to be a strangle, not a straddle.
Long straddle positions have unlimited profit and limited risk. If the price
of the underlying asset continues to increase, the potential profit is
unlimited. If the price of the underlying asset goes to zero, the profit
would be the strike price less the premiums paid for the options. In either
case, the maximum risk is the total cost to enter the position, which is the
price of the call option plus the price of the put option.
The profit when the price of the underlying asset is increasing is given by:
Profit(up) = Price of the underlying asset - the strike price of the call
option - net premium paid
The profit when the price of the underlying asset is decreasing is given by:
Profit(down) = Strike price of put option - price of the underlying
asset - net premium paid
The maximum loss is the total net premium paid plus any trade
commissions. This loss occurs when the price of the underlying asset
equals the strike price of the options at expiration.
There are two breakeven points in a straddle position. The first, known as
the upper breakeven point, is equal to strike price of the call option plus
the net premium paid. The second, the lower breakeven point, is equal to
the strike price of the put option less the premium paid.
Straddle Example
A stock is priced at $50 per share. A call option with a strike price of $50
is priced at $3, and a put option with the same strike price is also priced at
$3. An investor enters into a straddle by purchasing one of each option.
The position will profit at expiration if the stock is priced above $56 or
below $44. The maximum loss of $6 occurs if the stock remains priced at
$50 at expiration. For example, if the stock is priced at $65, the position
would profit:
Profit = $65 - $50 - $6 = $9
What Is a “Covered Straddle”
It is an option strategy that involves writing the same number of puts and
calls with the same expiration and strike price on a stock owned by the
investor. A covered straddle is a bullish strategy.
Strategy for Covered Straddle
The covered straddle strategy is not a fully "covered" one, since only the
call option position is covered. The put write position is "naked," or
uncovered, which means that if assigned, it would require the option
writer to buy the stock at the strike price. While gains with the covered
straddle strategy are limited, large losses can result if the underlying stock
tumbles to levels well below the strike price at option expiration. If the
stock does not move between the date that the positions are entered and
expiration, the investor collects the premiums and realizes a small gain.

The Selection Simultaneously buy put and call

contracts struck at the same price
(usually ATM).
Maximum Gain Theoretically unlimited on the
upside, minus the combined
premiums paid. The downside is
the maximum gain is the difference
between the put strike and zero
minus the combined premiums
paid.
Maximum Loss The premium paid.
Margining Not required.
Advantages Simultaneous access to the stock’s
downside and upside.
Drawbacks • The premium payment is never
recoverable.
• No access to dividends paid.

Butterfly (Sometimes Called an Iron Butterfly)

The Butterfly strategy is simply a modification of the Straddle strategy.

Implementing a Butterfly strategy generally reduces one’s overall cost of
entry, but also limits one’s potential profits. It is called a Butterfly because
when it is plotted out on a risk graph, it appears to have two wings
pivoting about a central point, have three strike prices (one shared). As
always, it is recommended that the calculation table be used to discover
the profit/loss situation before placing the trade. Make sure that the
market conditions support your idea, or, more appropriately said, make
sure that the strategy is justified by the market conditions. It may be a
mistake for a mechanic to try to change a tire on a car using a screwdriver.
The screwdriver is a very effective tool, but only under the right
application to circumstances.

The Selection There are different ways to enter

into this transaction, one of which
is by simultaneously buying an
ATM put contract and selling a
further OTM put contract, while
simultaneously buying an ATM
call contract and selling a further
OTM call contract.
Maximum Gain The difference between successive
strikes of the same type (i.e.,
between the two call strikes), less
the net premium paid or the two
put strikes less the premium paid.
Maximum Loss Net premium paid.
Margining Not required.
Advantages Simultaneous access to the stock’s
downside and upside.
Drawbacks • Premium payment is never
recoverable.
• No access to dividends paid.
Example of a Butterfly
A long iron butterfly spread is a four-part strategy consisting of a bear
put spread and a bull call spread in which the long put and long call have
the same strike price. All options have the same expiration date, and the
three strike prices are equidistant.

Sell 1 XYZ 95 Put at

1.20 1.20
Buy 1 XYZ 100 Put at
3.20 (3.20)
Buy 1 XYZ 100 Call at
3.30 (3.30)
Sell 1 XYZ 105 Call at
1.40 1.40
Net Debit = (3.90)

The maximum profit is realized if the stock price is above the highest
strike price or below the lowest strike price at expiration. The maximum
risk is the net cost of the position including commissions, and the
maximum risk is realized if the stock price is equal to the strike price of
the long options (center strike) on the expiration date. This strategy is used
in a "sideways" or neutral market but expecting some volatility in the
stock price. It is applied to minimize risk, but conversely only gives a
moderate return, if any. Also, if "unwinding" the trade by exiting one leg at
a time, it is more difficult than a spread that has only two legs, or
positions.
Short Iron Butterfly
Buy 1 XYZ 95 Put at 1.20 (1.20)
Sell 1 XYZ 100 Put at 3.20 3.20
Sell 1 XYZ 100 Call at 3.30 3.30
Buy 1 XYZ 105 Call at 1.40 (1.40)
Net Credit = 3.90
A short iron butterfly spread is a four-part strategy consisting of a bull put
spread and a bear call spread in which the short put and short call have the
same strike price. All options have the same expiration date, and the three
strike prices are equidistant. In the example above, one 95 put is
purchased, one 100 put is sold, one 100 call is sold and one 105 call is
purchased. This strategy is established for a net credit, and both the
potential profit and maximum risk are limited. The maximum profit is
realized if the stock price is equal to the strike price of the short options
(center strike) on the expiration date.
The maximum risk is the difference between the lower and center strike
prices less the net credit received. The maximum risk is realized if the
stock price is above the highest strike price or below the lowest strike
price at expiration.
This is an advanced strategy, because the profit potential is small in dollar
terms and because costs are high. Given that there are four options and
three strike prices, there are multiple commissions in addition to four bid-
ask spreads when opening the position and again when closing it. As a
result, it is essential to open and close the position at “good prices.” It is
important to ensure the risk/reward ratio including commissions is
favorable or acceptable.
The maximum profit potential is equal to the net credit received less
commissions, and this profit is realized if the stock price is equal to the
strike price of the short options (center strike) at expiration. In this
outcome, all options expire worthless and the net credit is kept as income.

Maximum Risk
The maximum risk is equal to the difference between the lowest and
middle strike prices less the net credit received. In the example above, the
difference between the lowest and middle strike prices is 5.00, and the net
credit received is 3.90, not including commissions. The maximum risk,
therefore, is 1.10 less commissions.
There are two possible outcomes in which the maximum loss is realized. If
the stock price is below the lowest strike price at expiration, then the calls
expire worthless, but both puts are in the money. With both puts in the
money, the bull put spread reaches its maximum value and maximum loss.
Also, if the stock price is above the highest strike price at expiration, then
the puts expire worthless, but both calls are in the money. Consequently,
the bear call spread reaches it maximum value and maximum loss.

Breakeven Stock Price at Expiration

There are two breakeven points. The lower breakeven point is the stock
price equal to the center strike price minus the net credit received. The
upper breakeven point is the stock price equal to the center strike price
plus the net credit received (for more explanation, see Fidelity.com).

Condor (Sometimes Called an Iron Condor)

The goal is to profit from neutral stock price action between the middle
two strike prices of the position with limited risk.

Explanation
Buy 1 XYZ 110 Put at 8.25 (8.25)
Sell 1 XYZ 105 Put at 4.65 4.65
Sell 1 XYZ 100 Put at 2.10 2.10
Buy 1 XYZ 95 Put at 0.70 (0.70)
Net Cost = (2.20)

A long condor spread with puts is a four-part strategy that is created by

buying one put at a higher strike price, selling one put with a lower strike
price, selling another put with an even lower strike price and buying one
more put with an even lower strike price. All puts have the same
expiration date, and the strike prices are equidistant. In the example above,
one 110 put is purchased, one 105 put is sold, one 100 put is sold, and one
95 put is purchased. This strategy is established for a net debit, and both
the potential profit and maximum risk are limited.
The maximum profit is realized if the stock price is between the middle
two strike prices on the expiration date. The maximum risk is the net cost
of the strategy including commissions; it is realized if the stock price is
above the highest strike price or below the lowest strike price at
expiration.
This is an advanced strategy because the profit potential is small in dollar
terms and because costs are high. Given that there are four strike prices
and four options, there are multiple commissions and bid-ask spreads
when opening the position and again when closing it. As a result, it is
essential to open and close the position at “good prices.” It is also
important to trade a condor with acceptable risk/reward ratios.
The maximum profit potential is equal to the difference between the
strike prices less the net cost of the position including commissions, and
this profit is realized if the stock price is between the middle strike prices
at expiration.
In the example above, the difference between the strike prices is 5.00, and
the net cost of the strategy is 2.20, not including commissions. The
maximum profit, therefore, is 2.80 less commissions.
The maximum risk is the net cost of the strategy including commissions,
and there are two possible outcomes in which a loss of this amount is
realized. If the stock price is above the highest strike price at expiration,
then all puts expire worthless and the full cost of the strategy including
commissions is lost.
Also, if the stock price is below the lowest strike price at expiration, then
all puts are in the money and the condor spread position has a net value of
zero at expiration. As a result, the full cost of the position including
commissions is lost.
There are two breakeven points. The lower breakeven point is the stock
price equal to the lowest strike price plus the cost of the position including
commissions. The upper breakeven point is the stock price equal to the
highest strike price minus the cost of the position.
This strategy is used in a neutral market with low volatility.

Sort Condor
The goal is to profit from a stock price move up or down beyond the
highest or lowest strike prices of the position.

Example
Sell 1 XYZ 95
Call at 8.40 8.40
Buy 1 XYZ 100
Call at 4.80 (4.80)
Buy 1 XYZ 105
Call at 2.35 (2.35)
Sell 1 XYZ 110
Call at 0.95 0.95
Net Credit = 2.20
A short condor spread with calls is a four-part strategy that is created by
selling one call at a lower strike price, buying one call with a higher strike
price, buying another call with an even higher strike price and selling one
more call with an even higher strike price. All calls have the same
expiration date, and the strike prices are equidistant. In the example above,
one 95 call is sold, one 100 call is purchased, one 105 call is purchased,
and one 110 call is sold. This strategy is established for a net credit, and
both the potential profit and maximum risk are limited.
The maximum profit is equal to the net premium received less
commissions, and it is realized if the stock price is above the higher strike
price or below the lower strike price at expiration. The maximum risk
equals the distance between the strike prices less the net premium received
and is incurred if the stock price is between the middle two strike prices
on the expiration date.
This is an advanced strategy because the profit potential is small in
dollar terms and because “costs” are high. Given that there are four
strike prices, there are multiple commissions and bid-ask spreads when
opening the position and again when closing it. As a result, it is essential
to open and close the position at “good prices.” It is also important to
trade a condor at acceptable risk/reward ratios.
The maximum profit potential is the net credit received less
commissions, and there are two possible outcomes in which a profit of this
amount is realized. If the stock price is below the lowest strike price at
expiration, then all calls expire worthless and the net credit is kept as
income. Also, if the stock price is above the highest strike price at
expiration, then all calls are in the money and the condor spread position
has a net value of zero. As a result, the net credit less commissions is kept
as income.
The maximum risk is equal to the difference between the strike prices
less the net credit received minus commissions, and a loss of this amount
is realized if the stock price is between the middle strike prices at
expiration.
In the example above, the difference between the strike prices is 5.00, and
the net credit received is 2.20, not including commissions. The maximum
risk, therefore, is 2.80 less commissions.
There are two breakeven points. The lower breakeven point is the stock
price equal to the lowest strike price plus the net credit received. The
upper breakeven point is the stock price equal to the highest strike price
minus the net credit.
This strategy is best used in a neutral market with low volatility. (Refer
to Fidelity.com for broader discussion.)
Something To Think About
A short condor spread with calls can also be described as the combination
of a bear call spread and a bull call spread. The bear call spread is the
short lowest-strike call combined with the second-lowest strike long call,
and the bull call spread is the second-highest strike long call combined
with the short highest-strike call.
Appendix E
The Greeks
From Investopedia:
"Greeks are dimensions of risk involved in taking a position in an option
or other derivative. Each risk variable is a result of an imperfect
assumption or relationship of the option with another underlying variable.
Various sophisticated hedging strategies are used to neutralize or decrease
the effects of each variable of risk.
Neutralizing the effect of each variable requires substantial buying and
selling and, as a result of such high transactions costs, many traders only
make periodic attempts to rebalance their options portfolios.
With the exception of vega, which is not a Greek letter, each measure of
risk is represented by a different letter of the Greek alphabet.
Delta
_ (Delta) represents the rate of change between the option's price and a $1
change in the underlying asset's price—in other words, price sensitivity.
Delta of a call option has a range between zero and one, while the delta of
a put option has a range between zero and negative one. For example,
assume an investor is long a call option with a delta of 0.50. Therefore, if
the underlying stock increases by $1, the option's price would theoretically
increase by 50 cents, and the opposite is true as well.
[Note from the author: Delta is also used widely as a "probability
indicator." As one might guess, the probability of the trade being ATM at
the strike closest to the current strike price is .50 or close to .50. The
deeper ITM the strike, the more likely that the trade will be profitable for
the options. For calls, that means strikes less than the current stock price,
and for puts that means strikes that are greater than the current stock price.
Delta is usually expressed in terms of dollars but can be extrapolated to
percent probability. This function is NOT to be confused with the % Delta,
which is a different calculation and meaning. Delta for CALLS will be
POSITIVE for ITM trades, and NEGATIVE for ITM trades for PUTS. See
the section of Finding Compelling Option Trades.]
Theta
_ (Theta) represents the rate of change between an option portfolio and
time, or time sensitivity. Theta indicates the amount an option's price
would decrease as the time to expiration decreases. For example, assume
an investor is long an option with a theta of -0.50. The option's price
would decrease by 50 cents every day that passes, all else being equal. If
three trading days pass, the option's value would theoretically decrease by
$1.50.
Gamma
_ (Gamma) represents the rate of change between an option
portfolio's delta and the underlying asset's price—in other words, second-
order time price sensitivity. Gamma indicates the amount the delta would
change given a $1 move in the underlying security. For example, assume
an investor is long one call option on hypothetical stock XYZ. The call
option has a delta of 0.50 and a gamma of 0.10. Therefore, if stock XYZ
increases or decreases by $1, the call option's delta would increase or
decrease by 0.10.
Vega
Vega represents the rate of change between an option portfolio's value and
the underlying asset's volatility—in other words, sensitivity to volatility.
Vega indicates the amount an option's price changes given a 1% change in
implied volatility. For example, an option with a Vega of 0.10 indicates the
option's value is expected to change by 10 cents if the implied volatility
changes by 1%.
Rho
_ (Rho) represents the rate of change between an option portfolio's value
and a 1% change in the interest rate, or sensitivity to the interest rate. For
example, assume a call option has a rho of 0.05 and a price of $1.25.
If interest rates rise by 1%, the value of the call option would increase to
$1.30, all else being equal. The opposite is true for put options. "
We are not going to concern ourselves with Vega and Rho as these are well
used with very large positions with options. For us, the small trader, using
these ratios will have no effect on our trading as the measurable
differences would be so small that it would not make any difference in our
selection of strikes.
So which Greeks are more important? Delta takes the premiere spot. Theta
can be a consideration also, but if you find two or three alternative trades
with similar or equal deltas and thetas, use gamma as the tie breaker,
going with the higher value for gamma.
Appendix F
Broker Ratings/Research
Barron's online broker ratings, reviews, rankings,
and comparison for 2017

Barron's magazine annual stock broker survey and review of the top
rated, best discount online trading (investing account) companies.
Barron's Broker Survey Overview

The financial publication Barron’s has already reviewed brokers

for 2017, and the results shed important light on the industry.
Fidelity was awarded first place, while Just2Trade rounds out the
bottom of the list. Surprisingly, E*Trade performed poorly. Let’s
take a detailed look at the Barron's broker rankings and see which
firms deliver the best value.
Brokerage Environment

The U.S. stock market has seen record highs so far in 2017,
further increasing interest in trading securities. Despite the surge
in equity prices, commissions at many brokerage firms have
actually fallen. Barron’s estimates the cost of trading has gone
down by about a fourth for the average investor. Less expensive
trading combined with a surging stock market means more profits
for traders. It’s a good time to have a brokerage account.
Fidelity Takes First Place in the Overall
Category

Receiving 4½ stars out of 5, Fidelity was awarded first place.

Despite lowering its stock and ETF commission to $4.95 earlier
in the year, the broker only received 2½ stars in the cost category.
Apparently, its IRA closeout fee, mutual fund transaction fee, and
other charges reduced its overall value.
Categories where Fidelity performed well include Portfolio
Analysis & Reports, Research Amenities, and Mobile. Barron’s
also liked Fidelity’s consistently good customer service and its
commitment to providing access to global markets.
The broker’s technology also caught the attention of the financial
publication. A new ETF screener with technical analysis tools
earned Fidelity high marks. The fact that the firm now has 91
ETFs trading commission-free also helped the broker reach the
top spot.
Interactive Brokers Is a Close Second

Frequent traders actually will pay less on a monthly basis at

Interactive Brokers Barron’s also liked the firm’s portfolio
analysis tools, its equity reports, and its range of offerings, where
it actually outperforms Fidelity.
Barron’s commented favorably on Trader Workstation, IB’s
flagship trading platform. A new addition this year is iBot, an
artificial intelligence that can answer questions in English. The
newspaper also liked IB’s range of robo-advisory portfolios. They
include not just ETFs, but stocks also. The most expensive option
is just 0.08%.
Merrill Edge at Four Stars

Barron’s admired Merrill Edge’s improvements on its mobile

platforms. Charting and order entry are now more user-friendly,
and the broker’s app includes education and research capability.
Morningstar will soon be incorporated as well.
The broker’s increased emphasis on options trading improved its
overall performance this year. Barron’s also gave it top marks for
stock reports and portfolio analysis tools.
E*Trade Fails to Impress

In eighth place is E*Trade. Despite lowering its equity

commission to $6.95 this year, and reducing its frequent trader
definition from 150 transactions per quarter to just 30, Barron’s
was not overly excited with the broker’s lineup.
The brokerage house performed poorly in Range of Offerings. Its
cost effectiveness was also viewed as poor. Nevertheless,
Barron’s commented favorably on the revamped E*Trade website
and the new charting tools available to its clients. Another strong
point at E*Trade is new syncing between the desktop platform
and the mobile app.
Firstrade Near the Bottom

Firstrade actually performs better than E*Trade in the cost

category. With a new $4.95 commission, the broker will attract
cost-conscious traders. Nevertheless, Firstrade performed poorly
in other categories, including Range of Offerings and
Technology.
Trading activity on Firstrade’s mobile app has grown, and the
broker expects the platform to see a larger share of trades in the
future. This flurry of activity has prompted the broker to start
working on a new mobile platform.
Best Brokers for Unique Categories

Barron’s also looked at special groups of traders, such as long-

term investors and beginners. Some of the results were a little
surprising. For in-person service, Merrill Edge received top
honors. This is probably due to its affiliation with Bank of
America, as there are many bank locations with a Merrill Edge
financial advisor.
Schwab was deemed the best choice for investor education, with
Fidelity and TradeStation in the top five. New traders will find
the best assistance at TD Ameritrade. Frequent traders will find
good values at Interactive Brokers and TradeStation. IB also
received top marks for option traders.
Worst Online Broker According to Barron's

Near the bottom of the results is Just2Trade. This broker received

high marks for its very low equity commission, but low marks for
its lack of mutual funds and fixed-income products. It also
performed poorly in the technology category.
TradingBlock received just 1.7 stars out of 5 for Portfolio
Analysis & Reports. The broker doesn’t have a mobile app, and
its overall technology was judged to be just 2.4. For costs,
Barron’s awarded the firm just 0.7 stars .
Differences From 2016

Despite Firstrade’s mediocre showing this year, it actually did

better than last year, when it received a score of 2½ for overall
performance. This year the broker was at 3 stars.
Scottrade and Ally Invest were noticeably absent this year.
Scottrade did not participate because of its upcoming merger with
TD Ameritrade. And Ally Invest didn’t have time due to its
purchase by Ally Financial.
OptionsHouse dropped half a star from 4½. Its costs went from
2.9 stars to 2.6. More stars mean lower fees. The broker’s mobile
app also performed more poorly this year, compared to 2016. In
the category of Research Amenities, OH also dropped from 4.8 to
4.3.
Barron's Online Broker Rankings Chart
(https://www.brokerage-
review.com/article/barrons-magazine-
survey.aspx)

Below you could see the comparison chart of 2017 Barron's

annual online brokers review, along with broker ratings and
rankings.
Brokerage Promotions
Many companies in this article offer incentives for opening a new
brokerage account. Some of these broker promotions work only for
non-IRA accounts, others for both IRA and non-IRA accounts.

TD Ameritrade: Trade free for 60 days + get up to $600.

Ally Invest: Get a $200 cash bonus or $500 in commission-free
trades.

Scottrade: Trade free for 60 days + get up to $600.

Charles Schwab: Make $100,000 deposit and get 500 commission-

free online equity and options trades.

Fidelity Investments: Get 500 free trades with $100,000+ deposit.

Firstrade: Up to $300 Cash Rewards + 500 Free Trades.

Capital One Investing: Get $50 when you open new non-IRA
account at Capital One Investing.

Merrill Edge: Get up to $600 when you open new Merrill Edge
account with at least $20,000.

E*trade: At E*TRADE, get $6.95 trades + 65₵ per options contract.

Motif Investing: None

USAA: None

Interactive Brokers: None

Wellstrade: None

Updated on 3/28/2017

Note: Barron's also has a brokerage sorting tool on their website. This
might be fun for you to do a little exploring there.
Appendix G
The Kelly Criterion
The Kelly Criterion is known among gamblers as a way to help decide
how much of available capital (pocket or purse) to "bet" when the odds are
in your favor. Here, we’ll cover the full version and give some numerical
tools to play with it. This tool can be used for trading in stocks and option
plays.
For an online calculator, see: http://www.albionresearch.com/kelly/
From Wikipedia:
In probability theory and intertemporal portfolio choice, the Kelly
criterion, Kelly strategy, Kelly formula, or Kelly bet is a formula used
to determine the optimal size of a series of bets in order to maximize
the logarithm of wealth. In most gambling scenarios, and some
investing scenarios under some simplifying assumptions, the Kelly
strategy will do better than any essentially different strategy in the long
run (that is, over a span of time in which the observed fraction of bets
that are successful equals the probability that any given bet will be
successful). It was described by J. L. Kelly, Jr., a researcher at Bell
Labs, in 1956.[1] The practical use of the formula has been
demonstrated.[2][3][4]
The Kelly Criterion is to bet a predetermined fraction of assets and can
be counterintuitive. In one study,[5][6] each participant was given $25
and asked to bet on a coin that would land heads 60% of the time.
Participants had 30 minutes to play, so could place about 300 bets, and
the prizes were capped at $250. Behavior was far from optimal.
"Remarkably, 28% of the participants went bust, and the average payout
was just $91. Only 21% of the participants reached the maximum. 18 of
the 61 participants bet everything on one toss, while two-thirds
gambled on tails at some stage in the experiment." Using the Kelly
criterion and based on the odds in the experiment, the right approach
would be to bet 20% of the pot on each throw (see first example below).
If losing, the size of the bet gets cut; if winning, the stake increases.
 Although the Kelly strategy's promise of doing better than any other
strategy in the long run seems compelling, some economists have
argued strenuously against it, mainly because an individual's specific
investing constraints may override the desire for optimal growth rate.
[7] The conventional alternative is expected utility theory which says

bets should be sized to maximize the expected utility of the outcome (to
an individual with logarithmic utility, the Kelly bet maximizes expected
utility, so there is no conflict; moreover, Kelly's original paper clearly
states the need for a utility function in the case of gambling games
which are played finitely many times[1]). Even Kelly supporters usually
argue for fractional Kelly (betting a fixed fraction of the amount
recommended by Kelly) for a variety of practical reasons, such as
wishing to reduce volatility, or protecting against non-deterministic
errors in their advantage (edge) calculations.[8]
In recent years, Kelly has become a part of
mainstream investment theory[9] and the claim has been made that well-
known successful investors including Warren Buffett[10] and Bill
Gross[11] use Kelly methods. William Poundstone wrote an extensive
popular account of the history of Kelly betting. (Poundstone, William
(2005), Fortune's Formula: The Untold Story of the Scientific Betting
System That Beat the Casinos and Wall Street, New York: Hill and
Wang)
See Wikipedia for Kelly Criterion for the actual expanded formula.
Here is a simplified method if one does not like the
longer calculations.
Statement
For simple bets with two outcomes, one involving losing the entire amount
bet, and the other involving winning the bet amount multiplied by the
payoff odds, the Kelly bet is:
.f *=(bp-q)/b
where:
f* is the fraction of the current bankroll to wager;
b is the net odds received on the wager (that is, odds are usually
quoted as "b to 1")
p is the probability of winning;
q is the probability of losing, which is 1 − p.
As an example, if a gamble has a 60% chance of winning (p = 0.60, q =
0.40), but the gambler receives 1-to-1 odds on a winning bet (b = 1), then
the gambler should bet 20% of the bankroll at each opportunity (f* =
0.20), in order to maximize the long-run growth rate of the bankroll.
If the gambler has zero edge, i.e. if b = q/p, then the criterion will usually
recommend the gambler bets nothing (although in more complex scenarios
such a bet may help ensure the best compounding rate of return: for
instance a short-priced favorite in a horse race may be worth covering to
provide downside protection even though the only advantageous bet is on
another outsider).
If the edge is negative (b < q/p) the formula gives a negative result,
indicating that the gambler should take the other side of the bet. For
example, in standard American roulette, the bettor is offered an even
money payoff (b = 1) on red, when there are 18 red numbers and 20 non-
red numbers on the wheel (p = 18/38). The Kelly bet is -1/19, meaning the
gambler should bet one-nineteenth of the bankroll that red will not come
up. Unfortunately, the casino doesn't allow betting against red, so a Kelly
gambler could not bet.
For even-money bets (i.e. when b = 1), the formula can be simplified to:
.f *=p-q

Since q = 1-p, this simplifies further to:

.f *=2p-1
Reasons to Bet Less Than Kelly
A natural assumption is that taking more risk increases the probability of
both very good and very bad outcomes. One of the most important ideas in
Kelly is that betting more than the Kelly amount decreases the probability
of very good results, while still increasing the probability of very bad
results. Since in reality we seldom know the precise probabilities and
payoffs, and since overbetting is worse than underbetting, it makes sense
to err on the side of caution and bet less than the Kelly amount.
Kelly assumes sequential bets that are independent (later work generalizes
to bets that have sufficient independence). That may be a good model for
some gambling games, but generally does not apply in investing and other
forms of risk-taking. Suppose an investor is offered 10 different bets with
40% chance of winning and 2 to 1 payoffs (this is the example used
above). Considering the bets one at a time, Kelly says to bet 10% of
wealth on each, which means the investor's entire wealth is at risk. That
risks ruin, especially if the payoffs of the bets are correlated. (This
scenario is not exactly following the Kelly rule, because Kelly-criterion
applies when the bets are made sequentially, only one at a time. If an
investor made 10 sequential bets of 10% of their current wealth on each
bet, and lost all of them, they wouldn't go broke, but would be left with
0.9^10 of their initial wealth which is 34.9%.)
The Kelly property appears "in the long run" (that is, it is an asymptotic
property). To a person, it matters whether the property emerges over a
small number or a large number of bets. It makes sense to consider not
just the long run, but where losing a bet might leave one in the short and
medium term as well. A related point is that Kelly assumes the only
important thing is long-term wealth. Most people also care about about the
path to get there. Two people dying with the same amount of money need
not have had equally happy lives. Kelly betting leads to highly volatile
short-term outcomes which many people find unpleasant, even if they
believe they will do well in the end.
One of the most unrealistic assumptions in the Kelly derivation is that
wealth is both the goal and the limit to what one can bet. Most people
cannot bet their entire wealth: for example, it is illegal to bet one's future
human capital (one cannot sell one’s self into slavery). On the other hand,
people can bet money they do not have by borrowing. A person who is
allowed to bet more than his wealth might choose to bet more than Kelly
(if one knows one can always borrow a new stake, it makes sense to take
more risk) while someone who is constrained to bet much less than his
wealth (such as a young college graduate with high lifetime potential
earnings but no cash or credit) is forced to bet less.
Bernoulli
In a 1738 article, Daniel Bernoulli suggested that when one has a choice of
bets or investments that one should choose that with the highest geometric
mean of outcomes. This is mathematically equivalent to the Kelly criterion,
although the motivation is entirely different (Bernoulli wanted to resolve
the St. Petersburg paradox). The Bernoulli article was not translated into
English until 1956,[10] but the work was well-known among
mathematicians and economists.
Appendix H
Balancing the Portfolio—Trigger Points

Christine Benz is Morningstar's associate director of fund analysis and editor

of Morningstar Mutual Funds. She can be reached at
christine_benz@morningstar.com.

Taking a Closer Look at the Factors

That Determine the Trigger Point
(As published in Alliance Bernst)

The formula for triggering the rebalancing trigger point is:

This looks far more complex than it actually is, and can be translated into
plain English fairly simply:

K represents the variable Kelly (sometimes called lambda),

which is a measure of an investor’s risk tolerance. It is a
constant that expresses the tradeoff between a unit of risk and a
unit of return. There’s no one answer for what Kelly should be—
some investors are more risk tolerant than others. Here we have
assumed a Kelly of 5%, which reflects the risk tolerance of
many of our clients.

Because this variable is the numerator, a higher Kelly means the

trigger point will be higher—the investor has a higher tolerance for
 deviations from the target asset allocation.

Ci is the cost of trading into or out of the asset class to be

rebalanced, including the market impact. The more expensive it
is to trade an asset class to be rebalanced, the larger the
deviation that will be tolerated before rebalancing makes sense.
For example, emerging-markets equities are expensive to trade,
so they should have a higher trigger point that US bonds, which
are relatively cheap to trade.

The denominator is the square of the tracking error, but it’s worth looking
at how the components of tracking error interact to influence the trigger
point:

i is the volatility of the asset being rebalanced. The higher

the volatility, the lower the trigger point will tend to be, since
each unit of deviation from the allocation target in a high-
volatility asset class is associated with more risk than the same
amount of deviation from a low-volatility asset class. Going
back to the emerging markets versus US bonds example, it can
hurt more to be 1% off the target allocation in emerging
markets than it would to be 1% off the target allocation in
bonds.

Because cost and volatility are generally related, those two factors—
cost in the numerator and volatility in the denominator—will tend to
offset each other.

2
is the volatility of the rest of the portfolio. Again, the
j
higher the overall volatility, the more pressure there is to stay
close to the allocation targets, which means a lower trigger
point.
 pij is the correlation between the asset and the rest of the
portfolio. If the asset class to be rebalanced is highly correlated
with the rest of the portfolio, then being off target doesn’t
matter much. Conversely, if there is a very low correlation, the
benefit of rebalancing is higher. This means that the single
biggest source of rebalancing opportunity will nearly always be
the allocation between stocks and bonds, because the correlation
between them is so low.

In short, this equation systematically ties together all the factors of cost
and risk needed to make a rational tradeoff between them, allowing
investors to identify their appropriate trigger point for each asset class.

(Refer to Table 1)
Calculating the Actual Trigger Points

This framework can be applied to any portfolio. Table 1 shows the

assumptions and resulting trigger points we computed for a client using a
simplified portfolio of four asset classes: US Bonds, US Growth stocks,
US Value stocks, and International Equities.
For example, we used a 5% Kelly (a measure of risk tolerance) and
assumed the cost of trading in or out of bonds and into the rest of the
portfolio is 1%, the volatility of the bonds is 10%, the volatility of the rest
of the portfolio is 16%, and the correlation between bonds and the
remainder of the portfolio is 0.1. Given these assumptions, the formula
returns a trigger point for US Bonds of + or – 3%. Assuming the target
allocation is 30%, the portfolio should be rebalanced if bonds rise above
33% of the total allocation or fall below 27%.
The assumption for the US Growth and Valued stocks and International
Equities are slightly different, but the outcome in either case is + or – 4%
trigger point. With international equities, the higher transaction cost
pushes the trigger up, but the higher volatility of the asset class and the
slightly lower correlation with the rest of the portfolio move the trigger
point down.
These are not the only possible trigger points. Volatility and the
correlation are forward-looking estimates rather than historical numbers,
and Kelly is a measure of investor preference. Different investors will
have different rebalancing rules base on their assumptions and risk
tolerance.

How Far to Rebalance

The trigger points indicate when to rebalance. A rebalancing policy,
however, also needs to address how far to rebalance: All the way back to
the target allocations, or some intermediate point? Our research found that
it doesn’t pay to rebalance all the way back to the initial target.
To return to an earlier example, in a portfolio with a 30% target allocation
to bonds, no one would rebalance if the actual allocations were 30.1%. The
cost of rebalancing would be greater than the benefit. However, if the
actual allocation reached 33% and triggered a rebalancing, the last bit of
rebalancing back to the initial target allocation would effectively be
moving from 30.1% to 30%. If this move wasn’t cost effective on its own,
why would it be sensible now? Instead, the key is to rebalance only to the
point where the incremental rebalancing still yields a marginal net benefit
and stop with the marginal benefit of rebalancing is exactly equal to the
marginal cost of rebalancing. It turns out that point is halfway between the
trigger point and the initial target allocation. (See table 2.)
As shown on the right side of table 1, this means that if a portfolio has an
initial target of 30% bonds and the trigger point is + or – 3%, then if bonds
drop below 37% of the portfolio, bonds should be bought until their weight
is halfway back to the original target, or 28.5%. If the bond allocation
exceeds 33% of the portfolio, bonds should be trimmed back to 31.5%. In
the same way, whenever the portfolio’s weight is US Growth falls below
21 %, growth stocks should be bought to bring the balance back to 23%.
Not everyone feels the same about risk, however, and that has to be taken
into account. If an investor is very risk-tolerant, or, more precisely, willing
to endure higher risk for higher potential returns, then the benefit of
rebalancing is smaller than it would be for an investor who is less risk
tolerant.
Given the investor’s risk tolerance, our quantitative analysis came up with
a way to mathematically express the benefits of rebalancing (Table 3, top).
It can be graphed as a curve that rises slowly at first, and then more and
more steeply.
Rebalancing entails portfolio transactions, so the benefit has to be weighed
against the costs incurred, including both direct trading expenses and
indirect market impact. Interestingly, while the benefit of rebalancing is
geometric, the costs of rebalancing are not: they are linear. If you sell
twice as many bonds, it will cost you roughly twice as much. As a result,
the cost of rebalancing can be graphed as a straight line. (Table 3, middle).
Putting the two concepts together—subtracting the costs from the benefit
—yields the net benefit of rebalancing (Table 3, bottom). The net benefit
actually starts out negative, which makes intuitive sense: If the portfolio’s
target allocation for bonds is 30%, and the actual weight is 30.1%, it isn’t
rational to rebalance. For a very small deviation from the target allocation,
the costs are higher than the potential reward. Eventually the curve flattens
out, then starts sloping upward and move into a positive territory. The
point at which the net benefit becomes positive is where the benefit begins
to exceed the costs—the trigger point for a rebalancing move.

Determining the Trigger Point

Clearly, when the net benefit of rebalancing exceeds the cost, you should
rebalance. But how do you determine exactly where that point is? And is
the rebalancing threshold or trigger point the same for all asset classes?
To answer the second question first, the trigger point will not necessarily
be the same for all asset classes. If the benefit for rebalancing comes from
avoiding tracking error, then more volatile asset classes would tend to
have lower trigger points for rebalancing, assuming all else is equal.
Putting all this into a single equation (see the front page) give us a way to
balance the investors risk tolerance and the cost of rebalancing against
tracking error. A higher level of risk tolerance generally means a higher
trigger point. Asset classes with higher transaction costs also tend to have
higher trigger points.

Deriving the Formulas

For the more mathematically inclined, here is the derivation of the trigger
point from the net rebalancing benefit:
and
Why Halfway Back is Best

The point to which it makes sense to rebalance is where the marginal net
rebalancing benefit is zero:

KC
Now, having said all of the above with the fancy calculations, which are
used by portfolio and mutual fund managers, we can simplify our process
by merely using the weighted average idea. When the percentage of your
portfolio for aggressive stocks grows too large, we take some profits and
roll them into stocks that have less volatility but will give us the stability
that we need with a base rate of return that supports the whole portfolio.
Example:
Let's imagine that we require a rate of return of 18% long term to reach
our goals. In order to reduce risk, we have allocated our holdings in the
following way.

60% of our portfolio is in dividend stocks that pay 4% yield and have a
growth rate of 8%, giving us combined benefit or 12% annualized. We
have invested 30% of our available capital in stocks that we swing trade
and are able to achieve a 30% annualized rate of return. Then we have
invested 10% of our available capital in option trades that have given us a
200% annualized rate of return, even with 35% loss rate in our trades that
we have there.
So,
60 x 8 = 480
30 x 30 = 900
10 x 200 = 2000
We add up all of the results and divide by 100 = 33.8 % annualized
average return for the portfolio.
We know that this shows too much risk, so we re-allocate to
75% of portfolio at 8% ROI = 600
25% of portfolio at 30% ROI = 750
5% of portfolio at 200% ROI - 1000
Again, doing the simple arithmetic, we come up with a 23.5% average ROI
for the portfolio. This is still too much risk, so we re-calculate and find
that if we allocate:
88% x 8% = 704
7% x 30% = 210
5% x 200% = 1000, giving us 19.14% ROI
89 x 8 = 712
8 x 30 = 240
4 x 200 = 800, giving us 17.52 % ROI
As we can see, balancing is a little tricky, but we are now in the required
range. One could choose a little more return with a little more risk, or less
return for a little less risk. In a bull market we are probably going to
outperform our expectations. In a bear market we will underperform. It is
now a subjective choice how an investor would allocate, but we want to
make sure that we a minimizing risk as rule number one.
Appendix I
Stop and Limit Orders

Stop Orders
Brief notes taken from the book, “Stop Orders: A Practical Guide to
Using Stop Orders for Traders and Investors”, by Tony Loton,
Harriman House, Great Britain, 2009.
The idea of using stops as trading tools in this book is designed for “day
traders,” “swing traders,” “long-term investors,” and “spread betters.”
Applications of the concepts might vary slightly and will be discussed in
Section 2.
SECTION 1
A “stop order” is an instruction to your broker to buy or sell a stock
holding at a future specified market condition at a less advantageous price
than the then current market price. Stop orders allow you to sell in a
falling market and buy in a rising market. Stop orders allow your profits to
“run.”
A Stop Order is designed to guarantee a buy or a sell, but not a price. The
order will execute at the next available price, not the last available price
(gapping or rapid movement may result in a vastly different price at
execution than the stop price originally designated. See “Guaranteed Stop”
and “Stop with Limit” to alleviate potential problems.
Contrast:
Market Order: An order to buy or sell immediately at the best
price right now.
Limit Order: Buy or sell at a time in the future with specific
price conditions—to buy at or lower than a specified price, or to
sell at or higher than a specified price. In this case you would be
buying in a falling market or selling in a rising market. Limit
orders are seen to limit your profits.
Types of Stop Orders
Stop Order to Sell (Stop Loss): An exit mechanism. Can also be used
when shorting the market. A stop order always triggers “from above” since
the stock price falls to the level you have set.
Stop Order to Buy: Is often used by “long trend followers” as an entry
point. Remember, A stop order to buy always triggers from below when
the price rises to the level you set. Designed to get a low price as the stock
price has descended and is now going back up again. Or, to close a
position for a short trader.
Trailing Stop Order to Sell: A trailing stop order to sell is designed to
execute sometime in the future when the price of the stock or other
security falls from any price peak by an amount that you set. It may be
trailing manually (i.e., that you adjust it yourself periodically), or your
broker may allow you to specify a stop order that automatically trails at a
fixed distance below a rising price. A trailing stop order to sell is often
used by long trend followers as an exit mechanism to exit a position when
the upward price trend reverses.
Trailing Stop Order to Buy: A trailing stop order to buy is designed to
execute sometime in the future when the price of the stock or other
security rises from a price trough by an amount that you set. May be
manually or automatically set. It could be used by a short seller to close a
position. The trailing stop order to buy could be used by a “bottom fisher”
as an entry mechanism of “buying low.”
Guaranteed Stop: A guarantee that the order will execute at exactly the
price that you indicate (for an additional premium). After all, a stop order
is merely a market order but triggered when a specific price is reached.
But there is no guarantee that you order will be filled at that price, and
may be significantly different if the price falls dramatically or “gaps.”
Each broker has the right to set the extra premium and to determine which
stocks and positions it will guarantee. So, so stock or specific positions
may not have a guarantee available.
Stop with Limit: Stop with limit is designed to trigger an order at the stop
criteria set, within the limits specified, or not trigger at all. Contrasted to
a stop with guarantee, which will fill as specified.
A stop order (with limit) to sell is an order to sell a security when the price
falls to a specified level (the stop level) providing the trade can be
executed above a second lower level (the limit level).
A stop order (with limit) to buy is an order to buy a security when the
price rises to a specified level (the stop level) providing the trade can be
executed below a second higher level (the limit level).
Trailing Stop with Limits: Where allowed by your broker, it requires that
you specify a stop distance and a limit distance rather than a stop level and
limit level. That distance can be specified in either actual amounts or
percentages, depending on what the broker allows. There may be a
minimum distance required.
Limit Profit Orders: Spread betting platforms may allow for a stop order
and a limit order on the same position, and they may not be linked. Check
with your broker to see how it works with their order entry tools.
Combining Stop Orders: Use of stop and limit orders in combination.
Buy on Breakout / Sell If False: In this pattern the objective is to buy in to
a rising price trend, signaled by a break through a resistance level, but to
sell out at the earliest opportunity if the uptrend signal turns out to be false
because the price falls back through the resistance level. In this case one
would use a stop order to buy when the stock price “breaks through” a
specified price, then attach a stop order to sell once the transaction is
completed at a lower level than the bought price, in other words, a Stop
Loss order. We could also place a stop order to buy the shorted stock if it
rises too much above our purchase price.
Buy Long, Sell Short: A spread trader may observe a price channel and
want to take advantage of any breakouts, either bull or bear, not caring
which way it my go. Placing a stop order to buy a little higher than the
resistance level will allow the trader to take advantage of any bullish
breakouts. Placing a stop order to sell at or a little lower than support
would put the trader in a short position if the price function went bearish.
Buy Low, Sell High: By placing a trailing stop to buy ABOVE (1.5%, for
example) the current stock price, it will follow a bearish stock price
downward, and will execute the buy as the price rises again, effectively
buying at a low point as the price recovers. We then immediately place a
stop order to sell (1.5% below buy price, for example), making it an
automatic or manual trailing stop, so that when the stock price peaks out
and starts to fall, our order to sell will be triggered at a little lower than
the peak.
Two Stop Orders to Sell: The first stop order to sell would take you out of
a falling position. The second would put you into a short position if the
stock price continues to decline. Example: You buy the stock with a stop
order at $25. The price continues to rise, but to prevent any losses, you
place your trailing stop loss at minus 5%. To take advantage of continuing
fall of price, you might place a second stop order to sell at minus 10%. If
the price continues to fall, you will be put into a short position on the
stock. With close monitoring, once executed, you would then place a stop
order to sell below your purchase price in case the price again rises (or a
little above your execution price as a stop loss to minimize losses).
IMPORTANT NOTE: A Stop Oder is not guaranteed to execute at the
designated price, but is only guaranteed to execute at the next available
market price.

SECTION 2
Strategic Applications: The idea of using stops as trading tools in this
book is designed for “day traders,” “swing traders,” “long-term investors,”
and “spread betters.” Applications of the concepts might vary slightly.
“It’s not all about entries and exits, and many traders fail to consider what
happens between trade entry and trade exit. They give scant attention to
trade maintenance.” Long-term traders will be more concerned about
entry and exit than a day trader, whose every position is effectively in long
term maintenance.
Pyramiding: Trade Maintenance
Example:
You invest $1000 in ABC at a price of $100 with no stop order,
so your value at risk is the full $1000.
 When the price of ABC rises to $150, you place a break-even
stop at $100, thus reducing your risk value to zero.
Notionally, at least, you have freed up another $1000 worth of
risk capital, so you can make a new, additional $1000
investment for no more than your original risk
The result is that you now have $2000 working for you, but you
are only at risk for the second $1000 since the first $1000 is
protected from loss.
Trading strategies can be more effective if more time is spent managing
the investment in the maintenance phase—by adjusting stop orders and
adding to positions—that is spent in entries and exits. When anxious to
make a new trade, think first about adjusting your existing stops rather
than looking for a new trade. This can add incremental profits as time goes
by.

Cancel Your Open Stops

If you are just doing normal trades with your brokerage to buy and sell
stocks or option positions, the stop order will be automatically canceled
once the order is filled, even if you manually fill, ignoring your stops. But
if you are “spread trading,”you will want to cancel your stops if you
manually cancel or “market order” your position. Otherwise, open stop
orders could then fill after the fact and put you into positions that you
don’t want.
Price Gaps
A price gap or spike may cause your stop to be ignored or even filled at an
unfavorable price, since a stop order does not guarantee price, but only
execution at market.
Gaps are caused by: (1) overnight trading, (2) unexpected good or bad
news, or (3) stock splits or consolidations.
Possible remedies include using guaranteed stops (if available), using a
stop with limits, or monitoring the after-hours “news” for potential
gapping, and adjusting the stop orders before the opening of the market
(also, spread traders usually will have access to the overnight stock price
movements on their charts). Another remedy is “over-trading,” where one
maintains very tight trailing stops to sell if there is any retracement, and
then apply a trailing stop to sell short as the stock price goes down, with
another trailing stop set to buy back in if the stock price again reverses and
continues back up. This tactic can be useful in an orderly market, but
dangerous in a very volatile one, and would also incur additional fees and
possibly taxes, or could force one to buy high and sell low if the price
slippage is significant enough.
Whipsaw Losses
It might be tempting to see stop orders as a panacea for all situations and
be able to make profits without conscious managing of the trades. When
markets move rapidly up and down and up again, it is possible to over-
trade and actually start compounding your losses if you are trying to catch
every possible twist in the market. A safer idea would be to merely widen
your stops and seek to capitalize on the more major turns in the market,
and ignore the minor “market noise” gyrations.
While it’s good to “cut your losses” using stop orders, a more conservative
approach would be to seek to hold a position as long as possible:
The less you will lose in dealing charges, bid-ask spreads, and
other whipsaw losses.
The more you will collect possible dividends on equity and
index positions.
The less trading work you will have to do, so you can hold down
a job and/or take a holiday.
The idea is to not so much “cut losses”, but to “limit losses.”
Note: Market makers can see your, and everyone else’s, stop orders to buy
or sell, and may arbitrarily cause the price to rise or fall just enough to
trigger the stops by manipulating the bid or ask prices, thus making money
for themselves through commissions and fees, whether or not you make or
lose money. Selecting non-obvious levels other than the obvious support
and resistance levels may help you avoid this action on the part of the
market makers. Check with your broker to find out their policy for
executing on stops.
Using “mental stops” is a safer way to enter and exit trades (but it will
require that you pay more attention to and manage your positions more
actively).

STOP PLACEMENT
The idea with the sell side of stops, or “stop loss” is:
Setting a stop order close enough to the prevailing price that it
keeps your potential loss to an absolute minimum, and
Not setting the stop order so close that it triggers so quickly—
and often—that you suffer whipsaw losses and frequently find
yourself out of position.
Volatility based stops:
Beta Adjusted Trailing Stops (BATS) : (A) A higher
value of beta necessitates a wider stop distance, so as
to not get stopped out due to high volatility. (B) A
lower price necessitates a wider stop distance, on the
basis that the low priced stocks (when the stock’s price
is at a low level) are more volatile.
Using Bollinger Bands for long term stop setting, both
to buy and to sell.
Average True Range: Setting stops based on the
movement of the ATR to determine volatility, can be
used as exact amount or percentage movements.
Example: If ATR is $6, then choosing 80 % of the ATR
or 4.8 would be a conservative approach, but has a
higher likelihood of stopping out, whereas 110% of
the ATR or $6.6 would be a riskier approach, but also
reduce the probability of being stopped. The longer
term the trade, the higher the multiple of the ATR
would be used. A day trader might choose 50% of the
ATR, while a swing trader my choose 100% ATR. A
long-term investor may chose 5x (or 500%) of ATR to
avoid too early exit from the trade.
Maximum Adverse Excursion: Look for places in the
stock chart where the stock has declined to a
 maximum value within a reasonable time frame, and
set that as, or a factor of that, as the stop loss level.
Use Support and Resistance levels to set stops to buy
or sell.
Timescales: Make sure that the charts that you are
using is congruent with the time frame of your trading
style. For example, you would not us an intraday chart
if you are a swing trader, and you would not use only a
3-month chart if you are a long term investor, etc.
Breakout Stop Placement for Trade Entry: Watching
for the Break signals on the charts (either up or down)
to place a stop order to buy. REMEMBER: SCARED
MONEY NEVER WINS, so placing a stop too close to
entry may only cause you to lose. It might be an idea
to choose a factor based on your observations of the
stock price volatility, and then place your stop to sell
(stop loss) that factor below the supposed support
level (or the resistance level that as now seen as new
support) as the stock price “breaks through” so as not
to get caught in a “whipsaw” of the stock price.
Money Management: It may be that a trade may
determine that they have a limit of loss desired, and no
more, so stops may be place based on the desire to
minimize losses rather than on the technical
characteristics of a particular stock price.
Buying Using Stops
Breakout strategy: placing a stop to buy above the
resistance line in anticipation of a breakout and run up.
Trailing Stop Placement for Trade Entry: “An alternative
to (long) trade entry is that of a trailing stop order to buy
downwards so as to buy in ultimately at a more attractive
(lower) price. Unlike a limit order, which would execute at
a level you presuppose would be the low point, and while
the price was still moving downwards, your trailing stop
order would not require you to guess the low point in
 advance and would execute only when the price started to
rise.” (See page 119, paragraph 3, Trailing Stop…) Note:
Also be careful to place a protective stop order to sell as
soon as the stop order to buy is executed, just in case the
price resumes its previous downward trend.
Short traders: Use the stop order to sell to open a position,
and then use the stop order to buy to close the position.
BEWARE OF DIVIDEND DATES, and adjust your stop
orders to compensate for the general movement of the
stock on dividend announcements, etc.
BEWARE OF OBVIOUS STOP LEVELS: Due to the fact
that brokers and “locals” will seek to push the stock prices
slightly beyond support or resistance levels to “take out
the stops” of other investors, thus triggering the buy or
sell, and making the broker the additional brokerage fees.
BEWARE OF OBVIOUS ROUND NUMBERS. By making
your stops at less than obvious round numbers, you will
minimize the “taking out the stops” techniques of the
brokers.
POSITION SIZING
The Kelly Formula: how much money of my available money do I put
into a trade based on the perceived probability of success?
Percentage of fund to put at stake = ((odds offered X probability of win) –
probability of loss) / odds offered.
Example: On a 50% probability play (2-1 odds), the math works out to be:
((2 x 0.5) – 0.5) / 2 = 0.25, which means that you would stake no more
than 25% of your available funds on each “bet.” To save you doing the
math all of the time, there are several online calculators, such as the one at
www.albionresearch.com/Kelly.
When applied to financial markers, the formula is not perfect as the
formula might encourage you to put large percentages at risk when very
small odds of losing are in play. For this reason, you might consider a
factor of the Kelly outcome, like 50% for example, or 30%, as your
minimization factor of the Kelly outcome. Or set an arbitrary percentage
to not exceed a certain percentage of your available capital on any “bet”,
like 15%, as an example.
Diversification: Putting your money in several stocks instead of one.
Dollar Cost Averaging: Buying the same lot of the same stock at regular
intervals to reduce risk of buying at the worst time.
Level of Confidence: Higher % of your money would go on stocks that
you have high confidence in vs. lower percent for stocks that you have
lower confidence in.
Use Position Sizing in Conjunction with Stop Orders
Track your success to help you determine “Expectancy rate.” Once you
have sufficient history of trading (more than 100 trades, for example),
analyze your past success. Example, you might discover that that 80% of
the time, your trade gets stopped out for a 10% loss (inclusive of trading
costs), but 20% of the time you manage to run 100% gain (inclusive of
trading costs). This would give a positive expectation of 12%, calculated
as: (.20 X 1) + (.80 x -0.10) = 0.12. (from page 137).
That means that over the long term, you average rate of return would be
12% per trade, despite losing 80% of the time. YOUR STOP DISTANCES
WILL AFFECT THE PROBABILITY OF YOUR TRADE AS THE
TIGHTER THE STOPS, THE MORE LIKELY YOU WILL GET STOPPED
OUT.
You might develop your own “risk tolerance” to determine what is
acceptable to you. Many experienced traders try not to ever get stopped
out by placing the stops at the appropriate placing, or managing, their
stops as time goes on to adjust for unfolding conditions.
PERFECT TRADES (Chapter 12)
A perfect trade is one where the stop allows the trade to run to a profit, or
stops a loss, as designed. It doesn’t mean that there is always a profit. See
chapter 12 for more details and examples.
IMPERFECT TRADES (chapter 13)
Imperfect trades, then, by definition, are those that perform contrary to our
strategy, whether they make us money or not, and usually, because they
DIDN’T make us money, but because of uninformed or faulty thinking, the
strategy didn’t work as designed. By keeping track (trading journal) we
can learn from our mistakes and count them as tuition in the school of
hard knocks until we can graduate. See Chapter 13 of the book for some
great examples. It outlines what can go wrong.
When to Hold and When to Fold (chapter 14)
Referring to writing by Malcom Pryor
1. Entering the trade is less important than Exits, Bet Size, and
Psychology.
2. Have a pre-planned exit point before taking a loss or being “put”
the position.
3. The amount risked should be directly related to (a) where the
stop will be placed, and (b) how much you are prepared to risk
per position.
4. Consider multiple uses of stops for exits to see which is more
profitable or appealing.
5. The techniques should be matched to trading style, risk
tolerance, and objectives of the investor.
6. Learn to use the broker available stops and tools (OCO, CFD)
etc. and then manually adjust for tools not available
7. Become very familiar with the order types available from your
broker BEFORE you start trading real money. This can be done
through educational helps and virtual trading platforms.
8. Using mental stops needs discipline in managing the trade.

Referring to Nick McDonald

1. Make sure that your use of stops is appropriate for that trade.
Conservative trading does not always mean wide stops (which
may not be profitable).
2. Compare scenarios for this stock and time frame with other
possibilities.
 3. Make sure that the issue has the potential of performing the way
that you want. It’s unreasonable to expect an issue to move 100
points, for example, in one week, if it customarily moves only
15 points per day in a good trend.
4. Clearly identify stop or loss targets, well defined strategy,
technically protected stop, and no technical support to limit
profits.
Referring to Mike Baghdady
1. Predetermine entrance and exit points. If you don’t have one,
don’t enter the trade!!
2. Exit points determine our risk.
3. “Once in a hole, stop digging.” Don’t use a Stop Limit Order to
exit a bad position, just get out now!
4. When volatility increases, we need to widen our stops and
reduce the size of the position.
5. Beware of stops that are too “tight.”
6. Determine your exit point below maximum profit using
technical analysis.
7. Use mental “time stops.” If the trade is not moving in your
direction as expected in a reasonable period of time, exit the
trade to minimize losses. He uses 5-6 times his candle length.
For daily candles, he would allow 5-6 days. If using 15-minute
candles (day trading) he would consider exiting if the trade were
not going in his direction in 75-90 minutes.
Take the emotion out of trading by have definite strategies and
contingency plans BEFORE entering the trade.
Top Tips of Using Stop Orders
1. Use Stop Order to stop a loss and trailing stop orders to secure a
profit.
2. Use trailing stops to establish a position at a favorable price and
protective stops for swing trades.
3. Use tight stops for day trading, wide stops for position trading,
and protective stops for swing trading.
 4. Consider Support and Resistance levels as well as volatility
when placing a trade.
5. Beware of “obvious” stop levels (so as not be “swept” by the
broker).
6. Use stop orders in conjunction with position sizing.
7. Consider using stops, stops-with-limits, and the temporary
removal of stops as protection against price gaps.
8. Use manually trailing stops as a cure for over trading and don’t
try to fully automate your trading strategy.
9. Spread betters should understand the difference between a
standalone stop order and a position-specific stop loss order.
10. Consider using stop orders as a mechanism for freeing up risk
capital to “pyramid” (chapter 8) positions.
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