eSignal Trading Education

Welcome to Trading 101 – Issue 4

Strategy: a plan of action intended to accomplish a specific goal.

Sounds simple doesn't it? It can be, when you practice the proven strategies devised by industry greats.

It's also the theme that runs throughout Issue 4. From using options to get you through the bear market and the strategic use of alerts to keep you abreast of opportunities, to mind conditioning techniques to help you keep your head. Entrench yourself in this issue's topics to learn about effective strategies for successful trading.

So, keep reading and keep learning -- with Trading 101 from eSignal.

Cynthia Crossland
Publisher



eSignal Trading Education

Options 101

By Bernie Schaeffer
Founder, Chairman and CEO, Schaeffer's Investment Research

What does the word options mean to you? To many, the word conjures up an image of a high-risk, mysterious investment that is only for the reckless speculator or strong of heart. One of our primary goals at Schaeffer's Investment Research is to take the mystery out of options through various education programs to bring them more into the investment mainstream. With this in mind, allow me to introduce you to the potentially very profitable world of options.

Definition

An option is an instrument that allows you to buy or sell a certain amount of an underlying security. For our purposes here, the underlying securities will be stocks. A stock (or equity) option contract typically represents 100 shares of the underlying stock, even though they are commonly priced on a per-share basis. Thus, a stock option priced at 2 will cost an investor $200 per contract. An option buyer is essentially leasing the movement in the stock over the life of the option at a fraction of the cost of owning the stock.

Calls

There are two types of options: Calls and puts. A call option purchase gives you the right (but not the obligation) to buy 100 shares of a stock at a specified price (known as the exercise or strike price) up until a specified date (the expiration date). That is, the call buyer can exercise his or her right to buy the 100 shares of stock at the strike price at any time before the option expires. Buying call options is a bullish strategy initiated when a call buyer believes that the underlying stock will rise substantially in price over the life of the option. In essence, the call buyer is renting the price appreciation in the stock over the life of the option.

The concept of a call option purchase (also called a long call) can be illustrated by examining the profit or loss of a particular option strategy over a range of stock prices at expiration. Table 1 shows the possible outcomes of purchasing a 50-strike call for $5. (This option would cost $500.) This option gives the buyer the right to purchase 100 shares of the underlying stock (up until the option expires) at a price of 50, no matter how high the stock price goes. Note that the breakeven point (profit of zero) for this trade would occur if the stock reached 55 at expiration (the strike price of 50 plus the premium of 5).

Any stock price greater than 55 will result in a profit for the trade while a stock price of 50 or less will result in a total loss for the trade. Between 50 and 55, the buyer will incur a partial loss. (For example, a price of 51 would result in a four-point loss.)

Table 1 points very clearly to three important characteristics of this long call position: (1) a breakeven point of 55 (strike price plus the premium), (2) a maximum risk of 5 (note that the loss is constant at any stock price of 50 or less) and (3) theoretically unlimited profit because there is technically no upper limit to how high the stock price (and, thus, the value of the option) can rise.

As the stock moves above the breakeven level, the call buyer will profit on a point-for-point basis with each point move higher in the stock. Keep in mind that the risk for a call buyer is truncated (because the maximum loss is limited to the premium paid) while the profit potential is theoretically unlimited.

Table 1

Stock Price
at Expiration
Value of 50-Strike
Call Option
Profit or
Loss
Less than 50
0
-5
50
0
-5
51
1
-4
52
2
-3
53
3
-2
54
4
-1
55
5
0
56
6
1
57
7
2
58
8
3
59
9
4
60
10
5
61
11
6
62
12
7
63
13
8
64
14
9
And so on...

Puts

A put purchase gives you the right (but not the obligation) to sell 100 shares of the underlying stock (by the expiration date) at the specified strike price. Put buyers are bearish on the underlying stock, believing that the stock price will go below the strike price before expiration. The put buyer is essentially renting the price decline in the stock over the life of the option.

Note that the put buyer achieves profits as the stock goes below the strike price, and losses occur as the stock advances above the strike price.

Table 2 is the profit-and-loss table for a put purchase (long put). Let's assume that a put buyer is bearish on a stock with a current price of 75 and buys a 70-strike put for 3 ($300 per contract). The breakeven point (profit of zero) for this trade is achieved if the stock falls to 67 at expiration (the strike price of 70 minus the premium of 3).

Any stock price less than 67 will result in a profit for the trade while a stock price of 70 or greater will result in a total loss for the trade. Between 67 and 70, the trader will incur a partial loss. (For example, a price of 69 would result in a two-point loss.)

From this, we can conclude the following: (1) the breakeven point is 67 (strike price minus the premium), (2) a maximum risk of 3 per share, or $300 per contract (note that the loss is constant at a stock price of 70 or more) and (3) a theoretical profit potential of 67, which is achieved if the stock falls to zero by expiration (highly unlikely, of course).

Note the difference between puts and calls: Calls have no theoretical maximum profit; whereas, a put's maximum value is capped at a stock price of zero.

Table 2

Stock Price
at Expiration
Value of 70-Strike
Put Option
Profit or
Loss
More than 70
0
-3
70
0
-3
69
1
-2
68
2
-1
67
3
0
66
4
1
65
5
2
64
6
3
63
7
4
62
8
5
61
9
6
60
10
7

LEAPS

For those who remain wary of options, a compromise exists that provides a "bridge" between the realms of stock and options trading. Long-Term Equity AnticiPation Securities (referred to as "LEAPS") are either calls or puts with expiration dates up to 2-1/2 years in the future. Like standard equity options, a LEAPS contract represents 100 shares of the underlying security and is available as either a call or a put.

LEAPS offer both option and stock investors an excellent profit vehicle by allowing a big-picture trend on a stock to play out, with much less capital required compared to buying the underlying stock outright. Yet, LEAPS are less risky than their short-term options counterparts. For those who prefer a one-year to two-year time horizon for their investments, LEAPS offer an excellent alternative using options.

Why Options?

You may be thinking to yourself, "Well that's all well and good, but why should I trade options?" I believe that options, when used properly, can enhance the performance of almost any investor's portfolio. Three main advantages make options attractive as an investment choice.

1) Limited dollar risk and limited dollar exposure As an option buyer, you benefit from being able to control the movement in a stock for just a fraction of the cost of purchasing that stock. Plus, you can never lose more than this modest dollar amount. As a result, you can keep the bulk of your investment dollars in the safety of cash where it is immune to the wild and often stomach-churning swings in the market.

2) Leverage You can achieve percentage gains from your successful options investments that are five-fold, ten-fold and even greater compared to those achieved by stock or mutual fund investors. Because of this leverage, strong bottom-line returns can be generated with limited capital at risk.

3) Profit in Bull and Bear markets alike This third advantage is at the heart of why experienced options traders have profited in the volatile market of the past year or so. By buying put options, you can achieve leveraged profits with limited dollar risk when a stock declines in price. What's more, compared to short selling, put buying has the advantage of placing fewer dollars at risk and capping losses at the initial amount invested. Of course, leveraged gains can be achieved on bull moves by buying call options.

Just in case you're still not convinced, The Options Industry Council (OIC) announced that option trading volume in 2000 set a new record for the ninth consecutive year. In fact, equity option volume on all U.S. options exchanges was an impressive 51 percent greater than 1999's record-setting pace. And, it continues to grow; volume increased 15.9 percent in the first quarter of 2001 compared to the same period in 2000. It's becoming quite clear that options are being more widely accepted as an important component of many portfolios.

Where to Find More Information

Obviously, I've barely scratched the surface of what options are and how they can be used. Numerous resources are available that can teach you everything you need to know about options and option strategies. My book, The Option Advisor: Wealth-Building Techniques Using Equity & Index Options, is suitable for the beginning and seasoned options trader.

Websites on options abound, including my award-winning SchaeffersResearch.com, the OIC's 888Options.com and cboe.com, the website of the Chicago Board Options Exchange. Whatever the source, I suggest you take a serious look at options if you're interested in giving your portfolio a boost. Once you understand what options are all about and how they can be used efficiently and safely, I guarantee they won't seem nearly as intimidating as you might have once thought.

Schaeffer's Investment Research began in 1981 when founder Bernie Schaeffer started publishing The Option Advisor monthly newsletter. As senior editor, Bernie's aspiration was to show traders just how they could discover profit opportunities in both stable and volatile markets. Now, as Chairman and CEO of Schaeffer's Investment Research, Bernie has led the monthly publication to success as one of the nation's largest circulation options newsletters. Bernie's approach to market timing has earned him a "Best of the Best" award from the Market Technician's Association, as well as a number-five market timing ranking from Timer Digest over the past decade.

For more information, contact:
Nicole Kessler
Schaeffer's Investment Research
Email address: nkessler@sir-inc.com
Web: www.schaeffersresearch.com/





eSignal Trading Education

Mind Conditioning for More Effective Trading

By Larry Jacobs, Editor, Traders World magazine

What causes the at-home trader, or, for that matter, any trader, to win or lose in the financial markets? One key factor is mind conditioning. Mind conditioning can overcome the psychological weaknesses of a trader. This article explains the psychological problems that face the trader and how they can be solved.

In a survey published in Traders World magazine, traders identified their major weaknesses in successfully trading the markets as:

  1. Execution (when to pull the trigger)
  2. Analysis
  3. No confidence in their trading
  4. An inferior trading plan

The traders' replies were from their own viewpoint, what they felt prevented them from being capable traders. If a poor trader is going to become a successful trader, he must change how he views his ability to trade.

The most important trader's weakness to overcome is an inferior trading plan. To be successful, the trader must do the following five things.

  1. Obtain a competent trading methodology.
  2. Dig out a profitable trading plan from the methodology.
  3. Put together rules for the plan.
  4. Back test the trading plan.
  5. Use self-control to trade the plan.

Having a good trading plan and implementing it are two different things. Many traders freeze up when they attempt to trade. The trader is sometimes unable to take action even though he knows the market has changed direction. He can't pull the trigger. This happens because trading and analysis of the markets are two different things. This is the reason many intelligent, analytical researchers cannot successfully trade the markets.

To be successful, a trader must maintain a mental equilibrium between actual trading and analysis of the markets. The greater the equilibrium, the greater chance there is for winning. The trader's subconscious mind must accept the fact that he has a good trading plan and transmit it to his conscious mind.

The hardest thing the trader must overcome is the subconscious memory of prior losing trades. This memory tries to protect him from sustaining additional losses. That is why, when he is about to make a trade, his adrenaline flows, he starts to sweat, and he goes into a state of fear. He freezes up.

A CD designed to influence mindset was developed for the trader to handle the challenges of maintaining the balance between actual trading and analysis of the markets and ignoring past memories of losing. The CD-ROM conveniently fits into a computer and plays continuous, subliminal, soothing background tones on the computer speakers during the trader's day.

The trader's mind becomes highly receptive to positive suggestions and conditioning and is put into the right frame of reference for better trading and learning. The sounds the CD plays also stimulate mental clarity.

So, if the trader has a high-quality, back-tested trading system, his or her subconscious and conscious mind can act in harmony, and the trader can more effectively execute a trading plan.

For more information about assembling your own at-home trading office, go to: www.tradersworld.com.

Larry Jacobs' articles also appear in Traders World magazine, and he can be contacted via email at publisher@tradersworld.com.





eSignal Tips and Tools to Trade

Using Alerts to Your Advantage

If you are a trader who manages all or most of your own portfolio(s), you will always be looking for target entry and exit points for existing and potential positions. You need a system that lets you program your own limit alerts on last price, bid, ask and volume and dozens of other criteria and that notifies you the instant any of these alerts are triggered.

With eSignal, you can receive immediate alerts on any of the issues in your portfolio and charts via email, smartphone or desktop through audio or visual (pop-up) and on prices, drawing tools and studies – so you can act immediately on profit-making opportunities.

eSignal enables you to:

  • Set alerts on bid price, ask price, % change, % change from open, trade size, 52-week high, news alert count and volume
  • Create alerts on an individual symbol or globally on all the symbols being tracked. The global alert function is good to have if you need to be alerted when any of the issues in your portfolio lose or gain more than a certain percentage on the day as measured from the previous day's closing price.
  • Associate an alert with a specific quote window or with your overall layout

You will also want to program eSignal to re-arm alerts so that once an alert is triggered, it resets automatically based on your specifications. For example, say you want to receive an alert if DELL rises two percent, every two percent. If the stock is currently trading at 90, you will receive the first alert when the price appreciates 2%, then 4% and so on. You will also be able to set an alert on a Daily High or Daily Low value and re-arm it.

This provides you with a powerful breakout tool that is useful for momentum trading.

Remember: You can't take advantage of the trading opportunities unless you know they're out there.


eSignal Trading Education: Investor's Library

A review of Options as a Strategic Investment by Lawrence McMillan

By Ed Dobson, private trader and former president and founder of Traders Press, Inc.

Options as a Strategic Investment

Whenever one sees a book in its fourth edition and learns that it is the bestselling title of all times for the topic it covers, it seems a reasonable assumption that it has something valuable to offer anyone interested in the topic it covers. Such is the case with Lawrence McMillan's classic on options strategies.

Up front, this reviewer must confess that he is an unabashed fan of McMillan's writings. When McMillan began publishing an options newsletter in 1972, the undersigned was a charter subscriber and still is, to this day, a weekly reader of it. In fact, this reviewer considers it one of the best sources of options information and recommendations available anywhere.

It is admittedly hard to give any sort of a detailed review of such a monumental work in the limited space available here. Therefore, a general overview and comments are in order. In short, Options as a Strategic Investment is the most comprehensive options reference manual available. There is no aspect of options trading or strategies that it does not cover in copious detail.

Although the material is admittedly "dry", it is well written and clearly explained. At 1,000 pages, it is the equivalent of a college course in options. Not a quick read, it should be considered an indispensable and valuable resource for anyone seriously interested in gaining a thorough knowledge of options…and well worth the considerable time that should be devoted to such a daunting task.

Newcomers to options would be well advised to begin with more elementary books on the subject before tackling McMillan's work. Indeed, in the preface, he states that, in writing the book, he assumes the reader already has a working knowledge of the basics of options, as well as peripheral subjects such as technical analysis.

Although the book does cover the basics, little room is devoted to them, and the reader is quickly immersed in detailed discussions of what would seem like esoteric subjects to the uninformed, such as naked writing, arbitrage, butterflies, ratio spreads, and the like.

It is my opinion that McMillan leaves no stone unturned when it comes to a thorough analysis of every aspect of options trading and strategies. While entire books are devoted to some of the strategies he covers in a single chapter (such as covered call writing), it would be hard to find a more professional or adequate explanation of the concept.

Some topics not covered in earlier editions are now also included, such as LEAPS, futures options, index spreading, index hedging strategies, and the like. A major section covers volatility and volatility trading techniques, among the most important and overlooked areas of options. Tax considerations, advanced concepts and the best strategies are covered in the final section. A separate study guide is available that will test your knowledge of the concepts and help to clarify each topic.

In short, if you have only a passing interest in options and just want to learn the basics, start...and stop…elsewhere. If you want to master the subject, start elsewhere to get the equivalent of your high school diploma…then, come here for your university level education.