Trader University – Stock Trading Knowledgebase

Table of Contents:

Trading For Beginners – Trading Rules for Successful Trading

Technical analysis can help you add objectivity to your trading strategy, thereby allowing you to make more disciplined decisions over the long-haul and ultimately improve your profitability and chances of beating the broad stock market.

Below we highlight a number of popular trading strategies, signals, and setups that warrant a closer look from any active investors looking to outperform the traditional buy-and-hold strategy over the long-term. As always, investors of all experience levels are advised to use stop-loss orders and practice disciplined profit-taking techniques:

This occurs when the short-term moving average (5-day blue line) crosses above a longer-term one (20-day red line).

1. Buy After a Bullish Crossover

Detailed Trading Chart

This occurs when the short-term moving average (5-day blue line) crosses below a longer-term one (20-day red line)

2. Sell After a Bearish Crossover

This is a sign of “oversold” conditions beginning to reverse, generally followed by a rebound.

Detailed Trading Chart

3. Buy When RSI Crosses Back Above 30 from Below

This is a sign of “overbought” conditions beginning to reverse, generally followed by a correction.

See Also: 25 Stocks Day Traders Love

Detailed Trading Chart

4. Sell When RSI Crosses Back Below 70 from Above

Watch for the security to establish a higher-low to confirm the rebound and that the bottom is in.

Detailed Trading Chart

5. Buy After a Security Holds Above a Major Support Level

Watch for the security to establish a lower-high to confirm that it has in fact topped out.

Detailed Trading Chart

If your long position is trading near the upper-resistance boundary of its longer-term channel, it’s time to lock-in some profits as pullbacks generally follow.

6. Sell After a Security Breaks Below a Major Resistance Level

Detailed Trading Chart

If your short position is trading near the lower-support boundary of its longer-term channel, it’s time to lock-in some profits as rebounds generally follow.

See Also: Best Stock Investment Sites

7. Take Profits Near Resistance

You should generally see a sign of accumulation and an uptrend typically follows.

Detailed Trading Chart

8. Cover Your Short Near Support

The sort of divergence you see in the chart below is generally bearish and a correction typically follows.

Detailed Trading Chart

9. Buy When a Security is Trading Sideways with Rising Volume

When a security falls below the lowest point in a “head and shoulders” topping pattern, place a stop loss above the breakout point to avoid severe losses in case of a fakeout.

Detailed Trading Chart

When a security rises above the highest point in an “inverse head and shoulders” bottoming pattern, place a stop loss below the breakout point to avoid fakeouts. Notice how in this example you would’ve likely been stopped out at the first two breakout attempts, but you still catch the bigger trend on the third try.

10. Sell When a Security is Trading Higher with Falling Volume

This chart pattern is complete when the price peaks, pulls back and then rallies back to very near the first high. The double top is complete, and a short entry is taken when the price falls below the low of the pullback.

Detailed Trading Chart

This chart pattern is complete when the price bottoms, rallies to a fresh high then pulls back to very near the first bottom. The double bottom is complete, and a long position is taken when the price rises above the high of the first rally.

RELATED: Review of Stock Advisor by The Motley Fool

11. Short-sell the “Head and Shoulders”

Buy when a security breaks above the highest point of a longer-term range that it has been confined in and place a tight stop loss in case the breakout fails.

Detailed Trading Chart

12. Buy the “Inverse Head and Shoulders”

Sell when a security breaks below the lowest point of a longer-term range that it has been confined in and if you are short-selling, place a tight stop loss in case the breakdown fails.

Detailed Trading Chart

This signal occurs when the 50-day moving average crosses above the 200-day moving average, confirming an uptrend.

See Also: Ten Commandments of Futures Trading

13. Short-sell the “Double Top”

This signal occurs when the 50-day moving average crosses below the 200-day moving average, confirming a downtrend.

Detailed Trading Chart

14. Buy the “Double Bottom”

This is a sign that new buyers are stepping in again at a key support level, and rallies typically follow.

Detailed Trading Chart

15. Buy the Breakout

This is a sign that sellers are still in control, and pullbacks typically follow.

Detailed Trading Chart

This occurs when a security endures a steep decline, then rebounds to a lower-high point, only to resume its downtrend in the days following. Fundamental analysis can help you identify which securities are “dead cats,” which should be avoided following a steep sell-off, and which ones are undervalued and potential buys.

16. Sell the Breakdown

Detailed Trading Chart

17. Buy the “Golden Cross”

Detailed Trading Chart

18. Sell the “Death Cross”

Detailed Trading Chart

19. Buy After a Security Holds Above a Fibonacci Retracement

Detailed Trading Chart

20. Sell After a Security Fails to Break a Reverse Fibonacci Retracement

Detailed Trading Chart

21. Sell the “Dead Cat Bounce”

Detailed Trading Chart

Disclosure: No positions at time of writing.


High Frequency Trading – The Rise of High-Frequency Trading: A Brief History

The concept of capitalism and free-market trading has been around for centuries. Since the world’s first stock exchange opened in Amsterdam in 1602, investors have sought ever more inventive ways of trading assets and making profits. The Dutch East India Company popularized the idea of owning shares of a company, paving the way for transferable assets that blossomed into the modern financial world we live in today.

Background

Prior to the computer age, trading technology consisted of carrier pigeons followed by telegraph cables. The founder of Thomson Reuters, Julius Reuters, actually combined the use of pigeons and telegraph machines to build what became a state-of-the-art news agency that revolutionized the speed at which information regarding news events were disseminated to the public.

It wasn’t until the 1980s that a real breakthrough in the logistics of stock trading was actually achieved. The advent of the computer allowed traders to access data on a level never before seen or thought possible. With an initial investment of $30 million from Merrill Lynch, Bloomberg designed and built the first computer system to use real-time market data to quote stock prices and relay information.

By the late 90s, the SEC ruled in favor of creating electronic stock exchanges. This laid the groundwork for a new type of trading: high-frequency trading or HFT. In just a couple of years, nearly 10% of all trades were done using HFT with a clearing time of just a few seconds. HFT is actually a thousand times faster than traditional human-to-human stock trading.

Understanding the World of High-Frequency Trading

High-frequency trading is an automated trading platform that executes buy and sell orders based on an algorithmic computer program. It’s a type of trading strategy implemented by large financial firms, such as hedge funds and investment banks, that allows them to trade millions of shares every day in transactions that often last less than a second.

Complex algorithms designed to analyze multiple financial markets and spot trends are the driving force behind HFT. These systems find arbitrage opportunities, pricing inefficiencies, and emerging trends using mathematical formulas that predict market movements and automatically execute trades. They move in and out of positions at an incredibly fast rate and almost never hold any position overnight, making these types of trading firms very liquid.

HFT strategies are purely algorithmic models that attempt to take advantage of mathematical opportunities and should not be confused with other investment strategies that utilize fundamental analysis and long-term growth planning. The method is risky because it deals with orders of magnitude higher than traditional investment models and therefore is not suitable for individual investors.

Many critics claim that HFT is an unfair practice that hurts smaller firms and individual investors because larger firms are able to take advantage of situations to which others do not have access. Proponents, however, point out that HFT increases liquidity in the financial markets and can lower bid-ask spreads for all investors.

High-Frequency Trading Since 2000

The advent of HFT at the turn of the millennium saw trades taking just a couple of seconds to clear and encompassing around 10% of all trade executions. Within just five years, HFT made up 35% of all stock transactions. From 2005 to 2009, high-frequency trading volume increased by 164%. By 2010, however, the first warning signs that this type of trading could be dangerous finally emerged.

HFT was officially responsible for more than half of all trade executions by 2010. In May that same year, computer-based trading sold off more than $4.1 billion in equity holdings, triggering a flash crash in which the Dow plunged 1,000 points in a single day. The initial sell-off triggered a wave of other sell-offs based on the designed algorithms, causing the extreme drop in values. While stocks quickly recovered from the error, the SEC became fully aware of the dangers associated with computer-driven trading platforms.

Trading times reached nanosecond speed in 2011 when a company named Fixnetix developed a microchip capable of processing trades at never-before-seen speeds. By 2012, nearly 70% of trades were accomplished using HFT. The same year brought a wave of HFT investments as well, including a transatlantic cable for the sole purpose of shaving 0.006 seconds off of trading time and a social media-based trading platform that executes trades based on social trending. The concept of micro-trends stemming from popular social media topics during the day helped amplify HFT successes.

As social media proliferated throughout the financial industry, a false tweet in 2013 triggered a brief panic sell-off, wiping 143 points off the Dow in a matter of minutes. The sheer speed and volume of HFT was once again seen when the Fed announced its plan to taper off of QE. Over $600 million were traded in milliseconds before the news hit the mainstream media.

What the Future Holds for HFT

In recent years, HFT has been the subject of regulatory talks, with Italy being the first to officially implement an HFT trading fee in order to discourage that type of investment activity. Economists and other financial leaders have been discussing new ways to regulate HFT trading as well, and it seems likely that new laws will be passed in order to curb dangerous trading activity that has systemic risks.

It hasn’t prevented the HFT industry from growing, though.

Since the flash crash in 2010, HFT platforms have been revamped in order to assess future risks and streamline the trading process. Stock analysis has given way to a more mathematical and technological approach whereby a single company’s balance sheet and earnings become meaningless next to algorithms designed to spot trading trends and pricing inefficiencies.

The Bottom Line

The real question moving forward is whether traditional investment models can still be used alongside HFT. If HFT prevents long-term investment planning, then it could be a danger to the entire modern financial system. So far though, aside from momentary lapses in technology, HFT hasn’t truly hurt long-term investment strategies and might even have helped introduce additional liquidity to the marketplace.


Darvas Box – Uptrends: How to Use Stock Uptrends

Making money from an uptrend is where most traders, and nearly all investors, focus their attention. While money can be made when stock prices are moving sideways or even down, most traders by default look for uptrends. This makes sense, since there is an inherent upward bias in the stock market; it has been rising overall since the New York stock exchange began operations back in 1898. Over shorter time frames, that bias isn’t always apparent, which means traders need to understand uptrends, how they are established, signs they are reversing, and the limitations of charting uptrends. Understanding these concepts allows traders to participate in uptrends and hopefully profit, and avoid some of the capital draw downs from the downtrend that inevitably follows every uptrend.

What Is an Uptrend?

An uptrend is more than just a rising stock price; it needs to be defined.

Price moves in waves or swings. During an uptrend the waves higher are larger than the waves lower (pullbacks), this allows the price to make headway to the upside. Stock prices don’t move relentlessly in one direction for long, instead price follow a three steps forward, two steps back, three steps forward type structure.

How Is an Uptrend Established?

Since prices advance through a push higher, pullback, push higher structure, an uptrend is in place when a stock’s price is making higher-wave-highs and higher-wave-lows. This shows the price is advancing to the upside and establishes the uptrend.

Stock charts are used to monitor these conditions. The low of a major price wave should be above the prior major wave low. Similarly, the high of a major price wave should be above the prior major wave high. When these conditions aren’t met, it is a warning sign that the trend may start to reverse (next section).

HAL Uptrend chart example
Figure 1. Stock Uptrend with Higher Highs and Higher Lows – Halliburton (NYSE:HAL)

Uptrends have varying degrees of strength. Some may move at 45 degrees, some less and others may move almost vertically. With a near vertical trend the space between former high and new highs (and former lows and new lows) can be quite vast.

ILMN Uptrend chart example
Figure 2. Steep Uptrend in Illumina (Nasdaq:ILMN) Daily Chart

Uptrends begin and persist for different reasons; the main reason is speculation. If traders (cumulatively) believe the price will continue to advance, they buy the stock in a self-fulfilling prophecy. Eventually, however, traders lose trust in the trend, and more and more stop buying, and begin to sell instead. This shift converts the uptrend to a downtrend.

The stock market exists to provide capital to corporations; the stock price is therefore tied to the outlook for that corporation. While traders speculate, their decisions to do so are often driven by their outlook for the company, outlook for the economy, factors that could affect the stock price, as well as their outlook on government and foreign policy.

The combined decisions of all traders on these matters are reflected in the price trend using stock charts.

How Is an Uptrend Reversed?

If an uptrend is composed of higher swing highs and higher swing lows in price, when these conditions are not satisfied the trend could be reversing.

The time frame being watched here is important though. For a trader who wants to trade every see-saw move in the market, any failure to make a new high, or a lower low may be cause for speculating on a reversal. This could be done on a 5-minute chart, hourly chart or daily chart. Investors, on the other hand, are likely only going to look at major swings on a daily or weekly chart, and they won’t worry about small moves that make a lower high or lower low.

Figure 3 shows Pandora Media (NYSE:P) in a steady rise. The price action is a bit choppy, but overall the price is making higher highs and higher lows. The price then shifts, making lower lows and lower highs. When the price makes a major lower low and major lower high, the uptrend is over. It is time to exit long positions and potentially look for short position entries.

Uptrend Reversal
Figure 3. Uptrend and Reversal in Pandora Media (NYSE:P) Daily Chart

Monitoring an uptrend for higher highs and higher lows is a sound method for discerning if the uptrend is intact. Other methods include using trendlines. During an uptrend a trendline connects the swing lows of an uptrend. If the price breaks below the trendline, it is a warning sign that the trend is weakening. This doesn’t mean the trend has reversed, it is just an advance warning that the trend is slowing. Use price action (highs and lows) to confirm trendline breaks and reversals.

Trend Reversal chart example
Figure 4. Price Breaks Trendline – Morgan Stanley (NYSE:MS) Daily Chart

Charting Uptrends: Limitations

Trend analysis is subjective. While the trend is easy to see in hindsight, in real-time we don’t know if a price will make a higher low until the price actually makes a higher low and then begins to move higher. We don’t know if the price will make a higher high until it does.

Trend analysis requires focus and adapting to conditions as they develop. It is also possible to get tricked. The price may make a lower high followed by a lower low, indicating the uptrend is over, but then the uptrend may in fact continue.

To help avoid being lured out of trend trades by these “false” moves, zoom out to a longer time frame. Instead of looking at one year of historical price data, look at two or three years, for example. When looking at two years of data, does the trend look different? From the larger perspective, you may notice that a lower low you were concerned about is only a small pullback on the longer-term view, and therefore not a reason to liquidate your position. Other times, the signal to liquidate will be valid.

Ultimately, trends are great while they last, but we can’t predict with great accuracy when they will end. We can see the trend ended once we have a number of lower highs and lower lows in place, but we can’t anticipate with certainty when that will occur.

The Bottom Line

Uptrends are moves higher in price, created by a two-steps-forward-one-step-back structure. When this occurs, the price makes higher highs and higher lows. Trends can be steep or shallow, but the same principles apply. Reversals occur across different time frames and perspectives, when the price fails to make higher highs and higher lows, and instead does the opposite. Monitoring price action and a trendline alerts traders to when the trend may be reversing. While we can see that a trend has reversed based on these tools, they don’t predict the reversal in advance; therefore, traders must be alert and adapt to changing market conditions as they arise.


Risk Reward Ratio – Risk/Reward Ratio 101: Everything You Need to Know

In trading, the risk-reward ratio (risk/reward ratio) is a key concept. Whether your are a technical or fundamental analysis trader focusing on short-term or long-term strategies, understanding the risk/reward ratio-and how it is applied to each trade-will improve your trading. To utilize risk/reward ratios effectively you’ll first need to establish the risk and reward potential of each trade, and then assess the risk/reward in combination with the probability of a successful trade. This helps you determine if a trade is worth taking or not. Here’s how to do it.

Risk/Reward Ratio

In theory, a risk/reward ratio is a simple concept. If you risk $1 to make $2, your risk, if you lose, is half of your potential reward if you win. The risk/reward ratio is $1/$2 (or risk divided by reward), which equals 0.5. The lower the risk/reward ratio, the smaller the risk is relative to the potential reward. If the ratio is above 1, then the risk is greater than the potential reward.

The risk/reward ratio is more complex in trading. How do you know what your risk is? How do you calculate your potential reward? Understanding the answers to these questions will help you utilize the risk/reward ratio effectively, making you a better trader.

Risk/Reward Ratios – The Risk Portion

The risk/reward ratio makes you think in terms of risk and profit potential, which are both affected by the entry price. Each element must be considered in order to formulate a trade with a good risk/reward ratio.

Risk is determined at the outset of the trade using a stop-loss order. Risk is the difference between your entry price and stop-loss price, multiplied by the position size. For example, if you buy a stock at $20, and place a stop-loss order at $19, you are exposed to $1 of risk per share. If you buy 100 shares, then your risk is $100.

A stop-loss should not be randomly set. Rather, set it at a location that shows that you are wrong about the trade (at least for now). When buying, a stop-loss is often set below a “swing low” on your price chart. When a price is moving down, and bounces off a certain price, that is a swing low. Since the price couldn’t go lower than that point, it shows there is some buying interest there. By placing a stop-loss below that level you’re making a calculated assessment that the price will continue higher before it falls through that area of support.

You want the stop-loss as close to your entry as possible in order to minimize risk while still being far enough that it isn’t touched by normal market fluctuations before it starts to move toward the target (discussed next). For additional reading, see 4 Ways to Exit a Losing Trade.

Figure 1. shows an entry and stop-loss method. A trendline is used to estimate where an area of support could develop. Wait for the price to stop falling (during an uptrend) showing the pullback may be over (there are no guarantees in trading). Once the price begins to move back higher, a long entry (buy) is taken, with a stop-loss placed below the recent low.

This leaves a relatively small distance between the entry price and stop-loss price, increasing the likelihood that the trade setup will have a good risk/reward ratio.

Charts courtesy of FreeStockCharts.com

Stop-Loss Helps Limit Risk
Figure 1. Well-Timed Entry and a Stop-Loss Help Limit Risk – LEN Daily Chart

Risk/Reward Ratios – The Reward Portion

With our entry point and risk determined, the reward portion of the trade is considered. The reward is set using a profit-target order. This is an offsetting order (a sell order in the case of the trade above) that closes the trade when the price reaches the profit-target price level.

As with the stop-loss, the profit target shouldn’t be set at a random level.

The profit target is set at a location that is within reach based on normal market movements. In Figure 1., the price is moving within a trend channel. By connecting the major swing lows in price with a trendline we see where the price has shown a tendency in the past to bounce. Similarly, by drawing a trendline that connects the major swing highs we see the general area the price has shown a tendency to stop rising and fall. For this type of trend channel strategy the logical place to put a profit target is just below the top of the channel. If using another chart pattern or strategy, place the target within reach of what the general price tendency has been.

If a bigger move is expected than what has happened in the past, or the trade is being taken for the long term, the profit target may be set outside of the normal market movement. For example, if a stock is trading at $10, but based on some upcoming events you believe it could trade as high as $60 within a year or two, a target could be set at that level. If an asset has been trading in a very small range or consolidation, but volatility is expected to expand, then a target is placed at a location that takes into consideration the expected expanding volatility.

Whether you are choosing a target within proximity of normal market movements, or outside of normal movements because you believe the price could have a big move in the future, always have a reason for why you think the price will reach that profit target level.

Figure 2. shows a potential profit target level just below the top of the trend channel that was used to help find our entry level and stop-loss. With a risk of $2.42 per share, our profit potential-the difference between our profit-target price and our entry price-is $5.88.

Entry, Stop-Loss and Target Determine the Risk/Ratio of Trade
Figure 2. Entry, Stop-Loss and Target Determine the Risk/Ratio of the Trade

The risk/reward ratio on the trade is $2.42/$5.88 = 0.41. The risk is less than half of the potential reward. Therefore, the risk/reward is favorable, so the trade can be taken if it adheres to your trading plan.

Another way to think of it is reward/risk: $5.88/$2.42 = 2.42. Flipping the ratio shows the reward is equal to 2.42 times the risk.

Risk/Reward Ratios – Choosing Trades

Successful trading, contrary to what most people do, does not mean picking the trades you want to take (usually at a random entry point), then applying a risk/reward to it (also usually random). Instead, think of going through a five-part check list to see if a trade setup is worth taking:

  • Where is the entry point for the trade?
  • Given this entry point, where do I place the stop-loss?
  • Where does the profit target go for this trade? Why?
  • Only after you’ve defined the above, calculate the risk/reward ratio. By going in this order you get the true risk/reward of the trade, and you can’t fabricate what you want the risk/reward to be.
  • Is the trade worth taking based on the risk/reward? If you win 50% of your trades, then in order to be profitable over many trades the risk/reward ratio must be less than 1 in order for you to take a trade. If the ratio is greater than one, skip the trade. If you win less than 50% of your trades, only take trades for which the risk reward ratio is less than 0.67.

Risk/Reward Ratios – Consider the Probability of Success

By following the method outlined above-only taking trades when the stop-loss is placed relatively close to the entry price, and the target is placed within reach of typical price action, providing a favorable risk/reward ratio-your trades have a decent chance at success.

While not always the case, as some fantastic opportunities do occasionally occur, as a general rule the lower the risk/reward ratio, the lower the chance of success on a trade. A trade with a risk/reward ratio of 1 is more likely to result in the target being reached than a trade in which the risk/reward ratio is 0.1.

In the case of the former, the stop-loss and target are both the same distance away from the entry price. In the case of the latter, the target price is ten times further away from the entry price than the stop-loss. In terms of dollars, if you enter long at $20, and place a stop-loss at $19, with a risk/reward of 1.0 the target is at $21. The 0.1 risk/reward requires the target to be placed at $30. Since the $21 target is closer to the entry price, it has a higher probability of success.

Each trader must find a balance between how often they tend to win (win rate) and the risk/reward they opt to use. Many active traders strive to win 50% to 60% of their trades and only take trades that have a risk/reward of 0.67 to 0.25 or slightly lower (profit potential is 1.5 to 4 times the risk).

Practice many trades in a demo account to see what works for you in terms of risk and reward. Practicing is also required to gain skill in choosing your stop-loss locations and profit target levels to maximize your win rate for that trade setup and risk/reward ratio.

The Bottom Line

Risk/Reward is a key trading concept. Many traders use it as the ultimate filter for which trades they take and which they don’t. By establishing your entry, stop-loss and profit targets first, then assessing the risk/reward ratio, you can decide objectively if the trade is worth taking. If the risk/reward is above 1, don’t take the trade. If the risk/reward is below 1 (the reward is larger than the risk), then consider taking the trade if it aligns with your trading plan and capital availability.


Algorithmic Trading Strategies – What Is Algorithmic Trading?

Algorithmic trading accounts for approximately half of all U.S. equity trading volume, according to a report in the New York Times. Unlike traditional trading, these strategies rely on automated computer programs to execute buy and sell orders. These trading programs often execute trades at a very rapid rate, especially in what has become known as high frequency trading.

In this article, we’ll take a closer look at the history of algorithmic trading, how it has grown over the years, strategies employed by these firms, and considerations for traditional traders in the market.

History of Algo Trading

Stock exchanges began transitioning from a traditional auction to computerized transactions in the early 1970s. In the late 1980s and early 1990s, Electronic Communication Networks (“ECNs”) became increasingly popular for traders looking for more efficient access to the markets. These developments set the stage for algorithmic trading that eventually took humans out of the equation.

Algorithms are simply a set of rules that a computer program executes in sequence until a desired end point. In the case of algorithmic trading, the algorithms are simply a series of criteria that must be met to execute a buy or sell order. For example, in an arbitrage scenario, algorithms may compute the difference between an ADR and foreign stock and execute a buy order when profitable.

In 2001, algorithmic trading received a boost when IBM researchers published Agent-Human Interactions in the Continuous Double Auction. The research paper found that simple agent bidding strategies were able to outperform non-expert human subjects by a clear margin, setting the stage for the high-frequency trading algorithms that are widely used today in the financial markets.

The development of low latency proximity hosting and global exchange connectivity in the 2000s helped accelerate the ubiquity of algorithmic trading. By executing trades faster and faster, these faster networks enabled trading algorithms to access and act on information more quickly than human traders. Many algorithmic trading servers are now located near major exchanges and data sources.

Algo Strategies & Limitations

Algorithmic trading is a highly competitive segment of the global financial markets, since the marginal profit per trade is so narrow and the potential for profit is so high. Trading algorithms must be modified over time in order to keep ahead of front-running competition. If an edge is lost, trades can quickly turn negative and losses can pile up, especially if nobody is paying close enough attention.

For example, Knight Capital famously lost $440 million in 45 minutes due to competition from the NYSE’s Retail Liquidity Program. Observers believe that Knight had tried to upgrade its algorithms to work around the NYSE’s new system, but the algorithms were flawed and thousands of bad trades were made. Dozens of stocks were affected by the glitch and faith in the markets was shaken.

The high profit potential of high frequency trading is compelling enough to look past many of the risks, however, with a number of strategies employed to profit.

Index Fund Rebalancing – Index funds must rebalance their portfolios at regular intervals, which presents an opportunity for traders looking to front-run the purchases for a small profit on a large scale. For example, United States Natural Gas Fund (UNG) has become infamous for its predictable rolling trades in Figure 1.

UNG Rebalancing Volatility
Figure 1. UNG Rebalancing Volatility – Source: StockCharts.com

Arbitrage Opportunities – Arbitrage strategies aim to profit from price differences between assets that are typically strongly correlated, including ADRs/foreign stocks, M&A transactions, or simply statistical correlations, as seen in Figure 2. In this case, a trader might take advantage of Exxon Mobil (XOM) and Chevron (CVX) divergence.

Arbitrage Opportunity in Energy
Figure 2. Arbitrage Opportunity in Energy – Source: Google Finance

Low-Latency Strategies – Faster connections to exchanges enable algorithms to front-run each other, creating an opportunity to profit from the speed of transactions relative to other traders in the market. Often times, these transactions are known as high frequency trading (“HFT”), with an example in Figure 3.

HFT Trading Example in Preferred Stock
Figure 3. HFT Trading Example in Preferred Stock – Source: Nanex Research

Market Making Trades – Many ECNs pay a fee to organizations willing to make a market in illiquid securities, which creates an opportunity for trading algorithm operators to earn a profit over time. Of course, these programs must be careful to account for the added liquidity risk present in these companies.

As algorithmic trading grows in popularity, the profit potential from many of these operations has significantly diminished. Many high-frequency trading operations are also competing with each other in low-latency trading and areas where profit potential is simply a matter of owning the best technology. As a result, algorithmic trading volumes have started to decline from their peak.

Retail Trading and Considerations

Algorithmic trading has largely increased the efficiency of the financial markets by narrowing the spreads in arbitrage opportunities, increasing liquidity where needed, and ultimately ensuring fast executions. The problems arise when these companies start front-running the market, which ends up digging into traders’ margins and increasing transaction costs and slippage.

Following some basic guidelines can avoid these problems:

  • Avoid Market Orders – Traders can use specific limit orders to ensure that their trades are executed exactly at their desired price. In particular, the forex markets are well known for excessive slippage in some cases.
  • Careful with Stops – Algorithmic trading can result in periods of high volatility, which can quickly trigger stop-loss orders. Traders that wish to use stop-loss points should be aware of the risks before placing those limits.
  • Hedge Your Bets – Algorithmic trading introduces greater volatility into the financial system at times, which means it’s also important to hedge bets using techniques like covered calls or put options in some cases.

Traders looking to become involved with algorithmic trading face intense competition these days, although there are some retail options available. Programs like TradeStation enable traders to devise automated strategies based on technical analysis and price/volume/order dynamics in many markets. Similarly, MetaTrader has become a popular option for similar trading in the foreign exchange markets.

The basic process used to build an algorithmic strategy is:

  • Identify a Strategy – Most retail trading algorithms are focused on using various forms of technical analysis rather than low-latency strategies involving the order book. For example, a strategy might be to buy when an equity’s price crosses above its 200-day moving average.
  • Backtest the Strategy – Many popular platforms enable traders to backtest their strategy using historical market data. That way, they can see if the strategy would have worked in the past. While past performance doesn’t guarantee future performance, it’s certainly a good starting point.
  • Implement the Strategy – Many popular platforms enable traders to upload their algorithms and then trade automatically. In many cases, the process is as simple as flipping a switch from paper trading to real trading.
  • Setup Risk Management – Risk management practices are extremely important to limit losses in extraordinary situations. Try to identify all possible scenarios and account for the risks by setting up rules that cut losses short.
  • Monitor and Refine – The markets tend to adapt to successful trading strategies, which makes it necessary for traders to constantly refine their systems to avoid trades becoming unprofitable over time.

The Bottom Line

Algorithmic trading gives computers the ability to make buy and sell trades based on sets of rules provided to them. In many cases, these automated trades can help make markets more efficient by minimizing spreads and increasing liquidity. In other cases, algorithmic trading can introduce greater volatility into the financial system by introducing automated instability, as in the case of Knight Capital Group.

Traders should keep these benefits and risks in mind when trading and take precautions to limit their exposure to the issues. For example, limit orders can be used to avoid slippage and other issues, while careful use of stop-loss points can avoid potential losses during times of instability. In the end, these tools can help traders ensure they aren’t being ripped off by automated programs.


Short Squeeze – Understanding a Short-Squeeze and How to Profit From One

Strong rallies happen in all sorts of stocks for various reasons, such as a positive earnings release, a proposed buyout or a news announcement favorable to the company’s future. A short-squeeze is another event that can drive the price of stock higher, and quickly. Profiting from a short-squeeze, or to avoid getting squeezed yourself, means understanding what short selling is, how it works, and ultimately being able to spot a potential short-squeeze.

What is short selling?

In the stock market most investors buy stocks, hoping to sell them at a later time at a higher price; they buy then sell. Short selling is the opposite. A trader sells first and then hopes to buy it back at a later time when the price is lower.

In order to short a stock it must be borrowed from someone who owns it. Brokers take care of this, so as long as a stock is shortable, then any trader with a margin account can short sell a stock.

Be sure to also read about the Best Investments of All Time

Say stock XYZA is trading at $100 and you believe it is overvalued. You can sell that stock, without owning it, simply by selling it in your trading account. If you sell 100 shares your account will be credited with $100 × 100 = $10,000 less commissions. Your account will also show a negative (-) 100 share position on that stock. At some point in the future you will need to get that share position back to zero, which is called “covering” your short position.

If the price goes up to $110 your account will show a loss of $1000 ($100 – $110 = -$10 × 100 = -$1000). If the price drops to $90, your account will show a gain of $1000 ($100 – $90 = $10 × 100 = $1000).

This is because if you buy back the 100 shares at $90, to cover your short position, it will cost you $90 × 100 = $9000. Initially you received $10,000, so by covering the short position you are left with $1000 in profit (less commissions).

You can cover a short at any time, for a loss or a profit. The higher the price goes the bigger your loss since the price can keep going up beyond where you sold it. The lower the price drops the bigger your profit; your maximum profit is the amount you initially received from the short-sale, but only if the stock goes to $0.

What’s a Short Squeeze? How Does It Happen?

Short sellers are predominantly short to medium term traders, not investors who are willing to ride out multiple ups and downs in a stock. Therefore, short sellers are generally price sensitive. Short trades are taken on margin, and if the stock goes significantly higher against a trader’s short position, they may be required to put up more capital or be liquidated from the position.

Such pressure causes many traders to panic and buy to cover their position. This mass exodus of short positions causes a lot of buying, in addition to the buying that spooked the short positions in the first place.

Therefore, a short squeeze is when a high number of short positions in a stock are muscled by the buyers into covering their short positions for fear of big losses. This causes a sudden jump in the stock price.

A short squeeze can happen very quickly on small intraday moves—for example, if one trader has a large position and is forced out of it—but usually there is an “escalating” process. The price starts to rise causing some shorts to cover, which causes other shorts to cover, as well as bringing other short-term buyers who see what is happening.

There are always multiple factors affecting a stock, so it is not always perfectly clear whether a short squeeze caused a stock to suddenly rally (usually in the midst of a downtrend, which is why traders are shorting it) or it was something else. But a high short interest usually indicates some sort of squeeze went on if the stock pops very aggressively. Higher than average volume is also usually a tip off.

Potential Short Squeeze in BTH
Figure 1. Potential Short Squeeze in BTH – Source: FreeStockCharts.com

How to Trade and Profit from a Short Squeeze

Isolating what stocks could experience a short squeeze is the first step to learning to trade them.

There are number of criteria traders use to pick stocks that could experience a short squeeze. Two of the most popular ratios traders look at are:

  • Short interest as a percentage of float. This is how many shares are short as a percentage of how many share are actually available for trade (not held by insiders). For instance, if a stock has a float of 10,000,000 shares a short interest of 5,000,000, the short interest is 50%. That is a high number and definitely noteworthy. A short interest above 20% is considered high.
  • Days to cover is another ratio derived by taking the total short position (in shares) divided by daily average volume. If the short position is 5,000,000 shares and the stock only does 200,000 in daily average volume, it would take at least 25 days for the shorts to cover. The longer the days to cover the bigger the potential danger for the shorts. Their position is so big that it can’t be easily exited without jacking up the price and volume to get out.

The Wall Street Journal publishes a list of biggest short positions, ranked by Days to Cover and Shorts as a Percentage of Float, among other criteria.

Add the “Float Short” criteria to your screen on Finviz to see stocks with a high short interest.

Nasdaq shows current and historical short positions: http://www.nasdaq.com/symbol/bbry/short-interest.

Once a potential stock is found, there are two ways to trade it. Often the trend will be down, which is why so many traders are short and expecting it to go lower. When it looks like a short squeeze is occurring, take short-term long trades (buy) to take advantage of the potential spike in price. Often these spikes are short lived, as once a bunch of short position stop loss orders have been triggered (buy orders) the buying loses steam.

See also Do You Know Your Trading Order Types? A Foolproof Guide

Potential Short Squeeze on MYGN Daily Chart
Figure 2. Potential Short Squeeze on MYGN Daily Chart – Source: FreeStockCharts.com

Figure 2 shows several potential short squeezes. We can assume they were short squeezes because of the strong volume, sharp price moves and the high short interest. Had the short interest not been so high in these stocks the moves higher would have likely been more muted.

These were short-term squeezes where the buying pressure was only sustained for a day or two. Figure 3 shows what the July 14 short squeeze looks like on an intraday chart.

Potential Short Squeeze on MYGN 10-Minute Chart
Figure 3. Potential Short Squeeze on MYGN 10-Minute Chart – Source: FreeStockCharts.com

A short squeeze needs a catalyst. For this trade it may have been the aggressive move above a short-term range. The strong volume indicates a lot of buy orders going through, potentially to cover shorts. The buying was sustained through nearly the whole day as shorts were forced to cover at any opportunity they could find. Buying continued into the close, which would have presented an opportunity to ext with a nice profit. Continuing to hold the long trade is possible, but these stocks can be quite volatile; the next day the stock sinks as the panic to cover is gone, and most of the traders who wanted out of their short position got out on the July 14.

The second way to trade a short squeeze is to only trade stocks that are in downtrends, and assume that the shorts have it right. Wait for the price to pop aggressively showing a potential short squeeze, and then as soon as the buying pressure ceases, enter a short position. This can be a short or medium term trade, since it is in alignment with the current trend.

Always keep in mind the high short interest if you are also short. If a large number of shorts get spooked it could result in a very sharp rally. Keep stop loss orders relatively tight to control risk.

Potential Short Squeeze on CALL Daily Chart
Figure 4. Potential Short Squeeze on CALL Daily Chart – Source: FreeStockCharts.com

The above charts show examples of short-term squeezes. But squeezes also occur over the long term. If there is a high short interest in a stock a trend reversal can act as a catalyst forcing many of those short positions to cover. Figure 5 shows as an example of this; as the trend reversed the number of short positions continually decreased until the uptrend ran out of steam (source: http://www.nasdaq.com/symbol/bbry/short-interest).

Long-term Short Squeeze on BBRY Daily Chart
Figure 5. Long-term Short Squeeze on BBRY Daily Chart – Source: FreeStockCharts.com

Risks and Rewards

Attempting to trade a short squeeze can be dangerous for multiple reasons. Mainly, there are always multiple factors affecting a stock, not just the number of short shares. A rally in a stock may just be a normal a rally, and not a short squeeze.

Typically a stock will be weak if there is a very high short interest. By attempting to buy and profit from the short squeeze you are potentially buying a weak stock. Instead of trying to take advantage of the pop higher in a down trend due to a potential short squeeze, wait for the price to pop and then begin to drop again, and hop on the short in the direction of the trend. Some shorts will have been forced out, but buyers may be temporarily exhausted and the downtrend may continue.

Buying a short squeeze can also be hard to time. The initial strong move often happens very quickly; traders need to have a list of stocks that are susceptible to short squeezes and be aware of catalysts (often a breakout of some sort) that could trigger a lot of buying a squeeze.

Since short squeezes can cause big moves in a small amount time, the reward is the profit potential. By shorting after a short squeeze the astute trader can a get a good price to participate in further downside if the downtrend continues.

The Bottom Line

Taking advantage of a short squeeze means short-term traders need to have a list of potential trade candidates, and be ready to pounce if enough buying commences to trigger a buying panic amongst the short sellers. Only act once price confirms your suspicions. If buying, strong buying should already be occurring. If looking to short after a short-term short squeeze, then wait for the buying to cease and selling to resume.

A high short interest doesn’t mean a stock will move higher, nor does it mean it will move lower. Ideally, you want to trade in the direction of the trend, and use short squeezes as a way to get into that trend, whether it is up or down.


Abcd Pattern – What is the AB=CD Pattern & How to Use It

Many traders rely on chart patterns to help them identify trading opportunities. In some cases, chart patterns are combined with technical indicators to produce greater insights.

Harmonic chart patterns were developed by H.M. Gartley in 1932 and popularized in his book, Profits in the Stock Market. Since then, market technicians have improved upon these concepts by incorporating Fibonacci ratios and specific rules. The AB=CD pattern is one of the most popular harmonic chart patterns.

In this article, we will take a look at how to identify the AB=CD chart pattern and use it to identify profitable trades.

Click here to learn about the Day Trading Rules applicable to U.S. investors.

What is the ABCD Pattern?

The AB=CD chart pattern is a reversal pattern that helps you predict when the price is about to change direction. Depending on the orientation, the pattern can be used to predict either a bullish or bearish reversal. It also appears relatively frequently in stock charts, making it particularly useful.

Follow our Education section to learn more about trading strategies.

Let’s take a look at a diagram of the pattern:

AB=CD trading pattern

The AB=CD chart pattern consists of three legs:

  • A-to-B: The A-to-B leg is the initial move higher or lower.
  • B-to-C: The B- to-C leg is a 61.8% Fibonacci retracement of the A-to-B leg.
  • C-to-D: The C-to-D leg is a 127.2% Fibonacci extension of the A-to-B move that should equal to the A-to-B leg in distance.

In some cases, traders may permit the A-to-B leg to be different in length than the C-to-D leg, as long as the retracement and extension fall on Fibonacci levels.

How to Use the Pattern

Buy and sell signals are generated after the final C-to-D leg, when a reversal is expected to occur. If the pattern is trending higher, you can look to sell or enter a short position at Point D. If the pattern is trending lower, you can look to buy the security at Point D in anticipation of a turnaround.

Stop-loss points are best placed just above or below Point D, depending on the direction of the trade. If the move extends beyond that point, the chart pattern is invalidated and the reversal is less likely to occur.

Take-profit points are typically placed using Fibonacci levels. For example, you might look for a move back to the original Point A and move a trailing stop-loss to 28.2%, 50% and 61.8% Fibonacci levels along the way.

As with most forms of technical analysis, the AB=CD chart pattern works best when combined with other technical indicators or chart patterns, such as the relative strength index (RSI) or pivot points. You may also want to use volume as a confirmation of a reversal once the AB=CD chart pattern makes a prediction.

Example of the AB=CD Pattern

Let’s take a look at the AB=CD chart pattern in the widely popular EUR/USD currency pair.

ABCD pattern example

In this example, you can see an initial A-to-B leg, followed by a 61.8% retracement between Points B and C. There was a brief period of consolidation before a move lower reached the 127.2% extension level. The stock again consolidated for a period of time before the start of the anticipated bullish reversal.

There was also some technical confirmation from trend line support a few days ago prior to the original move higher leading up to Point A. The only red flag in this pattern is that there was limited volume following the reversal, but the strong trend line support could be enough technical justification for a buy signal.

The Bottom Line

The AB=CD chart pattern is one of the most popular harmonic patterns developed by H.M. Gartley. Since it appears frequently in practice, traders can use it in conjunction with other forms of technical analysis to improve their odds of success. The key is matching up Fibonacci levels and setting the right stop-loss and take-profit points to manage the trade.


Downtrend – Guide to Stock Downtrends

Downtrends are not as popular as uptrends, as it is uptrends that investors and mutual funds profit from. Yet downtrends are a part of market life, whether liked or not, and learning about downtrends can help you stay out of them, or profit from them. In stock trading, money can be made from being long or being short. When long you profit if the price of a stock rises; when short you profit if the price of a stock falls. While avoiding downtrends will protect your pocket book, participating in downtrends may fatten it. Therefore, traders need to understand downtrends, how they are established, signs they are reversing, and the limitations of charting downtrends.

What Is a Downtrend?

A sustained move lower in a stock’s price could be a downtrend, but it needs to be more accurately defined.

Stock prices move in waves or swings. During a downtrend, the waves lower are larger than the waves high (pullbacks), this allows the price to make progress lower. In a downtrend prices don’t relentlessly drop, instead the price follows a two-steps-lower-one-step-higher type structure.

How Is a Downtrend Established?

Since prices decline via a drop-pullback-drop structure, a downtrend occurs when a stock’s price is making lower-wave-highs and lower-wave-lows. This shows the price is progressing to the downside and establishes the downtrend.

Use stock charts to monitor for such conditions. The low of a major price wave should be below the prior major wave low. Similarly, the high of a major price wave should be below the prior major wave high. When these conditions aren’t met, it is a warning sign that the downtrend is reversing or has already reversed (next section).

Stock Downtrend with Lower Highs
Figure 1. Stock Downtrend with Lower Highs and Lower Lows – General Motors (NYSE:GM). Source: StockCharts.com

Downtrends have varying degrees of strength. Some may move at 45 degrees, some less and others may move almost vertically. A sharp selloff is typically related to news, such as poor quarterly earnings. With a near vertical trend the space between former highs and new highs (and former lows and new lows) can be quite vast.

Steep Downtrend in Netflix
Figure 2. Steep Downtrend in Netflix (Nasdaq:NFLX) Daily Chart. Source: StockCharts.com

Downtrends begin and persist for a number of reasons, including fear and speculation. If traders (cumulatively) believe a stock price will continue to decline, they sell the stock in a self-fulfilling prophecy. Fear of further declines forces many traders and investors to sell their equities. Eventually, prices a reach a level that is viewed as a bargain. Buyers become more aggressive than sellers, and short-sellers cover their short positions (buying), pushing the stock back up. This shift in sentiment converts the downtrend to an uptrend.

The stock market exists to provide capital to corporations; the trend of a stock is therefore linked to the outlook for that corporation. While traders speculate, their decisions to do so are often driven by their outlook for the company, economy, government, and foreign policy. If traders are pessimistic on these factors, they will typically sell stock, resulting in downtrends reflected on the charts.

How Is a Downtrend Reversed?

A price downtrend is composed of lower swing highs and lower swing lows, so when these conditions are not satisfied the trend could be reversing higher.

Trends occur across different time frames though; it may be a downtrend on a 5-minute chart, while an uptrend on the 30-minute chart. Similarly it may be an uptrend on the weekly chart, but a downtrend on the daily chart. Investors typically only look at major price swings on the daily or weekly chart. If the trend is down on these time frames they avoid trading; when the price reverses and becomes an uptrend they re-establish long positions. Shorter-term traders, who don’t mind shorting stocks, can potentially profit from up or down trends across all time frames.

Figure 3 shows a downtrend in AT&T (NYSE:T), which reverses and becomes an uptrend. Initially the price is making lower lows and lower highs; when higher highs and higher lows appear the downtrend is over and an uptrend beginning. When this occurs it is time to exit short positions, and initiate long positions.

See Also: 50 Blogs Every Serious Trader Should Read

Downtrend and Reversal in AT&T
Figure 3. Downtrend and Reversal in AT&T (NYSE:T) Daily Chart. Source: StockCharts.com

Monitoring a downtrend for lower highs and lower lows is a sound method for discerning if the downtrend is intact. Another method is to use trendlines. During a downtrend a trendline connects the swing highs. If the price breaks above the trendline, it is a warning sign that the downtrend is weakening. This doesn’t mean the downtrend is over; the event is just an advance warning that the trend has slowed. Use price action (highs and lows) to confirm trendline breaks and reversals.

In Figure 4 the price breaks above the trendline, this in itself doesn’t prove a reversal has occurred. It does provide an early warning sign though, as the price proceeds to make higher highs and higher lows, confirming the reversal and new uptrend.

See Also: 5 Indicators that Foretold the 2008 Crash

Price Breaks Trendline
Figure 4. Price Breaks Trendline – AT&T (NYSE:T) Daily Chart. Source: StockCharts.com

Charting Downtrends: Limitations

Trend analysis can be subjective – what one person sees another may not. Trends are easy to spot in hindsight, but are more difficult to analyze in real-time. In advance we don’t know if the price will keep making lower highs and lower lows. It is only after the price starts making higher highs and higher lows that we can confirm there was a reversal.

The market also doesn’t move in perfect waves, and can therefore trick us. During a downtrend the price may make a higher high and higher low, indicating the trend is now up, but then proceeds to drop and continue the downtrend.

Some of these false signals, and potential losing trades, are avoided by looking at another time frame. Instead of looking at just one year of price data, look at two or three. You may notice the price wave of concern is not significant from this perspective, and therefore shouldn’t be a major factor in your decision making.

Trends can be profitable while they last, but we can’t predict with great accuracy when they will end.

See Also: 25 Stocks Day Traders Love

The Bottom Line

A downtrend is created by the price making lower swing highs and lower swings lows in price. Downtrends may be steep or shallow, but are still analyzed in the same general way. When the price starts making higher highs and higher lows the downtrend may be over and an uptrend beginning. Trendlines are a visual tool, used in conjunction with price analysis (highs and lows), to confirm trends and anticipate reversals. Trends can be tricky though; easy to spot in hindsight it is difficult to predict when a trend will reverse before it occurs. Traders must remain alert and conscious of changes in price which could affect the direction of the trend.


Trend Trading – Trend Trading 101

Trend trading is arguably the most popular style of trading, since traders are naturally inclined to latch on to existing trends. Between 2000 and 2009, Galen Burghardt showed that there was a “very high” correlation between trend-following commodity trading advisors and the broader index, confirming that it’s the predominant strategy used by technical traders in the markets.

The strategy was popularized among retail traders in the 1980s when Richard Dennis and Bill Eckhardt sought to find out if great traders were born or made. Using advertisements in financial publications, they recruited a small group of traders that became collectively known as the Turtle Traders, gave them a basic trend trading strategy, and watched them generate more than $100 million in profit.

In this article, we’ll take a look at trend trading concepts, how they are applied to the markets, and some strategies for investors to consider using.

Defining a Trend

Trends are typically thought of as a statistical regression that points in a particular direction. For example, stock prices may vary widely on a daily basis but a statistical regression of closing prices over a month might yield an upward sloping regression that would suggest a bullish long-term sentiment. These trends are useful because they help filter out the short-term noise in favor of more reliable long-term signals.

Raff Regression Channel
Figure 1 – Raff Regression Channel – Source: StockCharts.com

In the financial markets, technical analysts use a combination of tools to measure trends over time rather than relying strictly on statistical regressions. Trend lines are often drawn directly onto stock charts to show levels of potential support or resistance, technical indicators use mathematical principles to calculate things like trend strength, and a number of other indicators can be used to confirm trends.

Most trend traders also use multiple time frame analysis to ensure they are trading with long-term and short-term trends. For example, looking at a 3-month chart might show a bullish picture, but the long-term 5-year chart could show a dramatic bearish picture. Trend traders should be mindful of both long-term and short-term trends in order to ensure they are on the correct side of the trade.

Identifying Trends

Technical analysts use a number of techniques to identify and validate both short-term and long-term trends, as well as predict potential reversals or changes in the trends. Trend traders usually try to latch on to existing trends, while contrarians try to identify near-term reversals to generate profits. Trend trading should also be familiar with reversal patterns in order to know when to sell their positions.

Moving Averages

Moving averages simply average past prices from a certain point in time and overlays that point on a chart. By removing day-to-day volatility, moving averages make it easier for traders to identify long-term trends. The actual price’s location relative to the moving average can also provide insight into whether an equity is currently above or below its recent averages.

A popular trend trading strategy known as moving average crossovers generates buy/sell signals based on one moving average crossing above or below another moving average, signaling a change in trend. For example, a short-term 20-day moving average crossing above a long-term 100-day moving average might be considered a signal to buy and vice versa for a sell signal.

Moving Average Crossover Strategy
Figure 2 – Moving Average Crossover Strategy – Source: StockCharts.com

Moving Average Convergence/Divergence

Moving average convergence/divergence (“MACD”) is a popular technical indicator that turns two moving averages into a momentum oscillator by subtracting the larger moving average from the smaller. By taking this approach, the technical indicator provides trend traders with insights into both trend direction and momentum, which is important for determining entry and exit points.

Trend traders often watch for crossovers and divergences for signals. When the shorter average diverges further from the longer average, momentum is considered to be increasing and vice versa for decreasing momentum. Trend traders also watch for divergences between MACD trends and price trends as a sign of a potential upcoming reversal and end of the current trend.

MACD Trading Strategy
Figure 3 – MACD Trading Strategy – Source: StockCharts.com

Relative Strength Index

The relative strength index (“RSI”) is commonly used to measure the strength of a price trend by comparing days with a higher close with days with a lower close. By subtracting 100 from 100 divided by one plus the average number of up closes divided by the average number of down closes, the RSI generates a value that usually oscillates between 30 and 70 for the typical 14-day period.

In general, readings above 70 suggest that a stock is overbought, while a reading below 30 suggests that a stock is oversold. Trend traders may want to consider exiting long positions when the RSI rises above 70 for a prolonged period, while exiting short positions when the RSI falls below 30 for a prolonged period. However, RSI should always be considered in the context of other technical indicators.

RSI Trend Indicators
Figure 4 – RSI Trend Indicators – Source: StockCharts.com

Benefits and Drawbacks

Trend trading may be the most common form of trading, but that doesn’t mean that there aren’t significant risks involved. Trend traders should be aware of all of the risks and rewards before implementing a strategy of their own. In addition, it’s also advisable to back-test a strategy on paper before implementing it with real money using any number of different tools available online.

Benefits of trend trading include:

  • Statistical Support – Trend traders are focused on making high-probability investments using statistical tools to confirm their trades.
  • Long Holding Periods – Many trend traders hold positions longer than other strategies, which reduces churn rates and commission costs.
  • Money Management – Money management strategies for trend trends are often relatively straightforward compared to other strategies.

Risks of trend trading include:

  • Uncertainty – Financial professionals always warn that past performance does not guarantee future price performance.
  • Selectiveness – Strong price trends are difficult to find and require screening hundreds or thousands of stocks to find the best opportunities.
  • Sub-Optimal Price – Trend trading often involves buying well above 52-week lows, unlike many contrarian strategies, which can be uncomfortable.

The Bottom Line

Trend trading is the most popular trading strategy used in the financial markets and it involves identifying long-term tendencies either higher or lower. Using tools like moving averages, MACD, and RSI, trend traders can identify trends, determine their strength, and identify potential areas of reversals. These strategies usually involve longer holding periods and more certainty, but at the end of the day, they aren’t a guarantee.


Futures Quotes – Futures Quotes: An Introduction

Futures contracts obligate buyers to purchase and sellers to sell an asset at a predetermined future date and price. For example, a farmer might sell corn futures in order to lock-in a price for his or her crop and a trader might buy those contracts in order to speculate on a rise in corn prices without buying large amounts of corn, which would require storage and a host of other upfront capital costs.

In this article, we’ll take a look at where traders can find futures quotes, how to read the quotes, and some other information that traders may find valuable.

Finding Futures Quotes

Futures are traded on a number of different exchanges in the U.S. and around the world, including the New York Mercantile Exchange (“NYMEX”) for energy, the Chicago Mercantile Exchange (“CME”) for metals, and the Chicago Board of Trade (“CBOT”) for grains. Futures quotes from these exchanges are available on a number of different financial websites and futures brokerage platforms.

Some popular financial websites for futures quotes include:

  • Finviz – Provides current, open, high, low, and close data for all major futures contracts, as well as relative performance measurements and charts showing pricing trends over a longer period of time.
  • TradingCharts – Provides comprehensive futures quotes broken down by contract months with volumes, option interests, and last-trade data for more granular insights than other sources.
  • CME Group – Provides futures quotes for all of the contracts trading on its exchange and others, while also permitting downloadable data formats that can be useful for automated analysis in Microsoft Excel.

In general, futures traders should look to their brokerage platforms as a primary source of quotations since they usually provide greater depth of data. Platforms like Finviz, TradingCharts, and CME Group can provide ancillary data, such as options contracts on those futures and relative performance comparisons to quickly identify what commodity groups are performing the best over a period of time.

Reading Futures Quotes

Futures quotes, like the one in Figure 1 below, are similar to equity and options quotes in that they contain the current price, OHLC prices, and volume. But in addition to these metrics, futures quotes also contain unique elements like settlement dates, lifetime highs, and lifetime lows, although the way that futures quotes are reported often differ between service providers.

Corn Futures Example
Figure 1 – U.S. CFTC Corn Futures Example – Source: CFTC

Here’s a breakdown of the uncommon elements in Figure 1 above:

  • Month – Futures contracts are classified by their delivery month, which simply represents the month that physical deliver occurs. While most traders never take physical delivery of commodity futures, the months are important to consider since they impact volatility and valuation.
  • Settlement – Futures trading is often busiest in the last few minutes of the day with many trades occurring simultaneously, so exchanges compute the settlement price based on these figures. Clearing houses use the settlement price to calculate the market value of outstanding positions. Notably, the settlement price can differ from the closing price in some cases.
  • Lifetime – Futures contracts have a limited life, unlike equities, which makes their lifetime highs and lows important to consider. These values are simply the highest and lowest prices recorded for each contract maturity from the first day that it traded until the present day and time.
  • Open Interest – Open interest is similar to shares outstanding in a traditional equity in that it signifies the number of contracts outstanding. These metrics are important when considering the futures contract’s liquidity, particularly if the trader doesn’t plan on holding the contract to near expiration.

Of course, futures quotes will also differ significantly depending on the type of futures market in question. Financial futures, such as currencies, as well as stock index futures will look very different than commodity futures like the quote above. These futures quotes will have fewer moving parts in many cases, since they might not involve complex settlements or relevant open interest measurements.

CME Futures Quotes
Figure 2 – CME Futures Quotes – Source: CME Group

Futures Quote Abnormalities

Futures prices themselves are typically governed by arbitrage methodologies, since the forward price represents the expected future value discounted at the risk-free rate in markets with ample supply. Of course, some commodity markets have limited supply, which means they are more driven by supply versus demand and have greater volatility than would otherwise be expected.

Contango and Backwardation
Figure 3 – Contango and Backwardation

In some cases, far futures quotes can be higher or lower than the nearer future quotes in what’s known as contango or backwardation (Figure 3). In cases of contango, when the futures quote is higher than the spot price, buyers are willing to pay more for a commodity at some point in the future than the actual expected price due to the carry or storage costs exceeding the value of owning the asset itself.

These dynamics can make the futures markets a bit more complex than equity or even options markets. While futures quotes may not make sense on the surface, the dynamics often become apparent when taking a closer look at the market’s dynamics. For example, corn prices that are expected to fall due to new government regulations could make futures prices trade well below their spot price.

The Bottom Line

Futures provide traders with a great way to speculate on the future price of a commodity, currency, equity index, or other asset. Traders can find futures quotes in a number of different places, including financial websites and brokerage platforms, although brokerage platforms usually provide the most comprehensive data. Finally, traders should keep in mind the strange dynamics that can occur in futures markets.


Technical Analysis For Beginners – Technical Analysis: A Beginner’s Guide

“The illusion of randomness gradually disappears as the skill in chart reading improves.” – John Murphy.

Technical analysis involves the use of patterns and statistics to discern optimal prices and times to buy and sell securities. From chart patterns to technical indicators, there are many different ways that these patterns and statistics can manifest themselves. The common theme is that past performance can be used to predict future performance to a reasonable degree of accuracy. In this article, we’ll take a look at some common types of technical analysis and how traders can employ them to enhance their risk-adjusted returns.

Psychology of Candlesticks

Candlestick charts can provide tremendous insight into the psychology underlying the market in a particular security. For example, Figure 1 shows a doji star pattern that is indicative of a near-term reversal in price. The narrow daily price range and even closing price signals that the market is unsure of future direction, which means that the security may be ready for a move in the opposite direction.

Doji Star Candlestick Reversal
Figure 1 – Doji Star Candlestick Reversal – Source: StockCharts.com

There are many different candlestick patterns that are commonly used by market technicians, including bullish/bearish engulfings, long/short shadows, spinning tops, hammers, and several others. Each pattern has a specific meaning that’s backed by market psychology, which traders can use to predict likely future price movements and ultimately increase their risk-adjusted returns.

Here are some tips to keep in mind when using candlesticks:

  • Look at the Past: Candlestick charts provide insights into market psychology, but should always be analyzed in the context of larger bigger picture trends occurring in the prior candlesticks.
  • Seek Confirmation: Candlestick patterns can be somewhat unreliable as a sole indicator, which means that traders should look for confirmations in chart patterns and other types of technical analysis.

Reading Chart Patterns

Candlestick charts are great for interpreting near-term price action, but traders looking for longer-term swing trades may need to look at the bigger picture. Multiple days, weeks, or months of price patterns can provide additional insights into long-term price trends and areas of support or resistance. For example, Figure 2 shows an ascending triangle pattern that led up to a breakout.

Technical Breakout Pattern
Figure 2 – Technical Breakout Pattern – Source: StockCharts.com

There are many different types of chart patterns that traders use in order to identify areas of support, resistance, breakout, or breakdown potential, including ascending triangles, price channels, rising/falling wedges, flags, and many more. Each chart pattern has a specific implication of what may happen in the future, which traders can leverage in order to improve their risk-adjusted returns [see also Moving Average Trading Strategies: Do They Work?].

Here are some tips to keep in mind when reading chart patterns:

  • Multiple Timeframes: Traders should look at multiple timeframes (e.g. daily, weekly, monthly, and yearly) in order to determine the overall trend and ensure that they are staying on the right side of the trade.
  • Watch False Breakouts: Chart patterns may predict a breakout that materializes, but traders shouldn’t let their guard down, since false breakouts can also occur and generate losses.

Using Statistical Indicators

Traders often use technical indicators as a confirmation or gauge of a trade’s strength. For example, Figure 3 shows a stock that’s rebounding from a trend line support, but the technical indicators suggest that a breakdown remains a good possibility. A trader may analyze the situation and decide that the trade is too risky given the weak technical indicators even if the chart pattern looks promising.

Bad Technical Indicators
Figure 3 – Bad Technical Indicators – Source: StockCharts.com

There are many different types of statistical indicators available for traders to use to determine everything from trend strength to reversal potential, including relative strength indexes, moving averages, moving average convergence and divergence, and stochastics. Each of these technical indicators has a specific purpose and can even be used in the context of a trading system to generate buy and sell signals.

Here are some tips to keep in mind when using statistical indicators:

  • Consider Context: Technical indicators should never be used without putting them into context by looking at the bigger picture, including chart patterns, candlestick patterns, or even other technical indicators.
  • Get a Feel for It: Some technical indicators are rather esoteric, requiring traders to develop a feel for them before using them, which means that traders should paper trade these strategies before taking the plunge.

Online Resources

There are many different online resources available for market technicians looking to analyze securities. While many brokerage platforms offer comprehensive solutions, several websites provide automated technical trading ideas and platforms designed to enable easier sharing with peers for free. Traders should consider using both of these types of resources when analyzing securities.

Some popular websites include:

  • StockCharts.com: Free stock charts with a variety of different technical indicators, chart patterns, and chart types.
  • Finviz.com: Free resource for breakouts, breakdowns, and chart patterns that are automatically derived every trading day.
  • StockTA.com: Free resource for traders looking for chart pattern analysis and other technical indicators updated on a daily basis.
  • StockTwits.com: Free community of active traders and source of trading ideas and due diligence for any level of trader.

The Bottom Line

Technical analysis provides a great way for traders to objectively consider where a security’s price may be headed in the future based on its past performance. While these insights are never 100% reliable, they can help when determining when and at what price a trade could be made in order to optimize risk-adjusted returns. Multiple types of technical analysis should be used when developing a trade idea.

For example, a complete technical trade might involve a trader looking at a security’s price chart and seeing a durable uptrend across multiple timeframes. Upon further analysis, the trader may find an ascending triangle pattern showing a key breakout point that’s confirmed with technical indicators. The final buying decision may come after a bullish engulfing occurs in the candlestick chart.

In the end, technical analysis provides tools to help improve risk-adjusted returns, but it should be just one tool in a trader’s diverse toolbox.


– Do You Know Your Trading Order Types? A Foolproof Guide

Imagine losing more than $660,000 in less than 30 seconds! In January 2014, a professional trader managed to do exactly that in HSBC’s stock by having a “fat finger” and failing to place an upper price limit on his or her trade. In that case, the trader could have likely avoided the loses by placing a limit order instead of a market order, thereby establishing a ceiling price on the trade.

The boom in online brokers beginning in the 1990s opened the doors for individual traders, but with great power comes great responsibility, and traders should take the time to learn the basics. If professional traders make mistakes like these, individual traders are far from immune to potential disaster. Placing the wrong type of trade can lead to immediate losses and instant regret.

In this article, we’ll take a look at various order types available to traders using online brokers, as well as some key things to watch out for when placing trades.

Order Types

What Is a Market Order?

Market orders are the most basic order type and simply execute an entire trade at prevailing market prices. Specifically, a market order will go through a security’s order book and execute the trade at the ask prices available. For example, a trader buying 1,000 shares of Microsoft Corporation’s stock might pay $25.32 for the first 500 shares and $25.34 for the next 500 shares, based on the ask prices.

The problem with market orders is that the security’s quote may not accurately reflect the prevailing market price. Since quotes are based on the last successful trade, rather than the ask prices at any given time, traders may end up being quite a bit more or less than the security’s quoted price in what’s called slippage. This occurs most often in illiquid stocks, such as micro-cap, small-cap, or ADR securities.

What is a Limit Order?

Limit orders are arguably the most common order type and work by simply executing a trade only at a certain price. When a trader places a limit order at, say $10.00, they will only pay $10.00 per share for that security. Many traders use limit orders in order to reduce the risks associated with slippage, which was described above as one of the key problems associated with market orders.

The problem with limit orders stems from the availability of shares in the order book. If a trader places an order for 1,000 shares at $10.00 per share and there are only 500 shares available at that price, the trader may either receive a partial fill on the order (e.g. a 500 share purchase) or a failure to fill any shares at all, based on what they prefer when setting up the limit order.

Order Attributes

Trader looking at a screen

What Is a Stop Order?

Stop orders are market (stop orders) or limit orders (stop limit orders) that are only processed if the market reaches a specific price. For example, a stop order to sell (stop loss) set at $10.00 for a stock trading at $15.00 would process a market order to sell when the stock price reached $10.00 per share. These types of trades are commonly used to limit risks by setting a price floor.

What Is a Trailing Stop?

Trailing stop orders are a type of stop loss order that is set at a defined percentage or dollar amount away from a stock’s current market price. For example, a trader may set a 10% trailing stop loss on a position trading at $10.00 per share. If the stock moved to $20.00, the trader would still own the shares, but if it dropped below $9.00 before moving to $20.00, a sell order would have been placed.

What Are Conditional Orders?

Conditional orders enable traders to submit or cancel orders if certain criteria are met, which are defined by the trader when entering the order. For example, a trader looking at a breakout opportunity for a stock trading at $10.00 per share may only want to buy if a stock surpasses a certain trend line at $15.00 per share. A conditional order would enable a limit order to be placed at $16.00.

What Are GTC Orders?

Traders can either enter day orders that are automatically canceled at the end of the day or good ‘til canceled (“GTC”) orders that exist for 180 calendar days after they are placed or until executed. Often times, traders will place GTC orders when they are looking to automatically make trades that could take several days or weeks to reach the desirable price, removing the need to remember to check daily [see also 3 Ways To Exit A Profitable Trade].

What Are AON Orders?

As mentioned above, a key concern with limit orders are partial fills that create uncertainty. All-or-none (“AON”) orders ensure that the entire amount of an order is executable before making a trade at the limit price. Traders often use AON orders to avoid partial fills and the complications that arise with them, including a non-desirable number of shares or a high number of transactions.

The Bottom Line

Traders should be intimately familiar with the various types of orders before executing trades in order to avoid potentially catastrophic losses. In general, traders should use limit orders with the proper attributes in order to ensure that they are getting the prices and quantities that they were planning, but one size does not fit all and traders should consider their individual situations before deciding.

  • Market orders are ideal when a trader needs to immediately buy or sell securities, although the amount they pay or receive may be vary.
  • Limit orders are ideal when a trader wants to ensure they are getting specific prices for their securities, although they may have to wait awhile for it.
  • The two basic order types can be combined with a number of order attributes in order to achieve specific goals.


Lagging Economic Indicators – Economic Indicator Types: Leading vs. Lagging vs. Coincident

The economy affects us all, from the availability of jobs to how much bread and milk cost. Economic indicators help us assess how the economy is doing right now, how it could be doing in the future, as well as how it has done in the past. By understanding how economic indicators work you can monitor them yourself when they are released, forming your own opinion about the markets and the economy, as well as spot errors in others analysis, such as using a lagging indicator to predict the stock market.

Economic Indicators 101

The economy goes through four broad cycles: expansion, peak, contraction and trough. During the expansion and peak there are lots of jobs and most people are happy with how things are going. During the contraction and trough phases things get tougher, but the bright side is that the whole cycle then starts again.

Be sure to read A Trader’s Guide to Understanding Business Cycles

Where we are in the economic cycle affects everyone; it affects how much food costs, how much money is floating around and even your job security. This is why economic indicators matter, because they tell us where in the cycle we are, in which direction we are moving, and when we may (or are) entering the next phase.

This is accomplished through three types of economic indicators: leading, lagging and coincident, each discussed below.

Most analysts and traders don’t focus on the specific number from an economic indicator, but rather look for trends in the data over several releases. They watch for overall rises and falls, for example in Unemployment, to determine the health of the work force and economy.

Economic indicator data is released at recurring scheduled times, and can be viewed on an Economic Calendar, like this one available from Bloomberg.

Leading Economic Indicators

Leading economic indicators help us assess where the economy is headed. They foreshadow what is coming, such as moving from a peak phase into a contraction, before it actually happens.

One of the most significant leading indicators is the stock market itself, gauged by an index such as the S&P 500. It will begin to rise before economic conditions seems favorable, and it will be begin to decline before economic conditions seem to warrant it.

Building Permits are a leading economic indicator, since an increase in Building Permits also typically entails an increase in workforce and robust demand for houses. Houses cost money, and money isn’t available during dire times.

It is possible that Building Permits can increase, but there isn’t enough demand to buy all the homes. When this occurs housing prices are typically pushed down and will have a dampening effect on the whole economy.

Figures 1 and 2 below show Building Permits and the S&P 500. Building Permits were already starting to rise at the start of 2009, while the S&P 500 started to rise a couple months after. Remember though, Building Permits are a not a leading indicator of the stock market, they are a leading indicator for the economy. This is why both Building Permits and the S&P 500 turned higher while many analysts still thought the world was ending, and continued to trend higher as conditions improved.

See also 5 Indicators that Foretold the 2008 Crash

All charts provided by TradingEconomics.com

Building Permits 2009 - August, 2014
Figure 1. Building Permits 2009 – August, 2014
S&P 500 2009 - August, 2014
Figure 2. S&P 500 2009 – August, 2014

Another important leading indicator is interest rates. Low interests stimulate borrowing and buying, which favors the economy. An increase in interest rates shows the economy is doing well, but eventually rising interest rates lead to a slow down because less people borrow money to start new projects.

Interest rates can also be considered a lagging indicator, since interest rate adjustments come after economic forces demand them. Since interest rates tend to trend for long periods of time, changes potentially have a predictive quality.

Leading indicators help assess the outlook for the economy, but analysis of them is subjective. Building permits, and other leading indicators, such as the S&P 500, don’t move in a straight line. This means the outlook isn’t always clear, and is subject to interpretation.

Lagging Economic Indicators

Lagging economic indicators reveal past information about the economy, or the data takes so long to compile and release that it doesn’t reflect what is happening now, just what was happening months ago.

Gross Domestic Product (GDP) is how much a country is producing. It is released on a quarterly basis and data is released initially a month after the end of the quarter, and then revised another two months after that. There is significant lag time between when the data is compiled and when it is released, yet is a still an important indicator. Many consider a recession to be underway if two quarters see back-to-back declining GDP.

Instead of looking at the actual GDP number, many analysts and traders prefer to look at the percentage growth rate. For established economies this is usually fairly stable, with the economy growing between 2% and 5% as shown in Figure 3 for the U.S.. A drop below this, and especially below 0% growth, shows the economy weakened, while a rise above the range shows strong growth.

GDP Percent Changes 2009 - August, 2014
Figure 3. GDP Percent Changes 2009 – August, 2014

Note how GDP did not see positive growth (above 0%) until well into 2009/ 2010, while Building Permits and the S&P 500, which are leading indicators (figures 1 and 2), saw a rise much earlier in 2009.

GDP can be biased by government intervention, such as stimulus packages. Also, like other indicators, it will move up and down, making analysis subjective.

Other indicators, such as the Consumer Price Index (CPI), are also sometimes considered lagging indicators, since they reveal information that is already known to most consumers (they experience price increases or decreases before the CPI tells them prices are going up or down). Since this inflation data is generally released in a timely fashion though, and reflects a recent or current state of affairs, this and other indicators are covered under the Coincident Economic Indicators below.

Coincident Economic Indicators

Coincident economic indicators tell us where we are in the economic cycle, as well as information about the strength or weakness of the economy right now.

Non-farm payroll employees is one of the most followed economic indicators and has a big impact on financial markets because it provides data on the health of the job market (non-agricultural), which affects everything in the economy. Related to this is the unemployment rate. A declining unemployment rate shows demand for employees, and indicates the economy is in good shape. Rising unemployment means people are losing jobs and it will be harder to find work; as you may suspect, this is not good for the economy.

See also 10 Market Indicators Every Trader Watches

Employment Rate (%) 2009 - August, 2014
Figure 4. Employment Rate (%) 2009 – August, 2014

Figure 4 shows the unemployment rate increasing until the start of the 2010. Since unemployment tells us about the current state of the economy, we can see how the other indicators acted in relation to it. Mainly, the leading indicators (Figures 1 and 2) turned higher well before the unemployment rate turned lower.

Producer Price Index (PPI) and Consumer Price Index track price changes at the wholesale and retail level, respectively. The Inflation rate tracks similar data, but in month-over-month percentage terms. Slightly rising prices are a good thing, as it shows money is flowing freely in the economy. Falling prices are generally a poor sign for the economy as there is little demand for goods.

All coincident indicators are best analyzed in terms of overall trend, as fluctuations are common from month to month. Trying to interpret each data release on its own and out of context will likely lead to an improper assessment of current conditions.

The Bottom Line

Economic indicators are a useful but imperfect tool for seeing there the economy has been, where it is, and where it’s going. Economic indicators are subject to interpretation, and conflicting data from one release to the next is common. It is therefore best to look at overall trends in data, as well as assessing all three economic indicator classes: leading, lagging and coincident. By following a couple of indicators in each class, investors are more likely to be able to get a read of overall conditions.

The stock market itself is one of the most powerful leading indicators we have, which means applying economic data to try to predict it is often fruitless; instead, use the stock market to predict where the economic cycle is headed.

To familiarize yourself with economic indicators, scroll through and continually monitor an economic calendar. Events marked in red are typically high impact, and deserve close attention; yellow events have less of an impact, but still deserve attention.


Scalping Strategies – Getting Started with Points and Figures Charting

Point and Figure charts aren’t your typical stock chart; they are useful, easy to interpret, and can quickly be used to track and analyze asset prices. For these reasons, many traders and investors would benefit from using P&F charts. Point and Figure charts were more popular before computers, because P&F charts could (and still can) be quickly plotted by hand. These charts have been used since the late 1800s, although one of the most popular methods for using them was developed by A. W. Cohen in the mid 1900s.

What Is Unique About P&F Charts?

A point and figure chart will look very different from other types of charts for several reasons.

The first difference is that price moves are marked with X’s and O’s. An X marks a rising price, while an O represents a falling price.

The price must also move a set amount (called “box size”) before an X or O can be drawn. This means insignificant price moves are ignored. Because of this, it’s possible that traders will get fewer false breakouts, and will be able to more clearly see support and resistance areas.

Time is not considered in a P&F chart, only how the price is moving. Unless a price move occurs that matches or exceeds the box size, the chart is not updated.

See also How to Read Stock Charts: 10 Things Every Trader Should Know

Figure 1 shows a common candlestick chart, while Figure 2 shows the stock, over the same period, using a Point and Figure charting technique.

All charts courtesy of StockCharts.com

APPL Candlestick Chart, Two Year Daily Chart
Figure 1. APPL Candlestick Chart, Two Year Daily Chart

StockCharts.com includes a number of additional features in the P&F charts, which you’ll notice in figure 2 below. To give an approximation of time, January through September have been given the labels of 1 to 9 and October through December labelled A to C

Trendlines are also included, these will be discussed shortly.

APPL Point and Figure Chart, Two Year Daily Chart
Figure 2. APPL Point and Figure Chart, Two Year Daily Chart

How Are P&F Charts Made?

In order to construct a P&F chart, a box size must be established. The box size chosen should be at least partially determined by the price of the stock. Beyond this, the trader can choose any size they like; more price data is filtered out with a larger box size, while less data is filtered out with a smaller box size.

For a stock in the $30 to $100 range the box size may be $1, and the box size can always be increased as the stock rises by simply changing the scale on the right (change the Box Size on StockCharts).

For a $10 stock the box size may be $0.25 or $0.50. Only when the price moves by that amount is an X or O marked.

Referring to figure 2, note how each column is only composed of X’s or only composed of O’s. A new column starts when the price stops moving in the current direction, and moves in the opposite direction.

Also note how every column has at least three X’s or three O’s. This is the method developed by A. W. Cohen, called the 3-box reversal. In order to start a new column, and indicate a shift in direction, the price must reverse three box sizes. When this occurs the new column will drawn with three boxes (X’s or O’S) to reflect the price change. This is why every column will have at least three symbols.

See also Trend Reversals: How To Spot and How To Trade

For example, assume stock ZYZYZ has fallen from $50 to $45. This creates a column of five O’s moving down to $45, using a $1 box size. The price stops falling and moves up to $48. This is a three box-size reversal, so three X’s are plotted moving up to $48.

If the price only reaches $47 on the rally, we wait. Either the price eventually reaches $48 and we create our X column with three X’s, or we wait until it does before making an entry.

How Do You Read a P&F Chart?

Just like candlestick charts or other charting methods, Point and Figure Charts have their own patterns, forms of analysis and trade signals.

Support and resistance are levels the price has had a hard time getting through. When two or more X columns reach the same spot but can’t proceed higher, that is a resistance level. When two or more O columns reach the same spot but can’t proceed lower, that is a support level.

A buy signal is generated when an X column exceeds a prior X column by one box. A sell signal is generated when an O column exceeds a prior O column by one box. Knowing that prices can move in a choppy fashion, traders are encouraged to use other analysis techniques to filter out some of these signals, and not follow them blindly.

Figure 2 also shows trendlines; bearish trendlines in red and bullish trendlines in blue. A bullish trendline is created following a buy signal (see above), starting at a significant low (O column). Unlike trendlines on traditional charts, P&F trendlines don’t connect high or low points, but rather simply angle out at 45 degrees for an uptrend, or 135 degrees for a downtrend.

Even P&F charts, which filter out a lot of insignificant price movements, can get cluttered looking and hard to interpret. Trendlines can help pick out the dominant trend and keep you trading in the right direction. Just like traditional charts, uptrends are created by higher price highs and higher price lows. Downtrends are created by lower swing lows and lower swing highs. These guidelines still apply to P&F charts; during a downtrend, O columns should be making lower lows than prior O columns and the X columns (pullbacks) should be making lower highs than prior X columns.

The Bottom Line

Point and Figure charts filter out a lot of insignificant price movements, making trends and support and resistance levels easier to spot for some traders. These charts are a viable alternative for many investors who aren’t worried about minor fluctuations in stock price. P&F charts don’t have a time element, which means money can be tied up in a stock waiting for it to makes it move. The annotations StockCharts uses for labeling months help give some concept of time on the charts. There are many ways to apply P&F charting techniques, which include analysis and trade signals. The best thing you can do is play around with P&F charts, and study them, to see if they can help you with your trading.


Triple Doji Pattern – How to Trade Tops and Bottoms

Trends can persist for longer than most people anticipate, which is why attempting to spot and trade based on where a trend will end—tops and bottoms—is often met with this skepticism. Being able to isolate potential tops and bottoms has its advantages though. Trading tops and bottoms doesn’t mean “catching a falling knife.” On the contrary, top and bottom traders rely on evidence that suggests a top or bottom has already formed; this is different than assuming a top or bottom has formed.

Like any strategy, trading tops and bottoms has risks. Trades are in the opposite direction of the former trend, a trend that could re-emerge at any time. As long as risk is controlled, this downside is outweighed—with a proper strategy—by the profit potential of getting into a new trend early.

Be sure to read Trend Reversals: How to Spot and How to Trade.

Top and Bottom Chart Patterns

Certain chart patterns provide evidence a trend reversal is potentially underway. These patterns include double/triple tops and bottoms, head and shoulders, inverse head and shoulders and the cup and handle (like a rounded top/bottom yet more tradable).

Double and triple tops are formed when the price halts, and reverses, at the same price area two or three times during an uptrend. It shows momentum has stalled, as the price is no longer able to make “higher highs,” and could only muster a similar high to the last rally.

A double and triple bottom occurs during a downtrend, when the price falls to the same area two or three times, but fails to advance below that area. It shows the downtrend is losing steam.

double top chart pattern
Figure 1. Double Top with Traditional Short-Sell Entry

The traditional way to trade this pattern is to sell short when the price falls below the retracement lows between the double/triple tops, or buy when the price rallies above the retracement highs between the double/triple bottoms.

See also The Visual Guide to Bullish Reversal Patterns.

triple bottom chart pattern
Figure 2. Triple/Multiple Bottom with Traditional Long Entry

The head and shoulders and inverse head and shoulders also show a slowing of the trend. The head and shoulders is formed during an uptrend, when the price makes a higher high followed by a lower high.

An inverse head and shoulders is formed during a downtrend when the price makes a lower low followed by a higher low. This creates three points simulating the appearance of a shoulder, a head and another shoulder.

head and shoulders chart pattern
Figure 3. Head and Shoulders with Traditional Short Entry

The traditional way to trade this pattern is to sell short when the price falls below the retracement lows within the pattern, or buy when the price rallies above the retracement highs in an inverse head and shoulders pattern. Often the lows and highs within the pattern can be connected, forming a trendline called the neckline. An entry can also be taken when the price moves through the neckline.

See also The Visual Guide to Bearish Reversal Patterns.

inverse head and shoulders chart pattern
Figure 4. Inverse Head and Shoulders with Traditional Long Entry

The cup and handle is another reversal pattern. In the stock market, the bottoming pattern is much more common than a cup and handle topping pattern.

The pattern is formed by a decline that slowly tapers off, forming a rounded bottom. The price then rallies to where a section of the decline started, pauses or pulls back (forming a handle) and then proceeds to advance higher again.

A long trade is taken after the price breaks above the handle of the formation.

cup and handle chart pattern
Figure 5. Cup and Handle Bottom with Long Entry

Chart patterns provide evidence there’s potential for a reversal. Since chart patterns have their own trade signals, by the time the signal occurs it’s quite likely the reversal is underway and a top or bottom is in place.

Candlestick Reversals

Candlesticks are also used to provide evidence that a reversal may be occurring. Candlestick patterns occur over one or two time periods (days, on a daily chart), which means they get a trader into a reversal quicker than a chart pattern. Candlesticks are more prone to false signals though, since one or two days of reversal evidence isn’t as powerful as a chart pattern that shows a reversal forming over multiple days/weeks.

See also our Visual Guide to 8 Candlestick Patterns Every Trader Must Know.

There are two major candlestick reversal patterns: the kicker and the engulfing pattern.

Kicker patterns are rare, showing a very strong shift in momentum from one day to the next.

Bearish and Bullish Kicker Patterns
Figure 6. Bearish and Bullish Kicker Patterns

A bullish kicker occurs during a downtrend. The first candle in the pattern is a strong down bar (close below open), but the next day opens at above the prior day’s open, and continues to advance strongly. The close of the kicker candle is near the high of the day.

A bearish kicker occurs during an uptrend. The first candle in the pattern is a strong up bar (close above open), but the next day opens at below the prior day’s open, and continues to sell-off throughout the day. The close of the kicker candle is near the low of the day.

Trades are taken near the close of the kicker pattern, or near the following open, since the momentum often continues.

bearish kicker pattern
Figure 7. Bearish Kick Pattern with Short-Sell Entry

Engulfing patterns also show a strong shift in momentum, but are more common and aren’t as powerful as the kicker pattern.

A bullish engulfing candle occurs during a downtrend. The prior candle is strong down (close lower than open) but the following day the price opens at below the prior close and rallies to close above the prior open.

bullish engulfing candlestick pattern
Figure 8. Bullish Engulfing Candle with Long Entry

A bearish engulfing candle occurs during an uptrend. The prior candle is strong up (close higher than open) but the following day the price opens at above the prior close and falls to close below the prior open.

An entry is taken at the close of the engulfing candle (or as soon as it is visible in real-time on a chart) or near the next open.

bearish engulfing candlestick pattern
Figure 9. Bearish Engulfing Candle with Short Entry

Indicators at Tops and Bottoms

Indicators are also used to isolate top and bottoms. The MACD and RSI are two indicators commonly used. An indicator will almost always signal a reversal; the downside is that indicators often signal reversals that don’t actually occur.

The MACD is composed of two lines. When both lines are below zero (downtrend) and the MACD line (black) moves above the signal line (red) it indicates a bottom may be in place, and is a buy signal. The MACD line moving above zero (0) from below is also bullish.

When both lines of the MACD indicator are above zero (uptrend) and the MACD line moves below the signal line it indicates a top may be in place, and is a sell signal. The MACD line dropping below zero (0) from above is also bearish.

MACD top and bottoms
Figure 10. MACD Top and Bottom Buy and Sell Signals

The RSI is a single line indicator also used to isolate potential tops and bottoms. When the RSI moves below 30 the associated stock is considered oversold, and when the RSI moves above 70 the associated stock is overbought. During strong trends (down or up) these levels are reached frequently, and while this method may pick many market tops and bottoms, it’s prone to signaling reversals that don’t occur.

A buy signal, and potential bottom, occurs when the RSI moves below 30 and then rallies back above it.

A sell signal, and potential top, occurs when the RSI moves above 70 and then drops back below it.

rsi indicator top and bottom
Figure 11. RSI Top and Bottom Buy and Sell Signals

Use either the MACD or the RSI (or another indicator) based on preference. Using both isn’t required and provides little additional insight.

Putting It Together

While each method—chart patterns, candlestick patterns and indicators—could be used in isolation, they are also used together.

Until all three methods indicate a reversal higher, after a downtrend, avoid going long. Only when all align is the buy initiated. Same for an uptrend. Wait for all the methods to align before entering short. The last signal to occur is the one that initiates the trade.

Be sure to see our list of the Best Investments of All Time.

Figure 12 shows a downtrend, followed by a move higher in which all three reversal signals are present.

picking stock market bottoms
Figure 12. Bottom Confirmed by Three Signals

The same concept applies to isolating and trading a top.

picking stock market top
Figure 13. Top Confirmed by Three Signals

The Bottom Line

Isolating a top or bottom isn’t arbitrary or random. Traders who trade them compile evidence to suggest a reversal may occur. The price has already started to reverse course before a trade initiated. Using multiple signals help confirm a reversal, although even with all the signals aligning the former trend could still re-emerge, resulting in a loss. No matter what method is traded, control risk with a stop loss order, and consider at what point profits are taken if the trade works out.


Renko Charts – Beginner’s Guide to Renko Trading and Charts

Renko charts only show price moves of a specific magnitude, filtering out small movements. There are a number of Renko chart variations, but the main purpose of this charts style is to reduce chart clutter and make trends easier to identify and trade.

Renko charts aren’t for everyone though. Certain strategies require more price information than a Renko chart provides; learn about the benefits and limitations of this chart style before using it.

Renko charts were developed in Japan around the 18th century and are similar to Point and Figure charts.

What’s Unique About Renko Charts?

Certain features make Renko charts “smoother” and less cluttered than traditional candlestick or OHLC charts. Because Renko charts focus on movement, time is not a factor. While the charts have a time axis, it is not uniform like on a traditional chart. Renko charts only show specific movement intervals; until the price moves by a pre-determined amount the chart isn’t updated. If the market is quiet and barely moving, days or weeks could pass before a new price bar/box appears.

See also How to Read Stock Charts: 10 Things Every Trader Should Know.

Each bar or “box” on a Renko chart is the same size, so uptrends and downtrends always move at 45 degree angles. This often makes trends easier to spot, along with pullbacks and reversals.

Renko charts don’t constantly update like traditional candlestick charts. Some information is left out, such as the high, low, close and open on a particular day. This may be relevant information to some traders.

All charts courtesy of StockCharts.com.

traditional candlestick chart
Figure 1. 6-Month Traditional Candlestick Chart

Figures 1 and 2 show the same stock over the same period, showcasing the distinctive look of each chart type.

APPL Renko Chart
Figure 2. 6-Month Renko Chart

How Are Renko Charts Made?

There are several parameters to set when making a Renko chart. The first is deciding whether the boxes are based on a specific price movement, such as $1 in the case of a stock, or five points in the case of a futures contract.

If you choose the specific price movement, set how much you want each box to be. In Figure 2, each box is $1. Starting at the left of the chart, a new box is only created if the price moves $1. When it does a new box is created.

If the price moves $1 higher, the box is clear/white or green. If the price moved $1 lower the box is red or black. Boxes don’t have to be $1 dollar. The interval can be set to anything. The bigger the box interval the smoother the price will look, but the chart will update infrequently. With a smaller box interval the chart will update more frequently, will show more boxes and won’t be as smooth.

Another parameter to set is whether boxes are drawn based on high and low prices, or closing prices. If you select high and low prices, as soon as the price moves $1 (if that’s your interval) from the prior box a new box is drawn. If using closing prices, a new box is drawn only if the closing price of the stock was more than $1 away from the last box.

The Renko box size can also be based on Average True Range. ATR fluctuates with volatility, so the box size is related specifically to the asset being traded. As with choosing a specific price interval (discussed above), using an ATR based box requires choosing whether the boxes are based on closing or high/ low values.

Figure 3 shows the same chart as in Figure 1 and 2, except each box is now based on ATR (14). Notice the ATR is 2.8, which means over this period a new box is only drawn when the price moves $2.80.

ATR Based Renko Chart
Figure 3. 6 Month Renko Chart Based on ATR

Consecutive boxes never appear beside each other. If the last box was white, the price only has to move $2.80 (in the case of figure 3) higher to create a new box. If the last box was white, the price has to drop $2.80 × 2, or $5.60, in order for a red box to occur. Notice the trend shift in November/early December on Figure 3. The price trades near $117.50, but the next red box shows the price below $112.50.

How Do You Read a Renko Chart?

In an uptrend, the price must make overall higher highs and higher lows, and in a downtrend, lower highs and lower lows.

Long strings of white boxes indicate the trend is higher. Pullbacks are represented by red boxes that don’t fully retrace the last wave of white boxes. A long series of red boxes shows the trend is down and white boxes mark a pullback against the downtrend.

Where boxes touch a certain price area multiple times, but don’t move through it, indicates a support or resistance region. Since Renko charts filter out a lot of small price fluctuations, support and resistance are often clearly defined, and breakouts are as well (compared to traditional candlestick charts). When a box appears above resistance, or below support, is shows the levels have been breached, respectively.

Renko Chart Breakout
Figure 4. Renko Chart Breakout Through Resistance Area

Many chart patterns and standard technical analysis methods can be applied to Renko charts. Figure 5 shows a head and shoulders pattern. Traditional flags or pendants will not appear on Renko charts though; the charts only move at 45 degree angles, and when the market pauses (where a flag or pennant would appear on a traditional chart) the Renko chart won’t produce any new boxes.

See also A Trader’s Guide to Tops and Bottom.

Renko Chart with Head and Shoulders Pattern
Figure 5. Renko Chart with Head and Shoulders Pattern

The Bottom Line

Renko charts don’t factor in time, even though there is a time axis. Instead, the chart only updates with a new box when the price moves by a certain amount. This amount can be a set interval, or based on Average True Range (ATR). Renko charts appear smoother than traditional charts, because small movements are filtered out. This will appeal to some traders, but for others who want to see the open, high, low or close price on a particular day, Renko charts aren’t practical. Whether Renko charts are your primary chart type, or a supplement, Renko charts often simplify your trading decision and give you a clear picture of the trend (and reversals).


Prop Trading – Prop Trading 101

Proprietary trading, or “prop trading” for short, is when a firm uses its own capital to trade the markets and attempt to extract a profit. Prop traders are the people who do this job. They are allocated capital by the firm to trade a specific market or strategy that they specialize in. Prop traders don’t have clients like a stockbroker, instead their only job is to trade the firm’s capital and make money out of money. Proprietary trading is done by big banks–which trade hundreds of millions of dollars in assets each day, and mostly hire experienced traders– as well as small boutique firms, which hire experienced and inexperienced traders, train them and then provide capital to trade with.

Proprietary Trading at Large Institutions

Proprietary trading at major financial institutions, such as banks, is on the decline due to conflicts of interest with clients, and the potential for investors’ money to be at risk when speculative positions on the prop trading desk take a nose dive, like what happened during the financial crisis in 2008.

Traders on these large proprietary trading desks have strong academic backgrounds and usually some trading experience. Mathematicians and computer programs are in high demand, as automated strategies that attempt to capture inefficiencies in the market at lightning speed are a highly lucrative field. Since about 2005 the amount of “quantitative” or computer- and math-based trading is growing; computers can supposedly do the same job faster and more efficiently than a live trader.

Proprietary traders for large institutions are employees of the company for which they work, and are typically paid hefty salaries since they control large amounts of capital. Bonuses are awarded based on performance.

Since there are few proprietary trading jobs at large firms, this isn’t a career path many people will get to experience. Below we focus on smaller boutique proprietary firms, which are more accessible to those looking to trade for a career.

Proprietary Trading at Small Firms

Throughout the country and around the world there are proprietary trading firms in most major cities. These firms will each be slightly different since they are often independently run.

Who They Hire

These firms typically hire both experienced and inexperienced traders from a diverse array of backgrounds (not necessarily finance).

Most of these firms focus on day trading; day trading is less capital intensive since margin requirements are lower if you don’t hold positions overnight. Some firms may allow swing trading.

Training

Most firms offer a training program that teaches new traders about the markets. The quality of the training will vary greatly from firm to firm; some firms will provide you with proven strategies to follow, while others won’t teach you anything and expect you to create your own profitable strategies.

If you’re an inexperienced trader looking to join a proprietary trading firm, ask questions about the training and whether they provide you with strategies. High quality training will help you progress more quickly.

Capital

The business of a proprietary trading firm is to turn their money into more money. These firms, therefore, provide traders with capital to trade; if the trader makes money, the firm makes money.

Some firms provide traders with all the capital they need to day trade; this may be millions of dollars.
Other firms will require that the trader put up some of their own money. This helps the firm reduce its own risk as the money can be used to offset losses the trader may take. Experienced traders with a strong trading history may not be required to put up any of their own money.

Overall, a proprietary trading firm provides access to more capital than most traders could access on their own. This allows for a greater likelihood that the trader can actually make a living off trading.

Pay

Most small proprietary trading firms do not pay a salary; you are paid based on your trading performance. You’re not an employee; rather you are contracted by the firm to trade their capital.

For pay, you will receive a percentage of your profits. This ranges from 50% to 100% of the amount you pull out of the markets each month. Firms that pay 50% of your profits typically have very low trading fees. Firms that pay out a 100% of profits are making money somewhere else, typically off commissions or charging you other fees for accessing their capital and trading floor.

With this notion in mind, the payout percentage isn’t the only thing to consider when choosing a proprietary trading firm to work for. Very high fees can make it hard to make a profit; low fees make it easier to produce a profit, so 50% to 80% of something is better than 100% of nothing [see also Moving Average Trading Strategies: Do They Work?].

Under this model it may take several months or more before the trader receives a paycheck; it takes time to become profitable. Also, the company will allocate larger amounts of capital to the trader only after they prove themselves with smaller amounts.

There are a very small number of proprietary firms that hire you as an employee and pay you a salary until your profits are enough to produce an income. Signing a contract may be required, which prevents you from just collecting the salary and then leaving once you are profitable.

Trading Floor or Trading Remotely

Previously, all proprietary trading firms had physical offices, but with high quality infrastructure it’s now quite common for proprietary traders working from home. Referred to as “remote traders,” these individuals trade outside the physical office and are typically experienced, with a strong history of discipline and risk control. Trading remotely may require an additional deposit to offset losses the trader may incur due to personal system failures.

Traders on the trading floor carry less risk for the firm because the traders can be physically monitored, and if either a software or hardware failure occurs there are multiple people around to help resolve the issues.

The Bottom Line

Prop trading is an exciting field. Prop traders are provided with capital to trade, for the sole purpose of producing solid returns day in and day out. Salaried prop trader positions are in short supply and will typically require a high level education and/or an extensive profitable trading history.

Small firms offer prop trading opportunities, and capital to trade, to nearly anyone with a desire to learn and discipline to stick through the both tough and long process of becoming a consistent trader. Each small firm will be different and operate under a slightly different model. There are proprietary trading firms available in most cities, via physical location or remote access. If you join one, be sure to research their pay structure and training program so you’re assured the highest chance of success. With most small firms you are not an employee, you’re a contractor and it may take several months or more before you are able to make a living off your trading.


Howie Hubler – 10 Traders Who Cost Their Companies Billions

In an industry with so many supposed “watch dog” organizations, oversight and risk management protocols, it is hard to believe that a single trader can cost their company billions of dollars. It seems to come in waves, which makes sense, because stricter protocols are enforced after media latches onto a trader nearly (or completely) decimating his company. The early ’90s saw a number of rogue trader incidents. 2008 was another high loss year corresponding to the financial crisis, but that hasn’t curbed the trader losses. After 2011 there continues to be a steady stream of traders who cost their company billions. Here are 10 of the biggest trader losses of all time.

10. Kwedu Adoboli at UBS

The UBS trader lost $2 billion while working for the bank’s Delta division, and was arrested in September 2011. The division traded on behalf of clients and the firm, and trades were supposed to be hedged to minimize risk.

Adoboli made un-hedged bets, hid trades in false accounts and created fictitious counterparties to cover losses. The trader pleaded not guilty to fraud and false accounting charges, saying in court that others in the firm knew what he was doing but failed to do anything about it . Final reports tally the losses at 1.4 billion Pounds, or approximately US$2.2 billion based on the exchange rate at the time of the arrest.

In November 2012 the UBS trader was sentenced to seven years in prison after being found guilty on two counts of fraud.

9. Heinz Schimmelbusch at Metallgesellschaft

In 1993 Heinz Schimmelbush, the then CEO of the German industrial conglomerate Metallgesellschaft, lost approximately 2.63 billion Deutsche Marks on oil futures when a hedging strategy went sour. In today’s dollars and accounting for the exchange rate at the time, the loss equates to about US$2.3 billion.

The losses arose after the company entered into long-term contracts selling fuel at a fixed price. Oil prices fluctuate, though, so the company attempted to hedge this risk in the futures market. As oil prices fell in 1993 the paper losses mounted as the hedging strategy didn’t work. Deutsche Bank, the largest shareholder in the company, forced Schillembusch out of the company and liquidated the positions, realizing the loss.

Schimmelbusch was not the sole party responsible in this case, although was forced to take the blame because he was the CEO and overseeing the operation. He is currently the CEO of Advanced Metallurgical Group, a material science firm [see also Top 21 Trading Rules for Beginners: A Visual Guide].

8. Robert Citron of Orange Country

In 1994 Robert Citron—Democrat and Treasurer—thought we would help the constituents of Orange County, California by partaking in risky investment strategies in the Orange County funds he oversaw. He took highly leveraged positions in repurchase agreements and floating rate notes by offering up treasury notes as collateral. But as interest rates rose the position became unprofitable, to the tune of just under US$2 billion. Orange Country was forced to file for bankruptcy .

In today’s dollars the loss equates to about $US2.38 billion. Citron faced multiple felony charges, and was sentenced to one year of work release (going to prison in evenings after the work day) five years of probation and 1000 hours of community service .

Citron died in 2013 at 87.

7. Isac Zagury at Aracruz

Isac Zagury resigned in November 2008 from Aracruz, a Brazilian pulp maker, following massive losses in the foreign exchange market. Five other board members resigned as this currency play was not an individual decision, and there wasn’t foul play involved.

In total the company lost US$2.13 billion (US$2.43 billion in today’s dollars) by placing massive bets on the strength of the Brazilian real, which had been strong in prior years. The timing couldn’t be worse; from August to October 2008 the Brazilian real fell 24%. The shares of the company were also down more than 60% for the year following the announcement of the loss .

In 2009 the company was merged and renamed Fibria [see also 4 Ways To Exit A Losing Trade].

6.Yasuo Hamanaka at Sumitomo

Frequently squeezing and cornering the copper market backed by loads of cash, Hamanaka—known as “Mr. Copper”—lost Sumitomo US$2.6 billion in 1995. Today, that is roughly US$3.46 billion.

Over a 10-year period the copper company trader routinely tried to hold the price of copper artificially high, thus increasing revenues for the company where he worked.

As global copper supplies increased in 1995 copper lost nearly half its value, and as a result Hamanaka was staring down a huge loss. Forced to liquidate and no longer hide his actions, Hamanaka was sentenced to eight years in jail, but got out a year early .

Upon his release he stated amazement at the rise of copper prices while he was jailed.

5. Bruno Iksil at JPMorgan Chase

On May 10 2012 JPMorgan held an unscheduled conference called where it disclosed that the bank had lost $2 billion in aggressive trading activity. On July 13 the loss was updated to $5.8 billion. One of the traders implicated was Bruno Iksil, although a number of other traders and employees were involved. Based on reports the company was aware of the trades.

The division Iksil worked for was betting the credit market would strengthen by shorting a derivative that measures the difference in interest rates between high quality companies and LIBOR (London Interbank Offered Rate). Concerns over the European financial crisis devastated JPMorgan’s massive position. An internal investigation was conducted involving a large number of firm employees. Millions in pay to three employees—Achilles Macris, Javier Martin-Artajo and Bruno Iskil—was seized by JPM .

A number of hedge funds, including Saba Capital Management and Blue Mountain Capital, were on the other side of the trade, and directly profited from the JPMorgan blunder.

4. John Meriwether at Long-Term Capital Management

LTCM, founded by John Meriwether, suffered a $4.6 billion dollar loss in 1998 (approximately $5.85 billion today)—in just four months—as the Russian financial crisis progressed. The fund was a star in years prior, dishing up 40% gains in years two and three of operation based on arbitrage strategies. Other principles in the firm included Myron Scholes and Robert Merton—winners of the Nobel Prize for their work in pricing derivatives, including the Black-Scholes option pricing model.

With success the firm took larger positions, deviating from just focusing on government bond discrepancies. Leveraged at more than 25 to 1, and betting on merger arbitrage plays and a lack of S&P 500 volatility, when the Asian crisis (1997) and Russian financial crisis hit in 1998 losses mounted quickly.

The Federal Reserve stepped in to avoid further financial panic and help structure a settlement to pay off debts; the fund was dissolved in 2000 [see also The Best Investments of All Time].

3. Brian Hunter at Amaranth Advisors

A single trade idea by the co-head of energy trading at Amaranth Advisors was the firm’s undoing. In 2006 Hunter placed massive positions in the natural gas market believing that winter gas prices in the future would rise relative to summer prices. He bought winter contracts and sold summer contracts; the market did the opposite.

Unable to the hold position, as margin payments grew to more than $3 billion, the firm was forced to liquidate and realize a loss of $6.6 billion and cease operations .

Multiple accusations and suits were brought against Hunter by the Commodity Futures Trading Commission and Federal Energy Regulatory Commission. Ultimately, none of these held up.

2. Jerome Kerviel at Societe Generale

In an interview with Spiegel, Kerviel indicated the firm was aware of his trading activities and that it was encouraged. That was, until he lost $7 billion of Societe Generale’s money.

According the interview Kerviel had amassed big profits for his firm, so he was given more capital to take larger positions; the firm also raised his profit targets by 1,700%. The desk Kerviel traded for was supposed to have a 125 million euro cap on positions, yet Kerviel was taking 30 billion euro positions routinely.

Beginning January 21, 2008, after supposedly being alerted of the rogue trades, Societe Generale closed out Kerviel’s positions resulting in loss of 4.9 billion euros.

Kerviel spent three years in jail for breach of trust and illegally accessing computers, was ordered to pay 4.9 billion euros in restitution to his employer and is banned from working in the securities industry. At an average salary the restitution will take more than 170,000 years to pay, although Societe Generale is not enforcing the repayment .

1. Howie Hubler at Morgan Stanley

It’s 2007 and Howie Hubler is overseeing a trading unit of Morgan Stanley, which loses $9.4 billion. The loss resulted from multiple positions in credit default swaps, over hedging, poor timing and subprime-linked investments. He saw the subprime disaster coming, and positioned himself accordingly, what he didn’t see that is that slightly better mortgages would also fall, which he was using as a hedge. When the whole market collapsed, his bet on slightly better mortgages tanked, and resulted in Morgan Stanley declaring its first quarterly loss in 72-years.

Hubler left Morgan Stanley, with several million in compensation, and was largely unknown to the public until a “60 Minutes” interview with Michael Lewis, author of “The Big Short.”

Hubler now works to help solve issues related to underwater mortgages through a company he launched in 2010.

The Bottom Line

No matter what measures are put in place, certain traders will find ways around those protocols, either by deceit or simply because no one around them cares what they are doing … until the bill comes. When traders make money, the financial industry encourages them to take on more risk to increase profits, yet this is a double-edged sword – like doubling down at the casino after every hand, win or lose. These traders didn’t set out to lose, yet lack of oversight, greed, fear, and a culture of tolerance in some cases all conspired to put these men on the front page as traders who cost their company billions.


Equivolume – How to Trade with EquiVolume Charts

EquiVolume charts combine both price and volume information into every bar. The bar, or rectangle in this case, represents the high and low price for the period, and its width reflects volume. This chart type was developed by Richard W. Arms Jr and similar to candlestick charts, EquiVolume charts are highly visual.

What’s Unique About EquiVolume Charts?

EquiVolume charts have a very simple construction. Each rectangle/bar (hour, day, week, etc.) shows the high and low price for the period. The width of the bar shows the period’s volume; the wider the bar, the greater the volume.

See also How to Read Stock Charts: 10 Things Every Trader Should Know.

The advantage of EquiVolume charts is that you get pertinent price information (high and low) for each period, and volume is included right in the price data. The downside is that EquiVolume charts don’t show the open or close (just the high and low). CandleVolume, another type of chart, shows all the candlestick information, yet also incorporates volume.

All charts courtesy of StockCharts.com.

candlestick chart
Figure 1. Traditional Candlestick Chart

In Figure 2, each bar only contains the high and low price. Unlike candlesticks, which are uniform in width, the width of EquiVolume bars vary by volume.

equivolume chart
Figure 2. EquiVolume Chart

How Are Equivolume Charts Made?

EquiVolume charts are based on simple concepts. A bar is black/green if the close of that period is above the prior closing price. A bar is red if the close of that period is below the prior closing price.

Each bar marks the high and low for the period – the top of the bar is the high, and the bottom is the low.

The width of the bar is total volume (for look back period) divided by that period’s volume. For example, if looking at a three month daily chart, calculate the total volume for the three month period. The width of each candle reflects that period’s volume as a percentage of the total. This is why big volume days are “fat,” and very low volume days are skinny (see Figure 2).

Be sure to also read about How to Trade with Heikin-Ashi Candlesticks.

How Do You Read an EquiVolume Chart?

Since EquiVolume charts show highs and lows, trend analysis is conducted through the use of trendlines, or other trend following indicators such as a moving average. In an uptrend, the price must make overall higher highs and higher lows, and in a downtrend, lower highs and lower lows.

Volume is frequently used in technical analysis to confirm breakouts. Breakouts on large volume are more likely to succeed, while breakouts on low volume are more likely to fail since fewer traders are interested.

Note chart patterns—such as trading ranges, trend channels, triangles or head and shoulders—and then await a breakout. The EquiVolume bars should ideally be wider when the breakout occurs. This signifies volume is increasing, and the breakout is more likely to succeed.

Upside Breakout on EquiVolume Chart
Figure 3. Upside Breakout Confirmed by Wide EquiVolume Bars
Downside Breakout on EquiVolume Chart
Figure 4. Downside Breakout Confirmed by Wide EquiVolume Bars

While increasing volume helps confirm a breakout, climactic buying and selling often indicates a top or bottom, and a reversal of the prior trend. For instance, in Figure 5 an extremely wide EquiVolume bar signaled the bottom of a downtrend, and ultimately a reversal higher.

Learn more about Trend Reversals: How to Spot and How to Trade.

EquiVolume Chart Signals Bottom
Figure 5. EquiVolume Signals a Bottom on Climactic Selling

In Figure 6, climactic buying indicated there were few buyers left to continue pushing the price higher, and price reversed lower.

EquiVolume Chart Signals Top
Figure 6. EquiVolume Signals a Top on Climactic Buying

Benefits and Limitations

EquiVolume charts visually incorporate volume into the price data. This can highlight potential turning points, like those shown in Figures 5 and 6. Wide bars can also help confirm breakouts.

EquiVolume charts lack all the price information of candlesticks or OHLC charts. Mainly, the open and close price of each candle aren’t shown. Not a problem for longer-term traders, but for shorter-term traders this lack of information may be an issue. CandleVolume charts are a candlestick chart but the width of the candle varies by volume. This type of chart shows the open, high, low, close and volume on each price bar.

See our Ultimate Guide to Analyzing Trading Volume.

While volume aids in analysis, and thus EquiVolume have attained some popularity, increasing volume doesn’t always accompany a legitimate breakout. Also, very high volume doesn’t always indicate a top or a bottom; it’s just an additional tool. As with any type of chart, use trend analysis, trendlines, indicators and/or other forms of analysis to verify what you’re interpreting on the EquiVolume chart.

The Bottom Line

EquiVolume charts show the high and low price for each period, and the width of the bar reflects volume. This chart type provides some analytical insight, such as showing when a breakout is occurring on increasing volume, and when buying or selling is potentially reaching a climax. EquiVolume charts don’t show the open and closing price, which may be an issue for shorter-term traders. There are no guarantees that increasing volume on a breakout will result in a winning trade, or that very high volume signals a top or bottom in price. As always, be sure to use other forms of analysis to confirm your interpretation of the EquiVolume chart.


Quotron Machine – 10 Relics that Only Traders Can Appreciate

The financial markets have rapidly evolved over the past couple hundred years, particularly with the advent of electronic communication networks. In the wake of these changes, many legacy technologies used by traders throughout history have gone by the wayside, replaced by faster and more efficient tools used today.

In this article, we’ll take a look at 10 relics from the past that only (appropriately aged or well read) traders can appreciate.

#10: Ticker Tape

Ticker tape was the earliest digital communications medium designed to transmit stock prices over telegraph lines between 1870 and 1970. By running a paper strip through a stock ticker, the device provided traders with up-to-date price and volume information about stock market transactions in particular equities or indexes [see also Top 21 Trading Rules for Beginners: A Visual Guide].

Of course, ticker tape has left its market on the financial world. The word ticker is commonly used to refer to a given equity (e.g. ticker symbols), while many traders still believe price and volume transaction data is all that’s needed to profit. The same data can also be seen today scrolling across CNBC or Bloomberg television.

Ticker Tape trading relic

#9: Stock Certificates

Stock certificates are physical sheets of paper issued by a public company proving ownership in its stock. While some stock certificates still exist and can be requested at an extra cost from a broker, many large corporations have phased them out in favor of electronic stock certificates in order to cut costs and speed transactions.

In October 2013, Disney Corporation became perhaps the best example of these trends by halting the issuance of its famous stock certificates that have long made popular gifts and collectibles. Old stock certificates and famous corporate busts – such as those in 1999 – have even become highly sought after collectibles.

Stock Certificate

#8: The Original Opening and Closing Bells

Opening and closing bells were first introduced by the New York Stock Exchange back in the 1870s to signify the beginning and end of the trading day. Originally, a Chinese Gong was used as the open and closing bell, but brass bells quickly replaced them as a more practical alternative that’s easier to administer.

Currently, there is one large bell in each of the four trading areas of the NYSE, which are all operated synchronously from a single control. In the 1980s, the NYSE tried to have the bells refurbished but discovered nobody created such loud bells anymore, so a bell-making team was brought out of retirement to build them from scratch [see also Dow Jones Stocks: The Questions We Really Want Answered].

opening bell trading relic

#7: Specialists & Runners

The advent of electronic trading has made many jobs increasingly obsolete, including those of specialists and runners. By holding an inventory of a specific stock, specialists make a market by matching buyers and sellers. Runners would be responsible for passing orders between exchanges and brokers in a timely fashion.

Electronic exchanges, such as the NASDAQ, have become increasingly popular given their ability to automatically match buyers and sellers in a timely fashion using computer algorithms. With faster transaction speeds and no human intervention, these exchanges are both cheaper and more efficient than the human alternative.

Runners trading relic

#6: Quotron

The Quotron was the first device to deliver stock market quotes to an electronic screen rather than printed ticker tape. By 1986, the device grew to reach 100,000 terminals or roughly 60% of the market for financial data. Many traders may recognize the device for its appearance in the movie Wall Street.

The Quotron failed to keep pace with new technological developments, with companies like Thomson Reuters and Bloomberg taking its place. Currently, Bloomberg Terminals and Reuters Eikon are perhaps the most popular quotation devices/services in use throughout the U.S. and global financial markets.

Quotron trading relic

#5: Quotation Boards

Automatic quotation boards were large vertical electronic displays located in brokerage offices to provide current data on stocks followed by that particular brokerage. By 1964, over 650 brokerages had installed such electronic displays (that could also be seen in Wall Street) showing open, high, low and close data.

These automatic quotation boards were phased out by the advent of personal computers, which enabled individual brokerage representatives to maintain their own personal list of stock quotes. However, similar displays are still used in many offices to display popular index quotes, such as the S&P 500 or Dow Jones.

The image below was posted by the Museum of American Finance

Stock board trading relic

#4: Chalkboards

Large chalkboards were used throughout the late-1800s and early-1900s to show stock prices. Runners would carry the prices between the exchange and brokerage offices and write them on large chalkboards. In fact, the job was a common entry point to becoming a trader, according to Reminiscences of a Stock Operator.

The use of chalkboards led to terms like the “Big Board,” which was coined to represent the New York Stock Exchange. Some countries only recently switched away from chalkboards to convey current pricing information. Of course, electronic communications were responsible for their demise over time.

Chalkboard trading relic

#3: Newspapers

The average trader used to receive information via newspaper the following day, with many publications printing large tables of stock market data. In 1889, the Wall Street Journal became the first newspaper focused exclusively on the financial markets, while the New York Times added similar data around the same time.

Stock market index and commodity prices are still regularly published in newspapers, but most individual traders get their information electronically over the Internet. The lack of a delay in getting information has helped the markets become much more efficient over time with greater liquidity.

Newspaper trading relic

#2: Am-Quote

Am-Quote was a telephone stock quotation system developed by Teleregister in 1964. Using magnetic drums to access data, brokerages could enter a code into a standard telephone and receive up-to-date pricing information on a stock. The system was much faster than other technologies available at the time.

While the telephone is no longer the primary source of stock quotes – replaced long ago by Internet-based quotations, most investors can still call up their brokerages for automated price quotes and/or to place orders. Telephone orders still tend to be more expensive than orders placed over the Internet, however.

am-quote trading relic

#1: Spreadsheets

Spreadsheets became extremely popular throughout the 1980s in trading rooms. Using programs like Lotus 1-2-3, Excel, Applix, or Wingz, traders could quickly make calculations designed to compute various technical indicators. For example, historical pricing data could be used to calculate moving averages and create charts.

While spreadsheets are still in use, most technical traders utilize real-time data provided through online applications like StockCharts.com or brokerage platforms like TradeStation. Spreadsheets are commonly used to calculate more complex fundamental data points, such as discounted cash flows.

Spreadsheet trading relic

The Bottom Line

The advent of electronic communications has rapidly changed the way that the financial markets work. Over time, trading evolved from a highly manual process that involved runners writing prices in chalk and quotes being delivered by telegraph to information being nearly simultaneously delivered everywhere.


Price Action Market Trap – Swing Trading: How to Trade the Swing

Swing traders are often called “momentum traders” – jumping into the market when big price moves are occurring, or are potentially about to occur. This method of trading is very popular because it doesn’t have the same capital requirements as day trading stocks. Swing trading involves taking positions that last from a couple of days to a couple of weeks.

Swing Trading 101

Swing trading has been around since the various financial markets began trading, and speculators, such as Jesse Livermore in the early 1900s, attempted to capture big price moves. Futures and options may have made swing trading more prevalent, since these contracts have expiries, and thus require a more robust approach than the classic investor buy-and-hold model.

Swing traders are distinct from day traders, in terms of market approach and legally speaking. Stocks day traders enter and exit positions within the day, and are therefore required to maintain an account balance of at least $25,000 (see What is Day Trading?). Swing traders are not subject to this limitation, nor are day traders in the futures, options or currency markets.

Day traders focus on smaller intra-day moves, while swing traders focus on multi-day price moves. One is not easier than the other; it is all proportionate.

Swing traders also differ from investors. Investors hold stocks for long periods of time, often through multiple ups and down in a stock price. The swing trader focuses on riding momentum, and then getting out before the momentum shifts back in the opposite direction.

All charts created using StockCharts.com

Different Approaches to Trading a Stock
Figure 1. Different Approaches to Trading a Stock

A swing trader will be far more active than an investor, potentially making different trades every couple of days (or every day), while the investor will typically make only a few trades a year. A day trader makes multiple trades each day, and will therefore be more active than the swing trader.

How to Find What to Trade

Swing trading involves finding stocks—or other financial products such as futures, ETFs, options or currencies—that are moving with strong momentum or are about to.

Momentum is the distance the price is able to travel within a period of time. The greater the percentage price movement, the greater the momentum, and thus the greater the profit potential. Swing traders typically avoid quiet, low volume stocks, or markets with little action.

Stocks that have recently had major surprise news releases are often good candidates for swing trades, as the ensuing volatility creates big price moves and the ability to make big gains (but also losses) in a short amount of time.

Also, a stock or market that has a trend, either up or down, may also attract swing traders looking to capitalize on big trending moves. This approach could have been utilized in Figure 2, as there was strong selling momentum on multiple down waves, which could have produced significant gains on short trades, in a small amount of time [see also Top 21 Trading Rules for Beginners: A Visual Guide].

Multiple Opportunities to Short with Momentum During Downtrend
Figure 2. Multiple Opportunities to Short with Momentum During Downtrend

Swing Trading Strategies

Swing traders take different approaches to the market. One method is to trade chart patterns breakouts – triangles are a popular one. The price consolidates during a trend within a defined space marked by trendlines. When the price breaks out of that pattern the swing trader enters the trade, capitalizing on what is likely to be another trending move. Other chart patterns include ranges, head and shoulders, flags, pennants and wedges.

Chart Pattern Breakout
Figure 3. Chart Pattern Breakout

Another popular method is to trade trends that are already in progress. Wait for a pullback and then enter a trade when the price starts to move back in the trending direction. The object is to profit from the next price wave in the trending direction.

Swing Trading with Trend
Figure 4. Swing Trading with Trend

Other strategies include reversal strategies, which may be based on strong support or resistance areas, or candlestick patterns … or both combined.

Candlestick Reversal After Hitting Resistance a Third Time
Figure 5. Candlestick Reversal After Hitting Resistance a Third Time

Risks and Rewards

Swing trading can be highly lucrative, but is can also result in quick losses for those without an established plan.
Swing trading risks include:

  • Difficulty: In hindsight it looks easy, but in real-time the decisions aren’t so obvious. Swing traders often flourish when others are panicking, as the panicking creates big price moves. The problem is that swing traders themselves may get caught up in the psychology of others, causing them to lose their cool, make poor decisions and ultimately lose money. It takes a solid strategy and steady nerves to be an effective swing trader.
  • Price Gaps: It is recommended that swing traders use stop losses on positions in order to limit risk. Unfortunately, even a stop loss doesn’t totally define your risk. When holding trades overnight, the price could “gap” from the prior close to the next open. This means you may experience a loss bigger than anticipated if the price gaps against you. A stop loss, once reached, typically fills at the next available price, which could be very different from one day to the next. This is why a gap can result in increased risk.
  • Losing Sleep: Swing traders hold positions overnight, sometimes for weeks, in volatile conditions. Not everyone is able to handle this. If you can’t sleep with trades on, then swing trading may not be right for you. You may also wish to decrease your position sizes so that the fear of losing, or anticipation of winning, isn’t as strong and won’t keep you up at night.
  • Leverage: Leverage isn’t only for day traders. Swing traders can also typically receive 2:1 leverage, meaning only 50% of the purchase is required up front when making a stock trade. Leverage allows you to make and lose more money, so it must be treated with respect.

Swing trading benefits include:

  • Freedom: Swing traders aren’t tied to their screens all day like day traders. They can typically monitor the market for some time each day, put out their trades, stop losses and targets, and allow the market to fill their orders.
  • Price Gaps: A risk and an advantage. If you on the right side of the trend, gaps will often occur in your favor, which means big gains in a short amount of time.
  • No Capital Requirements: You only need enough capital to trade; there are no set minimums for what is needed (may vary by broker). If you trade lower priced stocks, or futures or options, your capital requirements could be substantially less than the $25,000 required for day trading stocks. That said, you still want to make sure you have enough capital to accommodate market fluctuations, and the risk on trades should only put a small percentage of the account capital at risk.

The Bottom Line

Swing trading involves holding typically high momentum stocks (or other financial asset) for a couple days to a couple weeks. The goal is to exploit momentum, capturing the bulk of move, and getting out before the price reverses course. Swing trading can be utilized in all markets, and offers freedom as it doesn’t need to be time consuming. There is no minimum capital requirement (may vary by broker) for swing trading. While there are multiple methods you can use to swing trade, it isn’t easy. Swing traders need to keep their cool when others are panicking, and need to be able to sleep like a baby even with trades on overnight.


Options 101 – Options 101: American vs. European vs. Exotic

Options provide traders with a valuable tool to gain or limit exposure to a particular asset without actually buying or selling that asset. Option buyers have the right, but not obligation, to buy or sell an asset at a certain price on or before a certain time, while option sellers have the corresponding obligation to fulfill the transaction. Traders most often use options to either gain leverage or hedge against risk.

In this article, we’ll take a look at the different flavors of options available for traders, including American options, European options, and exotic options.

American Options

American options are options that can be exercised at any point before their expiration date. For example, a trader might purchase an American option for 100 shares of IBM with a strike price of 100.00 and an expiration date one year into the future, and then exercise it the next week after shares rally. The added flexibility means that these options tend to trade at a premium to European options.

Simple Call Option Diagram
Figure 1 – Simple Call Option Diagram – Source: TheOptionsGuide.com

Traders often sell American options into the market rather than exercise them before expiration due to the time value premium, but there are instances where it makes more sense to exercise the option. For example, a put option may be exercised early if the underlying asset files for bankruptcy or an in-the-money call option may be exercised just before a stock pays a dividend.

Valuing American options can be very difficult due to the uncertain exercise date associated with them. Often times, traders use the Black-Scholes price assuming no early exercise occurs and then add a premium depending on the perceived risk of early exercise. The difference between the Black-Scholes valuation and the market price conversely serves as an indicator of the likelihood of early exercise.

European Options

European options are stock options that can only be exercised at their expiration date. For example, a trader purchasing a European option for 100 contracts of S&P 500 e-mini futures at a strike price of 1,500.00 and an expiration date one year in the future could not exercise the option if the price of the futures contracts were to rise the following day, although they could sell the option contract itself.

Valuing European options is a very straightforward process using the Black-Scholes or Black Model formulas, which are simple equations with a closed-form solution that has become standardized in the financial community. By comparison, American options do not have a standardized model for valuation, which means that there’s no real consensus on what the options are worth at any given time.

Black-Scholes Formula
Figure 2 – Black-Scholes Formula – Source: OptionsEducation.org

Unlike many American options, European options are also most often index options that are traded over-the-counter rather than on an exchange. Institutions may prefer to use European options due to their cheaper and more certain valuation relative to their American counterparts. Most individual traders, however, trade American options on a daily basis due to the greater flexibility and liquidity.

Exotic Options

Exotic options are simply those that do not fit into any category. As their name implies, these options are even more thinly traded than European options and typically involve unusual and difficult-to-value characteristics. Exotic options are usually only traded over-the-counter by institutions, which makes them off-limits to many individual traders sticking to standard exchanges.

Lookback Option
Figure 3 – Lookback Option – Source: Amex.com

For example, an exchange option may offer a trader the right to exchange one asset for another rather than to receive cash, while a basket option uses the weighted average of several underlying assets instead of a single one. The varying underlying assets and dynamics make the options very difficult to value in any standardized way, which makes them difficult to profit from for individual traders.

Some popular exotic options include:

  • Lookback Options – Path dependent options where the owner has the right to buy or sell the underlying asset at its lowest or highest price over time.
  • Binary Options – Options that pay a fixed amount or nothing at all depending on the price of the underlying asset at the option’s maturity.
  • Barrier Options – Options that involve a limiting price whereby the option can be exercised only if the underlying asset crosses it.
  • Rainbow Options – Options where the underlying is a basket of assets with the weightings depending on the final performance of the components.

The Bottom Line

Options provide traders with valuable tools for gaining or limiting exposure to a particular asset without buying or selling it. While most individual traders will likely be using American options, they should be aware of the different options available to the market, including European options and exotic options that offer different types of characteristics suited for different situations.


– Dow Theory: Everything You Need to Know

There are plenty of techniques that investors and traders alike can use to find positions for their portfolios. From simple value screens to more rigid systems like CANSLIM, these methods can be used to find stocks and other assets to buy. The hope is that the investor’s method will help guide their decision making towards big profits and take the emotion out of the markets. One of the oldest practices is Dow Theory.

By looking at technical analysis and price action, as well as market philosophy and sentiment, investors can use Dow Theory to uncover various stages of the market and profit from the trends. Dow Theory isn’t hard to understand or use, but it does take some basic knowledge to use it right.

Dow Theory Basics

Dow Theory began as a series of editorials in the Wall Street Journal nearly 100 years ago. Charles Dow developed the Dow Theory from his analysis of market price action in the late 19th century. He noticed several relationships between both the transportation—at the time just rail—and industrial averages. William Hamilton later refined Dow’s work in the 1920s, and in 1932, Robert Rhea took Dow Theory one step further and analyzed the nearly 250 different editorials written by the two men.

Through his book, “The Dow Theory,” Rhea gave birth to the concept’s modern understanding and set forth the various assumptions essential to the model. Rhea was also the first person to actually use and coin the term Dow Theory to describe the method for stock market fluctuations.

The Major Assumptions

For Dow Theory to work, investors need to familiarize themselves with several major assumptions of the markets and the model. These points are critical to understanding how the relationships between the various indexes, stocks and market movements are related.

Manipulation: While it is possible to manipulate indexes and stocks over a single day, it is impossible to manipulate the primary trend of the market over longer periods of time. Investors recognizing the primary trajectory of the market can ignore the day-to-day movements to prosper.

Stocks Discount All News: The current price of a stock represents the total of all the hopes, fears and expectations of all owners with regards to that stock. Basically, stocks are fairly priced based on all that is known about that company today. That means any unknown news will cause the stock to move accordingly.

The Theory Is Not Perfect: Both Hamilton and Dow in their writings have basically come out and said that the Dow Theory is not necessarily a sure-fire means of beating the market. Major events—such as the Lehman Brothers Bankruptcy or the September 11th terrorist attacks—can completely shift the model to its side. However, over most normal market cycles, the theory is quite sound and can used to predict movements.

The Indexes Must Confirm Each Other: Dow Theory is as much about the strength of the economy as it is about individual stocks. To that end, Charles Dow postulated that in order for the market to signal its trends, the economy must also be cooking. Both the transposition and industrial index must both be moving in a similar direction to confirm this. When the performance of the two economic averages diverge, it can serve as a warning sign that change is in the air [see also Dow Futures: What Every Trader Needs to Know].

The Market Has Three Movements: When studying the two indexes, both Hamilton and Dow recognized that the averages had basically three patterns of movements – primary movements, secondary reactions and daily fluctuations. Primary movements are the major trend of the market and can last from a few months to several years. Typically, when investors say that stocks are in a bull or bear market, they are describing a primary movement. A secondary reaction or market swing is usually opposite from the primary direction of the market. This may last from 10 days to three months and generally retrace around 30% to 66% from the original movement. They are basically mini-rallies or sell-offs during a bull or bear. Finally, daily fluctuations are just that: swings up or down on a very short-term basis. Understanding the movements are key if investors want to profit from the market’s overall trend. Realizing that a secondary movement is just that and not a full on bear could lead to buying opportunities.

Three Stages of Bull & Bear Markets

Full Market Cycle Diagram

One of the other major parts to Dow Theory is understanding that markets—bull or bear—have three parts to them. Investors need to familiarize themselves with the various stages in order to understand how the market trends will play out. Primary market movements are categorized in three ways: an accumulation phase, a public participation phase and a distribution phase.

The accumulation phase is where investors and traders “in the know” begin buying stocks against the general opinion of the market. This is where the smart money is getting in or out of the markets. Prices for stocks don’t generally move that much and insiders are able to accumulate larger positions.

The public participation phase is when most retail investors begin to jump on board. The market’s trend has been well established and many investors get off the sidelines and begin buying with abandon. It is here that we see prices for stocks begin to really move. Talks of bubbles begin to make the airwaves and speculation becomes rampant.

The distribution phase is where the market tops and the smart money has already left or is starting to leave the building. By this point, most retail investors are just now joining the show and are buying at the top. Overpriced asset classes and sectors begin to pop and the market will drift downwards. This is also the start of the bear market cycle.

As for bear markets, the phases happen in reverse. The smart sells at the top, while less-sophisticated investors begin buying.

Putting Dow Theory To Work

Start of bullish trend

For investors, all of this information is no good unless you can put it to work in your portfolio. The real reason for all of this is to help identify a trend, so you can follow that trend to profits. Robert Rhea describes how a classic “buy signal” will occur during the end of a bear market. Rhea shows that after a primary downtrend in a Bear market is established, a secondary upwards bounce will occur. After this a retraction of at least 3% on one of the averages will occur. If that downward bounce does not go below the previous lows of the industrial and the transportation indexes, investors can begin buying the market.

start of bearish trend

Conversely, a bear market sell signal is determined in much the same way, but in reverse. New highs will be made, followed a slight dip before the market surges higher. However, if the market falls short of reaching the previous highs and then penetrates the recent lows on the next decline, it’s time to sell and move on.

The system isn’t perfect and doesn’t take into account various Black Swan style events, which can throw the entire model off in a matter of seconds. Another issue is the just when to determine how that secondary move up or down is really occurring. Traders have many interpretations on how that movement is defined. This can lead to false bear or bull market call for newbie investors.

The Bottom Line

Dow Theory in a nut shell is the oldest form of technical analysis and can be a great way for investors to spot the market’s overall tends. It takes some practice and basic knowledge, but once understood it can serve a portfolio well. Just keep in mind that it isn’t the end-all-be-all of market systems. The theory should be used in conjunction with other tools and indicators to make informed and profitable trades.


Chaikin Money Flow – Chaikin Money Flow (CMF) – How to Use It

Marc Chaikin developed the Chaikin Money Flow (CMF) to combine price and volume information into one indicator. It was developed based on the belief that price follows volume. The indicator fluctuates above and below zero, highlighting whether the stock is in a bullish or bearish phase. The CMF is mostly a confirmation tool to help isolate strong trends, although it can be combined with a moving average or support/resistance to provide trade signals. To use the CMF effectively, traders should understand how the indicator works, its applications, as well as its strengths and weaknesses.

What Is the Chaikin Money Flow?

CMF incorporates both price and volume and into one indicator. Traditionally, it is used on daily charts over a 21-period time frame, which is approximately one month in trading days.

When prices are closing in the upper portion of the day the indicator moves higher; when prices are closing in the lower portion of the day the indicator moves lower.

Sustained buying—or closes in the upper portion of the daily range—will push the indicator above zero (0). Sustained selling—closes in the lower portion of the daily range—will push the indicator below zero (0). Volume is also factored though, so each day is multiplied by its volume. Therefore, an up day on high volume will result in a bigger jump in the indicator than an up day on low volume.

When the indicator fluctuates around zero it means the stock has little trend, and buyers and sellers are evenly matched. When the indicator stays above zero for a sustained period of time, especially with increasing indicator values, it shows a strong uptrend. If the indicator is below zero for a sustained period of time, and indicator values are decreasing, it shows a strong downtrend.

Figure 1 shows how the CMF looks on a chart.

CMF Applied to Daily Stock Charts
Figure 1. CMF Applied to Daily Stock Charts Source: StockCharts.com

Chaikin Money Flow Calculation

Calculating the CMF takes two steps:

Daily MF = [(Close – Low) – (High – Close)/ (High – Low)] * Volume

CMF = 21 Day Average of Daily MF / 21 Day Average of Volume

Many trading platforms and charting sites divide the CMF by 100, making it a decimal. For example, some platforms will show readings of 28, or -5, and others will show it as 0.28 or -0.05 respectively.

The CMF is available on most trading platforms, such as ThinkorSwim, and a number of free online charting sites including FreeStockCharts.com and StockCharts.com.

How Chaikin Money Flow Is Useful

The CMF indicator is used primarily as a confirmation tool, and therefore can be combined with other indicators or chart patterns to find trade signals. One method is to apply a moving average to the chart, and capture trend trades. Another method is to use the CMF to confirm breakouts.

With both the methods, the number of days used in the CMF calculation can be altered to suit individual trader needs. The 21-day indicator is for short-term or swing traders. A six month or 126-day time period can be used by traders looking to catch intermediate trends and trades lasting several months. A 12 month CMF, or 252 trading days, will show the long-term accumulation or distribution of a stock.

The longer the time frame used, the slower it is to react to trend changes.

Be sure to also read our Ultimate Guide to the MACD Indicator

Breakout CMF Method

For the breakout method, establish areas of support or resistance which the price has struggled to surpass on multiple attempts. When price moves above the resistance level make sure that the CMF is above zero. If it is, proceed with buying the resistance breakout. When the price moves below a support level, note if the CMF is below zero. If it is, proceed with short-selling the support breakout.

Resistance Breakout Confirmed by CMF
Figure 2. Resistance Breakout Confirmed by CMF Source: StockCharts.com

Multiple CMF time frames can be used to further confirm the breakout. Figure 2 uses an 84-period CMF, which is approximately four months. It is above zero when the breakout occurs. You could also check a 21-period CMF, or a 126-period CMF (six months) to see if they are also above zero. If they are all above zero it shows accumulation of the stock over both the shorter- and longer-term, and further confirms the breakout.

A stop loss can be placed just below the old resistance level in the case of a resistance breakout (upside), and just above support in the case of a support (downside) breakout.

Profit targets can be used for an exit, or alternatively, hold long trades until the CMF turns negative. Hold short trades until the CMF turns positive.

Moving Average CMF Method

CMF Uptrend with Buy Signals at Moving Average
Figure 3. CMF Uptrend with Buy Signals at Moving Average Source: StockCharts.com

Since this strategy involves buying when the price is falling, a fixed stop will be hard to implement. Instead place a stop based on a percentage of price. You may opt to give the price 3% leeway from your entry price. Therefore, if you enter at $37.50, you’d place a stop 3% below at $36.37. For more volatile, stocks increase the percentage leeway; for more stable stocks, decrease the percentage leeway.

Profit targets can be used for exits, or use the CMF: hold long trades until the CMF turns negative. Hold short trades until the CMF turns positive.

Chaikin Money Flow Limitations

CMF is predominantly a confirmation tool, helping establish the strength of a trend that can aid in trade selection. Therefore, the indicator itself isn’t a trade system. The trader is responsible for implementing a stop loss and finding a profitable exit based on a strategy, or attempting to interpret the information the CMF is producing. If the CMF is used to exit trades—by flipping from positive to negative or vice versa—the trader won’t know their exit price in advance, which means the reward to risk ratio of the trade is unknown.

Very high or low data values will have a large impact on the indicator. This can skew the indicator reading, and sometimes even make it useless. The large impact is seen on the day the data is first calculated into the indicator, and the day the data drops off from being included in the calculation.

See also: 10 Market Indicators Every Traders Watches

Major Chaikin Money Flow Proponents

Marc Chaikin is the founder of the CMF, and discusses it on his site http://www.chaikinpowertools.com/. He is founder of Chaikin Analytics, which helps investors via an array of market indicator and professional quality research reports.

He has more than 40 years of market experience, is a stock market lecturer and appears regularly on CNBC, Fox Business News and Bloomberg.

The Bottom Line

The CMF showcases price and volume information in one indicator. Rising indicator values show the stock is being accumulated, while a falling indicator value shows the stock is being distributed. The Chaikin Money Flow is mainly a confirmation tool, but it can be combined with support/resistance or moving averages to produce trade signals. Stop losses or targets are not provided by the indicator, so traders need to develop their own, using either support/resistance or a percentage lee-way model. Profit targets can be used, or exit trades when the CMF turns negative on long trades or positive on short trades.

No indicator works all the time, and the CMF may be skewed by days with very high or low data values. Always control risk with a stop loss, and keep position size manageable so a single loss won’t significantly draw down the trading account.


Force Index – Bollinger Bands: How to Use Bollinger Bands

Bollinger Bands are applied directly to price charts, providing a gauge for how strong a trend is, and spotting potential bottoms and tops in stocks prices. Band width fluctuates based on volatility; the ability for Bands to adapt to changing market conditions makes it a popular indicator amongst traders. To use Bollinger Bands effectively, we must understand how they work, their trading applications, and pitfalls.

What are Bollinger Bands?

Bollinger Bands® are a volatility based indicator, developed by John Bollinger, which have a number of trading applications.

There are three lines that compose Bollinger Bands: A simple moving average (middle band) and an upper and lower band. These bands move with the price, widening or narrowing as volatility increases or decreases, respectively. The position of the bands and how the price acts in relation to the bands provides information about how strong the trend is and potential bottom or topping signals.

Bollinger Bands are used on all timeframes, such as daily, hourly or five-minute charts. Bollinger Bands have two adjustable settings: the Period and the Standard Deviation. The Period is how many price bars are included in the Bollinger Band calculation. The number of periods used is often 20, but is adjusted to suit various trading styles.

The Standard Deviation is typically set at 2.0, and determines the widths of the Bands. The higher the Standard Deviation, the harder it will be for the price to reach the upper or lower band. The lower the Standard Deviation the easier it is for price to “breakout” of the Bands.

Bollinger Bands denoted (20,2) means the Period and Standard Deviation are set to 20 and 2, respectively.

The indicator is calculated using the following formula. First calculate the Middle Band, then calculate the Upper and Lower Bands.

  • Middle Band = 20-day simple moving average (SMA)
  • Upper Band = 20-day SMA + (20-day standard deviation of price x 2)
  • Lower Band = 20-day SMA – (20-day standard deviation of price x 2)

Where SMA = the sum of closing prices over n periods / by n.

Figure 1 shows how Bollinger Bands looks on a chart as they move and adapt with price.

Apple (AAPL) with Bollinger Bands
Figure 1. Apple (AAPL) with Bollinger Bands (20,2).Source: StockCharts.com

Trading with Bollinger Bands

The first way to use Bollinger Bands is for analysis. Some common occurrences provide us with information on the direction and strength of the trend. This information can then be used to confirm trade signals from other indicators or strategies to make trades.

  • If an uptrend is strong it will reach the upper band on a regular basis. Reaching the upper band shows the stock is pushing higher and buying activity remains strong.
  • When the price pulls back, within the uptrend, if it stays above the middle band and then moves back to upper band it shows a lot of strength.
  • During an uptrend the price shouldn’t break below the lower band; if it does it warns the uptrend has slowed and may be reversing.
Bollinger Band Trend Analysis
Figure 2. Bollinger Band Trend Analysis – Illumina (Nasdaq:ILMN). Source: StockCharts.com

The same principles apply to a downtrend.

  • If a downtrend is strong it will reach the lower band on a regular basis. Reaching the lower band shows selling activity remains strong.
  • When the price pulls back (higher), within the downtrend, if it stays below the middle band and then moves back to lower band it shows a lot of strength.
  • During a downtrend the price shouldn’t break above the upper band; if it does it warns the uptrend has slowed and may be reversing.

These are general guidelines for trading with Bollinger Bands to help analyzed the trend. Adjusting the Bollinger Band settings may help avoid getting false signals from these guidelines.

Another way to use Bollinger Bands is for trading W-Bottoms and M-Tops.

A W-Bottom signals a reversal from a downtrend into an uptrend.

Initially there is a wave lower, which gets close to or moves below the lower band. The price then pulls back to the middle band or higher, and proceeds to create a lower price low than the prior wave, but doesn’t close below the lower Bollinger Band. When the price moves above the high of the prior pullback the W-Bottom is in place. A long trade is initiated and a stop is placed below the recent lows.

W-Bottom in AT&T
Figure 3. W-Bottom in AT&T (NYSE:T) Daily Chart. Source: StockCharts.com

The W-Bottom is similar to a Double Bottom chart pattern. One potential profit target is to add the height of the W-bottom to the breakout price. In Figure 3 the W-Bottom is roughly $1.50 high, added to a breakout price near $33, this gives a target of $34.50. If a major uptrend unfolds, a trailing stop can be used to attempt to capture more profit from the rally.

An M-Top signals a reversal from an uptrend into a downtrend.

Initially there is a wave higher, which gets close to or moves above the upper band. The price then pulls back to the middle band or lower, and then proceeds to create a higher price high than the prior wave, but doesn’t close above the upper Bollinger Band. When the price moves below the low of the prior pullback the M-Top is in place. A short trade (and exit long positions) is initiated and a stop is placed above the recent highs.

M-Top in Pandora Media
Figure 4. M-Top in Pandora Media (NYSE:P) Daily Chart. Source: StockCharts.com

The M-Top is similar to a Double Top chart pattern. One potential profit target is to subtract the height the M-Top from the breakout price. In Figure 4 the M-Top is roughly $9 high, subtracted from a breakout price near $31, this gives a target of $22. If a major downtrend unfolds, a trailing stop can be used to attempt to capture more profit from the short position.

Bollinger Band Limitations

Bollinger Bands are a helpful indicator, but they have a number of limitations. Bollinger Bands are derived from a simple moving average, which is the average price over a certain number of price bars. This means Bollinger Bands will always react to price moves, but won’t forecast them. Bollinger Bands are reactive, not predictive.

Standard settings won’t work for all traders. Active traders may want a small number of periods or lower standard deviation, while long-term traders may prefer a greater number of periods and a greater standard deviation, so few signals are presented. By adjusting the settings though it may be more difficult to gauge the trend based on the guidelines or spot W-Bottoms or M-Tops.

M-Tops and W-Bottoms may not actually end up not being reversals, but rather just consolidations where the price continues to head in the trending direction after a false breakout. A false breakout is when the price passes through the entry point, initiating a trade, but then quickly moves back in the other direction resulting in a loss. This is why stop losses are used.

The Bottom Line

Bollinger Bands are comprised of a middle band (SMA), and upper and lower bands based on standard deviation which contract and widen with volatility. The Bands are a useful tool for analyzing trend strength and monitoring when a reversal may be occurring. Combining Bollinger Bands with M and W price patterns aids in spotting major reversal signals. Bollinger Bands are not predictive though. They are always based on historical information and therefore react to price changes, but don’t anticipate price changes. Like other indicators, Bollinger Bands are best used in conjunction with other indicators, price analysis and risk management as part of an overall trading plan.


– Understanding Business Cycles and Stock Trading

Predicting the stock market is notoriously difficult, but there are some well-defined and predictable patterns that arise from the chaos. Business cycles are a great example of these predictable patterns, arising from the inherent boom-bust nature of capitalist economies. Of course, there are many well-known variations of these cycles, such as the so-called January Effect or the 17.6 Year Stock Market Cycle.

In this article, we’ll take a look at business cycles and how they impact the financial markets, as well as how traders can track them to maximize their alpha.

What Is the Business Cycle?

Business cycles arise from changes in economic growth within an economy. For example, the U.S. stock market has gone through several business cycles over the past few decades highlighted by events like the tech bubble in 1999/2000 and the subprime mortgage crisis in 2007/2008. These types of events cause the peaks and troughs within the cycle, which is also called the economic or boom-bust cycle.

U.S. GDP with Recessions
Figure 1 – U.S. GDP with Recessions – Source: FRED®

As seen in Figure 1, business cycles don’t necessarily mean that market downturns completely erase the progress made during market upturns. The U.S. has realized long-term growth in its gross domestic product, but the grey areas in Figure 1 show the temporary downturns along the way. As mentioned above, these downturns consist of peaks and troughs within the long-term bullish trend.

The changes in economic growth that cause business cycles are driven largely by liquidity in the financial system. For instance, excess liquidity in the U.S. financial system was a large contributing factor to the subprime mortgage crisis. Low interest rates made housing affordable to almost anyone, while investors looking for yield were willing to take on excessive risks when it came to lending.

Stages of Business Cycles

Business cycles can be broken down into various stages, according to the U.S. National Bureau of Economic Research (Figure 2). For traders, each portion of a business cycle presents different opportunities to profit given that the dynamics tend to favor certain industries or asset classes. For example, market contractions tend to prefer defensive industries like consumer staples.

NBER Business Cycle
Figure 2 – NBER Business Cycle – Source: Sector Rotation over Business-Cycles

Expansions occur between the trough and peak of a business cycle and are characterized by an increase in production and prices, which are powered by low interest rates set by central banks. These periods tend to favor industries like technology, financials, and capital goods, which benefit from increased leverage relative to safer and more traditional industries.

Peak

Peaks occur at the top of a business cycle and are characterized by stock market crashes, multiple bankruptcies of major firms, and/or lower consumer sentiment, driven by the realization of excesses and the spread of fear throughout the financial market. These periods tend to draw capital into energy and precious metals sectors, which provide investors with a bit of a safe-haven [see also Top 21 Trading Rules for Beginners: A Visual Guide].

Contraction

Contractions, or recessions, occur between a peak and trough of a business cycle and are characterized by falling production and prices, as well as decreasing or stagnant income growth. These periods tend to draw investors out of safe-havens and into more conservative industries like consumer non-cyclicals and utilities, which often have a dividend component and low beta coefficients.

Trough

Troughs, or recoveries, occur at the bottom of a business cycle and are characterized by a slow recovery in stock price, driven by the fall in prices and incomes that form the beginning of an expansion. These periods tend to favor turnaround industries like financials and consumer cyclicals, which are riskier than many other sectors, but not quite as bullish as technology or pharmaceutical sectors.

3 Ways to Trade Business Cycles

There are many different ways that traders can profit from business cycles, ranging from simply moving money into favorable industries to using specific strategies. While many of these strategies may seem straightforward, determining where an economy is within a business cycle can prove very difficult on its own, which means that sector rotation is half art and half science in the end.

Simple Sector Rotation

Traders can improve their risk-adjusted returns by focusing on certain sectors during a given business cycle. Figure 3 shows how long-term performance compares between simply investing in the market, using sector rotation, and using market timing in addition to sector rotation between 1948 and 2006. While the market has eliminated some inefficiency, many of these trends still exist today.

Business Cycle Performance Comparison
Figure 3. Business Cycle Performance Comparison – MarketOracle.co.uk

Elliott Wave Cycles

The Elliott Waves Principle was developed by Ralph Nelson Elliott in order to analyze financial market cycles and forecast trends by identifying extremes in investor psychology. The patterns described by the principle can be accurately overlaid with business cycles in many cases, helping technical traders improve their market timing and ultimately enhance their risk-adjusted returns.

17.6 Year Stock Market Cycle

Kerry Balenthiran, a mathematician and chartered accountant, elaborated on the so-called 17.6 Year Stock Market Cycle in his book on the subject that sought to connect the panics of 1929, 1987, 2000, and 2007. In addition to these cycles, Mr. Balenthiran introduces a shorter 2.2 year cycle that could be more closely associated with the business cycles that are commonly found in economics.

The Bottom Line

Business cycles are a natural part of the boom-bust nature of capitalism, but they can also provide opportunities for traders. By knowing favored industries within each business cycle, traders can improve their long-term risk-adjusted returns, while other strategies like Elliott Waves can help improve market timing within those cycles in order to further enhance profits and limit losses.


– Three Key Elements Needed to Become a Successful Trader

Trading in the market is one of those things

It can result in consistent, profitable yields or devastating losses from which one may never recover—especially to the new, or middle-class investor. There are those who ask me constantly, “isn’t investing in stocks just gambling?”—to which I smile politely and attempt to explain why most outsiders feel this way. Those who wish to participate in the market need to respect its vastness and depth. I liken the stock market to that old jungle cliché —because everything lurking does want to hurt you. Couple that with a great degree of uncertainty, and its plain to see that one must approach trading with purpose, discipline, open-mindedness and most importantly, patience.

The bottom line of what I try to tell them, if you are a middle-class earner and you think the market will make you the next Warren Buffett, you are headed for some immediate letdowns and potential disasters. This is especially true for the market we’ve seen in the last while.

Success in trading is not just a function of one component. It is a function of three components or resources that form the cornerstones of a trading foundation; the building blocks of an effective market strategy. These resources are categorized under Behavioral, Fundamental and Technical Analyses.

I. Behavioral Analysis

In order to trade the market, you must first develop an understanding of what the market is. A market provides a venue or an environment for determining the balance or equilibrium point for the demand and supply of an asset. The demand and supply of an asset is influenced by the number of buyers and sellers participating in the market. As the participants move to find the equilibrium point between demand and supply, the market is subjected to various forces that constantly shift the advantage between buyers and sellers. These forces reflect the underlying psychology of the market. Thus, for a trader to become successful in the market he or she must develop an understanding of the forces that influence market behavior. These can be broken down into a separate items:

  1. Psychology of the Market: The trader must acknowledge that the market is made up of thousands of unique individuals with different personalities. They react, observe, view, and analyze the market differently. Thus, we can make an argument that the psychology of the market is irrationa,l which explains why group behavior otherwise referred to as “Collective Psychology” is prevalent. An individual who joins a collective loses all rationality as he is carried over by the general sentiment of the group.
  2. Dimensional Analysis of the Market: The trader should develop a key understanding of the three components that drive markets: Price, Volume and Time.

The movement of price is dictated by the shifts in forces between the buyers and sellers in the market. Stronger buyer movement brings prices up and inversely, stronger selling action moves prices down.

Volume is generated by the forces that influence the decisions of the buyers and sellers in the market and is a consequence of news, information and other factors that enter the market.

Time refers to the period in which the trader wants to trade. Is he a fund manager who seeks long-term trading positions, or an intra-day trader who wants to exit the market before close of market?

Collectively, price, volume and time will determine the movement of the market and give the trader a firm perspective on its underlying behavior.

Understanding Risks in Trading

Success in trading is not just determined by having a well-structured, well-researched trading plan and skills enhanced by constantly working to improve competencies in technical and trading analysis. A lesser known key to achieving consistent success in the market is the trader’s acknowledgement of the value of risk management policies.

Obviously, people who enter the market do so with the objective of earning an appreciable level of profit. But profit in market trading is a function of earnings and losses. It is not enough that a trader focuses his or her resources only on mechanisms and strategies toward achieving profit. He or she must develop a set of policies or guidelines that determine the amount of risk s/he is willing to take. This ensures the protection of trading capital.

II. Fundamental Analysis

This is one of the two core approaches to market analysis and remains the prevalent methodology among traders today. Fundamental analysis refers to the use of reports, economic data, newsfeed and other informative media that relates to the value of an asset or commodity. Traders can source data to formulate their fundamental analyses online and via media channels such as Bloomberg, RanSquawk and Reuters plus traditional sources such as stockholder’s meetings. Professional Fund Managers who favor long-term position trading often use sources from inside corporations of traded securities to gain first-hand information on developments that could influence market movement. There are generally three key areas of Fundamental Analysis:

  1. Corporate Value: Factors such as earnings, dividend yield, asset valuation and bond/stock yield of a security are collated, broken down and analyzed to come up with a specific recommendation.
  2. Economic Factors: These are factors that affect demand and supply in the economy such as the rate of inflation, level of unemployment, manufacturing and non-farm payrolls, new job creation, and foreign currency fluctuation.
  3. Government Policies: Investors and traders are always on the lookout for information on government policies that could have an effect on taxation, trade policies, credit accommodations for foreign investors, plus conditions that could adversely affect market confidence such as wars, political unrest and general elections.

Using Market Indicators

These are systems that are formulated to help the trader find points of entry, exit, and stops during periods of trading. Some of these systems, such as Stochastics, measure trading volume while another one, the Relative Strength Index or RSI, measures the levels of buying and selling. Seasoned technical traders use indicators in conjunction with price levels to look for Divergence levels. A Divergence level is the point where any further increase in price is supported by declining levels of buying volume or strength which may indicate a market reversal is imminent.

You can dig deeper into Fundamental Analysis here.

III. Technical Analysis

The second core approach to market analysis is highly misunderstood. Technical analysis is not just the use of tools and processes, the majority of which are based on mathematics and science. More accurately, it can be used to measure market psychology by studying the underlying structure of the market. When a trader uses Technical Analysis, s/he is asking the question, “What is the market trying to tell me?” Thus, the successful application of any tool or system of Technical Analysis must have a substantial basis to answer that question.Understanding Market Structure: All modes of Technical Analysis must start with understanding market structure. Traders are usually indoctrinated in Technical Analysis through the use of trend lines and channels to determine support and resistance levels. Other forms of Technical Analysis that study market structure are:

  • Dow Theory: This approach uses shapes and formations to determine market movement, including trends and reversals.
  • Elliott Wave Theory: Formulated by Ralph Elliott, this theory assumes that collective investor behavior moves in patterns or waves; an impulsive 5-wave pattern and an ensuing corrective 3-wave pattern.
  • Fibonacci Ratios: This is based on a “Golden Ratio” that can be used to measure the relative proportions of nature’s smallest units, such as the atom, to the most advanced patterns in the Universe. Fibonacci Ratios are used to measure retracements and price targets.

Read more on Technical Analysis here.

The Bottom Line

The final reality that traders need to acknowledge before they decide to participate in the market is that regardless of their level of planning, preparation, consultation and research, failure and the actualization of losses is a non-negotiable truism in the world of trading.

Everyone who engages in the markets will inevitably fail so to speak.

The realization of failure is not meant to discourage traders but rather open their minds to the underlying and all-encompassing truth that the market is so vast and powerful it can never be cornered or controlled by any one entity or group of entities.

Thus, while traders enter the market for the purpose of generating profits, they should remain mindful that risks exist and therefore, discipline and caution must be exercised every single trading day. Greed will leave you bruised. Much like a batter at the plate, if you’re constantly swinging for the fences (i.e. trying to get rich quick), you’re going to strike out more often than not—with devastating results. I take a Chipper Jones approach to trading: Swing for singles and play the percentages. Sometimes you’ll finish with a double or a triple. Home runs are nice, but if they are your sole focus, you are putting yourself under unnecessary pressure and great risk.

Fun fact, Jones holds the Atlanta Braves record for career on-base percentage—yet sits in third place on the team’s all-time home run list… Mr. Consistent. Keep that in mind next time you step up to the dish.


Wall Street Moguls – The Biggest Names on Wall Street

When trying to do a bit of research on some of the biggest names on Wall Street, most will inevitably turn to Google and find more information than they probably ever wanted to know about a particular person. We decided to have a little fun with Google’s auto-fill feature, which populates your search bar with the most popular searches given the text you input. We put the biggest names on Wall Street to the test, asking Google “why is…” and the results are quite entertaining .

Warren Buffett

Dubbed the Oracle of Omaha, it seems that many want to know how exactly Warren Buffett got to be so rich, and of course his political stance.

Buffett2

Carl Icahn

A Wall Street heavyweight, Carl Icahn has his hands in almost every major story in corporate America. Investors, however, are more concerned with his dealings with Apple and Dell [see also A Stock Trend You Never Considered: Comparing Search Traffic and Stock Performance].

Icahn

George Soros

Best known for breaking the British pound, hedge-fund guru George Soros apparently isn’t too well liked, considering how many want to know why he is “evil”.

Soros

Bill Gross

While he may be known as the Bond King, apparently investors aren’t too interested in Bill Gross’s fixed income strategies.

Gross

Bill Ackman

It seems many people are not too fond of hedge fund manager Bill Ackman, as well as his stance on Herbalife [see also 50 Blogs Every Serious Trader Should Read].

Ackman

Charlie Munger

Though he is best known for being the right-hand man and investment partner of Warren Buffett, people apparently are more concerned about Charlie Munger’s political and religious ideologies.

Munger

Mohamed A. El-Erian

No surprises here. After Mohamed A. El-Erian announced he would leave PIMCO, many are wondering why exactly he left.

El%20erian

Jeff Bezos

With Amazon.com being the largest online retailer in the world, investors want to know how exactly Jeff Bezos managed to make the company such a success.

Bezos

Steve Ballmer

Though many are wondering why Steve Ballmer stepped down as CEO of Microsoft, the most important question concerns his excessive sweating.

Ballmer

David Einhorn

While this hedge fund manager has made headlines for his actions (shorting Lehman), most want to know why he filed a lawsuit against tech giant Apple.

Einhorn

Nouriel Roubini

Though well known for his “Dr. Doom” predictions, people are seemingly more concerned with his marital status.

Roubini

Jamie Dimon

Apparently most people are quite split on their views of Jamie Dimon; some want to know why he is a good leader while others wonder why he is not in jail.

Dimon

Peter Schiff

Peter Schiff is certainly known for voicing his opinion; investors, apparently, have their own opinions on the infamous commodity bull.

Schiff

Mark Zuckerberg

Many wonder how social media giant Mark Zuckerberg came to be so successful. Others, however, find Zuckerberg less endearing.

Zuckerberg

Cameron and Tyler Winklevoss

Possibly one of the most bizarre autofills on this list, there are a apparently a lot of questions about the infamous Winklevoss Twins, Cameron and Tyler.

Winklevoss%20c
Winklevoss%20t

Bill Gates

Usually found towards the top of Forbes’ Billionaires List, most people want to know how Bill Gates came to be so rich and famous.

Gates

Steve Jobs

According to the results of Google autofill, the Apple King Steve Jobs is well-liked and respected by investors.

Jobs

Sam Zell

Wall Street mogul Sam Zell has had many noteworthy investment deals, but most people are only concerned about why he bought the Chicago Tribune.

Zell

Mark Cuban

Though he may be an infamous businessman and investor, most people want to know when Mark Cuban will be on the show “Shark Tank.”

Cuban

Eike Batista

Many people searching for Brazilian oil and gas giant Eike Batista apparently want to know more about his ex-wife – Luma de Oliveira, former model, actress and Brazilian carnival queen.

Batista

John Paulson

Though Paulson is best known for betting against the U.S. subprime mortgage market, most investors want to know why he is buying precious metals.

Paulson

Larry Page

Considering his success, it’s not surprising to see people asking why Google’s Larry Page is such a good leader.

Page

The Bottom Line

Though Google’s autofill feature can turn up some humorous results, some of these searches are perhaps not too far off base of how investors perceive some of the biggest names on Wall Street.


– 7 Rules Every Contrarian Investor Must Follow

“The time to buy is when there’s blood in the streets.” – Baron Rothschild

Contrarian investors attempt to profit by exploiting opportunities where consensus opinion appears to be wrong. For example, widespread market pessimism can drive a stock price below its intrinsic value, leading a contrarian investor to buy the stock and sell for a profit after the stock reaches fair value. The risk is that crowds can defy logic for extended periods of time, but patience can pay off handsomely.

On the whole, contrarians appear to outperform the market when accounting for risk. A November 2009 study titled Uncommon Value: The Investment Performance of Contrarian Funds found that contrarian funds outperformed by more than 2.6% per year, both before and after fund expenses, holding stocks with much greater improvement of profitability compared to so-called herding funds.

In this article, we’ll take a look at seven rules that every contrarian investor should follow to enhance the odds of making successful trades.

#1. Mind the Noise

From the talking heads on CNBC or Bloomberg to catchy headlines in the WSJ or IBD, the markets’ sentiment is swayed by a relatively limited number of sources.

Contrarian investors should stick to the numbers and tune out the television or newspaper when analyzing investments. While headlines certainly can impact stock price, they often have very little impact on a company’s true value, which is ultimately the price that contrarian investors are looking to beat.

Former managing director at Drexel Burnham and current “Doom & Gloom” specialist, Dr. Marc Faber was famously quoted as saying “Follow the course opposite to custom and you will almost always be right.” Basically, the good doctor is saying if the talking heads are on CNBC saying buy it – don’t.

#2: Have Your Own Plan and Stick to It

Sun Tzu once said, “Victorious warriors win first and then go to war, while defeated warriors go to war first and then seek to win.”

Much of contrarian investing comes down to actual stock or sector analysis. That means digging into numbers and firm’s corporate filings. From price-to-book ratios, historical earnings metrics, price-to-sales etc. All must be used to determine if a stock or sector is truly a bargain. That analysis is key to finding unloved and forgotten about investments, while everyone else is rushing towards the next big thing. The only way to gain foresight and conviction to buy when everyone else is selling is by keeping up with your own analysis and developing the discipline to follow through with your ideas.

By focusing on stocks are actually worth via real metrics, you can make sure that gaining real values rather than just the flavor of the month picks.

Contrarian investors must carefully plan trades and rely on those plans, since the rest of the market has a different plan. In order to do this, investors must also have the foresight and conviction to buy when everyone else is selling, while maintaining their due diligence throughout the trade to deal with any problems that arise.

#3: Don’t Ask Your Barber for Stock Picks

The Dunning-Kruger effect, first tested in 1999 at Cornell University, found that people without a set of skills tend to overestimate their abilities.

Contrarian investors should realize that there are no shortcuts to uncovering great investment ideas, which means that they must rely on their own wits to identify and execute on their own ideas, especially when they’re not popular. The same goes for following through with ideas when many people may be advising otherwise.

#4: Always Be Skeptical

A key hallmark of market bubbles is a lack of skepticism, particularly within the popular press, as occurred with the tech bubble in 1999 and 2000.

Contrarian investors must be inherently inquisitive by nature, training themselves to always ask challenging questions that media pundits and the status quo are ignoring. By doing these things, investors can mold themselves into contrarians in the truest sense and avoid looking at the market through rose-colored glasses.

Are the concerns with coal legislation really detrimental to stocks in the sector? Why exactly are Japanese bonds so hated right now? You’ll never know unless you take the time to at least look at all of the opinions out there. Just don’t let them go to your head and sway your analysis if it’s truly sound.

#5: Be Patient

The Iranian Poet Saadi once said, “Have patience; all things are difficult before they become easy,” which couldn’t be any truer for contrarian investors.

Value investing is often called time arbitrage. That’s because it can take years before an asset class or stock gets Wall Street’s full attention. You need to wait until the market realizes just how valuable an asset class or stock is that you have uncovered. For a true contrarian investor to be successful, they must be patient. Slow and steady wins the race here.

Contrarian investment ideas often take a lot of time to unfold given that they are going against the conventional market wisdom. For example, it took Bill Ackman several months before his bet against the ratings agency MBIA was validated by the market, making him billions when others were losing their shirts.

Another example lies in pipeline Master Limited Partnerships (MLPs), which are all the rage with investors during low rate environments. However, the asset class has been around since the 1980s with many of the modern MLPs forming in the late 1990’. Many just sat there as investors favored faster moving tech stocks. Twenty years later and share prices for the major MLPs have all but exploded upwards.

#6: Use Panic to Your Advantage

Declining stock chart

As Baron Rothschild said in the quote that began this article, the best opportunities to buy are when everyone else is desperate to sell.

Contrarian investors look for opportunities when the market is being irrational, which can consist of irrational exuberance or irrational selling. When the market is panicking, contrarian investors should diligently do their research and identify the point at which the market has significantly overreacted.

A political strife here, a natural disaster there, a missed earnings guidance number – all of these can send a market or stock price downwards into the basement. Wall Street has a very itchy trigger finger and will often do a knee-jerk reaction to a bit of bad news. However, not all bad news is as dire as it may seem in a headline or blog post. An informal Security & Exchange Commission (SEC) Inquiry is not the same thing as an SEC action or sanction. Just because a firm missed analyst estimates doesn’t mean it wasn’t profitable or making money.

Yet, the market will often see all these events as the same and sell off on the news.

That’s where a contrarian can truly shine. By sifting through the real events from the non-ones, they can score deals on stocks and snag other assets as others sell with abandon. During the panic caused by the Great Depression, famous value investor John Templeton took $10,000 and bought shares in every small-cap stock trading on a major exchange for $1 or less. While some of those didn’t make it, the vast majority were just fine and rose higher. Those stocks became the foundation of Templeton’s vast wealth.

#7: Focus on Out of Favor Securities

The best opportunities aren’t those that nobody sees, they are those that everybody sees but nobody cares about.

Contrarian investing is all about going against the crowd rather than with it, which means that out-of-favor securities should be the focus. These securities can include those that have been downgraded by analysts, missed earnings, or those operating in out-of-favor sectors, although that shouldn’t be an exclusive basis for selection.

By combing through the most hated sectors/stocks and using real analysis, you can uncover great long term bargains and score some real hefty returns as these firms revert to the mean. Look at the rail roads. A decade ago they were dead money. Today, fracking and fuel efficiency has brought them screaming back.

The Bottom Line

Contrarians have consistently outperformed the overall market over time on the whole, suggesting that there’s merit to looking at what others dismiss. To do this, these investors pride themselves in finding opportunities where the rest of the market has moved on and profiting from turnarounds. Contrarian investors should keep the aforementioned seven tips in mind when trading in order to enhance their risk-adjusted returns.


– How to Trade Stock Options in 2020

Suppose that you own a stock that has done pretty well over the past few years, but you believe that new regulations could cause a short-term decline in price. Selling the stock would trigger a large capital gains expense when you’d really just be repurchasing the stock later. A better alternative might be to agree to sell the stock at a certain price to lock in profits and then pay the difference if it rises.

The agreement cited in the example above is a type of stock option known as a protective put option. Stock options like these provide traders with flexible tools designed to hedge against risk, increase leverage, and/or execute a number of other strategies to enhance risk-adjusted returns. In this article, we’ll take a look at what stock options are, as well as how, why, and when to use them.

Stock Options 101

Stock options provide buyers with the right, but not obligation, to buy or sell a stock at a certain price at or before a certain date. Conversely, stock option sellers have the obligation to buy or sell a stock at a certain price and date depending on the whims of the stock option buyer. Multiple stock options can also be combined in order to create complex and highly specific trading strategies.

Before getting into the various types of stock options, it’s helpful to learn some of the jargon that traders use when trading options. Every option has a strike price and an expiration date at its core. The strike price refers to the price at which the option is exercised (e.g. the price that the buyer pays for the stock), while the expiration date is the date at which an option contract expires and becomes worthless.

There are also two basic types of stock options known as call options and put options and traders can either be buyers or sellers of each type of option. Call options give the option buyer the right to buy the stock at a certain price at or before the expiration date and the option seller the obligation to sell, while put options give the option buyer the right to sell and the option seller the obligation to sell.

Apple Inc. Option Chain
Figure 1 – Apple Inc. Option Chain – Source: NASDAQ

Stock options are usually quoted in option chains showing a variety of different strike prices and expiration dates for both call and put options, as seen in Figure 1 above showing the NASDAQ’s stock option table for Apple Inc. The table is divided into call options on the left and put options on the right for the same strike prices, with other important data points like bid, ask, and open interest.

Why Stock Options?

Stock options are useful because of their tremendous flexibility when executing on a trade thesis. For example, suppose that a trader believes that a stock will remain range-bound over the next six months based on a strong price channel. The trader could buy and sell the stock at the channels highs and lows over time, but a stock option strategy called the iron condor was designed specifically for that purpose.

Iron Condor Strategy
Figure 2 – Iron Condor Strategy – Source: TheOptionsGuide.com

On a more general level, there are many reasons for traders to use stock options:

  • Risk Management – Stock option strategies, like the protected put, and be very useful in managing risks associated with existing stock positions or in hedging risks by gaining or reducing exposure to broad market indexes.
  • Increased Leverage – Stock options provide a lot more leverage than plain vanilla stocks, particularly when looking at stock options that have strike prices distant from the current stock price (known as out-of-the-money).
  • Specific Strategies – Stock option strategies exist for practically any anticipated stock price action (including price inaction!), making them ideally suited for capitalizing on exacting predictions.

In general, stock options provide traders with additional flexibility, acting as a complementary tool alongside traditional stock and other derivatives. There are almost always times in which stock options would be useful in simply providing a hedge against market risk or substituting for stock transactions to make a particular trade thesis pay off more handsomely in terms of risk-adjusted returns.

How to Trade Options

Stock options are complex financial derivatives, which means they are both highly risky and subject to additional regulation. Many brokerages require clients to apply for approval to trade options, certifying that they are experienced in the financial markets and are willing to assume the risks. Traders should also take education seriously and understand the positions they’re entering beforehand.

After gaining an understanding of how options work, traders must analyze both a stock and its options in order to identify an opportunity. Stock option prices are based on a number of different factors, including the underlying stock’s volatility and the time until expiration. These factors are represented by option greeks like delta, vega, theta, and gamma, signifying various factors influencing valuations.

Stock Option Valuation with Black-Scholes Model
Figure 3 – Stock Option Valuation with Black-Scholes Model – Source: Wikipedia

Traders must also consider the many different strategies available before making the trade through their brokerage platform. While covered calls may be relatively straightforward in selling call options using an existing long stock position as the underlying stock, complex strategies can involve multiple types of options at different strike prices and expiration dates to achieve various objectives.

When traders are ready to sell, there are three possible outcomes for option buyers:

  • Hold Until Maturity – The stock option buyer can hold the stock option until the contract expires and then exercise the option at the strike price.
  • Trade the Option – The stock option buyer can sell the option itself to someone else before the expiration date at a profit or loss.
  • Let it Expire – The stock option buyer can let the option expire if it’s worthless at the time of expiration based on the strike price.

When selling options, there are two different possibilities to exit the position:

  • Covered Calls – The stock option seller owns the underlying stock, meaning the stock option buyer simply buys it from them.
  • Uncovered Calls – The stock option seller doesn’t own the underlying stock, meaning they must buy the stock and provide it to the stock option buyer.

The Bottom Line

Stock options provide traders with a flexible tool to enhance risk-adjusted returns by hedging risks or leveraging returns. With their ability to profit in any market conditions, stock options also provide greater flexibility than vanilla stocks in capitalizing on certain situations that may be occurring – such as a stagnant stock that isn’t moving in any particular direction at all.


– What Is High Frequency Trading?

High frequency trading (“HFT”) is a type of algorithmic trading that uses technology to rapidly interpret data and execute trades. By 2009, HFT accounted for between 60% and 73% of all U.S. equity trading volume with individual traders placing thousands or millions of trades per day. Since then, its popularity began to decline amid greater competition and government scrutiny following the Flash Crash.

In this article, we’ll take a look at the rise of HFT, who’s behind the trades, examples of HFT trades, risks versus rewards, and why it has become controversial.

HFT History & Players

High frequency trading started taking place shortly after the U.S. Securities and Exchange Commission (“SEC”) authorized electronic exchanges in 1998. At the time, HFT trades took several seconds to execute and computational power was relatively slow, limiting the strategy’s effectiveness. The subsequent reduction in execution times and increases in computing power drove increased adoption over time.

In the U.S., HFT firms represent just 2% of the total number of firms, but account for the majority of all equity order volume. Companies like Getco LLC, Knight Capital Group, Jump Trading, and Citadel LLC began focusing their operations on taking advantage of small inefficiencies. Since they used no leverage and had short holding periods, the strategies theoretically produced low-risk, high-reward opportunities.

Profits from these strategies peaked at about $5 billion in 2009 and have since fallen to about $1.25 billion in 2012 by some estimates. The increasing number of HFT traders in the market has led to heightened competition and fewer inefficiencies in the market that are available for exploitation. Regulators have also introduced limits to HFT in some cases, including Italy’s taxation on all HFT trades.

Examples of HFT Traders

High frequency traders use a number of different strategies designed to take advantage of market inefficiencies. Since these trades take place algorithmically, market researchers can spot them relatively easily (Figure 1). Patterns produced by HFT have been the focus of extensive research by organizations like Nanex that focus on documenting the activity for regulators and other interested parties.

KORS Quote Stuffing – Source: Nanex Reserach
Figure 1 – KORS Quote Stuffing – Source: Nanex Reserach

Perhaps most famously, many HFT traders rely on so-called low-latency strategies to generate profits. HFT traders with extremely fast connections, using things like microwave networks over long distances, take advantage of the difference in price that the same security may have on multiple exchanges. These differences may be individually very small, but may add up to significant numbers very quickly.

HFT traders focused on market making operations aim to capitalize on the spread between bid and ask prices. For example, HFT trading firms might place a limit order to buy or sell in other to earn the bid-ask spread. Some exchanges also offer rebate income to market participants willing to make markets in relatively illiquid securities, providing yet another venue to generate automated profits.

HFT traders can take advantage of arbitrage opportunities, such as event or statistical arbitrage, using automated software, too. For example, there may be market inefficiencies in the pricing between domestic and dollar-denominated bonds or spot and forward contract currencies. HFT traders can generate profits by buying one asset and selling another until the difference between them closes.

All of these strategies are focused on generating small profits from inefficiencies that add up to big numbers over time. With thousands or millions of trades placed every day, making even pennies per trade can translate to millions of dollars.

HFT Risks & Rewards

High frequency trading can generate significant profits at a relatively low risk, since the strategies involve very little risk and a high Sharpe ratio. For example, HFT traders capitalizing on an arbitrage scenario face exceptionally low risk, since they aren’t using any leverage and the simultaneous buying and selling removes any risks associated with the individual security being traded.

The problem arises when the computer algorithms being used to generate HFT trades become error-prone. For instance, Knight Capital Group famously lost $440 million in just 45 minutes when trying to modify its algorithms to effectively compete against a new NYSE program launched on the same day. The technology went on a trading frenzy (Figure 2) and nearly caused a financial crisis on its own.

One Second of Trades in EXC with 39 Trades
Figure 2 – One Second of Trades in EXC with 39 Trades – Source: Nanex Research

HFT firms are also facing increased competition, which makes the markets more efficient and limits profit potential. Some experts estimate that the profits from these strategies have fallen from an estimated peak of $5 billion in 2009 to about $1.25 billion in 2012, since there is less inefficiency to exploit and a greater number of HFT trading firms going after a smaller piece of the pie.

HFT Controversy & Regulation

The Flash Crash on May 6, 2010 set the stage for increased regulatory scrutiny of high frequency trading operations. On that day, the Dow Jones Industrial Average plummeted roughly 1,000 points or 9% and recovered the losses within minutes in the biggest one-day point decline on an intraday basis in the index’s history. The SEC and CFTC concluded that HFT was largely responsible for the crash.

The government’s report indicated that a large mutual fund firm began selling usually large numbers of E-Mini S&P 500 contracts that exhausted available buyers and triggered HFT trading firms to begin aggressively selling. Arbitrage-based HFTs then began buying the e-minis and selling the equivalent amounts of stock in the equity markets and then eventually began buying and selling with each other.

Regulators have also grown concerned with frontrunning. New York’s Attorney General Eric Schneiderman called HFT “insider trading 2.0” though SEC head Mary Jo White insisted that using computer algorithms to trade ahead of other investors is “not unlawful insider trading.” FINRA has since suggested that the SEC at least consider registration requirements for HFT firms to avoid systemic risks.

The Bottom Line

High frequency trading involves rapidly buying and selling securities in order to capitalize on market inefficiencies. Often times, these inefficiencies come in the form of arbitrage opportunities, event-driven opportunities, or simply low-latency strategies that take advantage of faster access to information. HFT firms have fallen in popularity since 2009 but remain a big part of the U.S. equity markets.

Some regulators are concerned with HFT firms’ significant footprint that introduces some level of systemic risk, while others are concerned with the ways that the firms generate profit by front-running investors. Over time, these concerns could result in additional regulations for HFT firms that could further limit their participation in the U.S. equity markets, for better or worse.


– Dow Jones Stocks: The Questions We Really Want Answered

The investing world has rapidly changed as the internet has made it easier than ever to conduct research and analysis on various companies around the world. A lot of that research starts on Google, where investors and users will search just about anything you can think of, and a lot you probably can’t. We decided to have a little fun with Google’s auto-fill feature, which populates your search bar with the most popular searches given the text you input. We put the Dow 30 stocks to the test, asking Google “why does …” and the results are quite entertaining.

3M (MMM)

Best known for its scotch tape and post-it notes, it seems that most investors are curious about what “3M” stands for in the first place.

MMM search query results

American Express (AXP)

Cutting down on costs has always been a major theme among consumers, demonstrated here by their inquisitions into AMEX’s fee structure.

AXP search query results

AT&T (T)

The internet certainly pulls no punches for this telecom giant, wondering why AT&T has a number of issues.

See Also: 25 Stocks Day Traders Love

T search query results

Boeing (BA)

We’ll hand it to Googlers, these are actually legitimate and interesting questions.

BA search query results

Caterpillar (CAT)

Unfortunately, this grammatical atrocity is only in reference to the insect, not the company.

CAT search query results

Chevron (CVX)

An affinity with the number 126, curiosity about gas prices, and a look into a company’s origins define the Internet’s interests in this oil & gas giant.

CVX search query results

Cisco (CSCO)

More negative searches and the quest to discover more about the mysterious “cicsoe morris.”

CSCO search query results

Dupont (DD)

Conoco is a big theme when it comes to DuPont, but it was no match for John Eleuthere du Pont’s murder of Dave Schultz and the career trajectory of Nascar driver Jeff Gordon.

DD search query results

Exxon Mobil (XOM)

It would seem that the internet is curious as to how Exxon’s taxes are so low, and perhaps how they could lower their own.

XOM search query results

General Electric (GE)

There weren’t too many searches for General Electric, but trust us, this is better than using just “GE” in the search bar.

Goldman Sachs (GS)

It’s always good to see people’s priorities. The Internet is very concerned with Goldman’s global sway, and is still trying to figure which 2012 Presidential candidate the company backed. Oh, and don’t forget about cupcakes, those are important too.

GS search query results

Home Depot (HD)

Home Depot sells just about everything you could possibly need for a DIY construction project. But it seems people are curious about what’s in the mini-fridges at checkout.

See Also: 50 Blogs Every Serious Trader Should Read

HD search query results

Intel (INTC)

Competition with AMD and confusion over the existence of celeron processors apply to the company, while intellectual property and the importance of intelligence are borne out of general curiosity.

INTC search query results

IBM (IBM)

Outsourcing jobs seems to have struck a chord with investors, though some wonder why IBM even bothers to make computers these days.

IBM search query results

Johnson & Johnson (JNJ)

The Internet loves animals and they would also like to know why Johnson & Johnson tests its products on furry little creatures.

JNJ search query results

JP Morgan (JPM)

A disappointing result, we had hoped for something more interesting or laughable than shorting silver, but the next company in the Dow does not disappoint.

JPM search query results

McDonald’s (MCD)

This is probably the most entertaining on the list as half of the Internet seems to be concerned with the impact of the food, while the other half is scratching their heads, trying to decipher how the food can be so delicious.

MCD search query results

Merck (MRK)

Merck does, in fact, own the sunscreen line, but investors simply want to know why the consumer product makes its way onto the balance sheet of a pharma giant.

MRK search query results

Microsoft (MSFT)

Apparently Windows 98 still reigns supreme.

MSFT search query results

Nike (NKE)

Fun fact, the Nike Swoosh was originally commissioned for $35 (the creator was later given stock in the company).

NKE search query results

Pfizer (PFE)

To answer your question, Pfizer does not own Monsanto. Though Pfizer’s Pharmacia did have an 85% stake in Monsanto for several years at the turn of the millenium, leading to the confusion.

PFE search query results

Procter & Gamble (PG)

Three points for animal testing, it’s a hot button issue on google.

PG search query results

Coca-Cola (KO)

Cocaine was not made illegal in the United States until 1914, and it appears that evidence suggests Coca-Cola originally contained trace amounts of the now-illicit substance until 1903.

KO search query results

Travelers Companies (TRV)

It could be worse Travelers, you could be Disney.

TRV search query results

United Technologies (UTX)

Not much to say here, United Technologies seems to be less popular of a search than the other firms on the list.

See Also: Ten Commandments of Futures Trading

UTX search query results

Wal-Mart (WMT)

The Internet seems to think Wal-Mart’s clientele is a bit off their rocker. In fact, there is even a website dedicated to strange sightings in Wal-Mart locations.

WMT search query results

Verizon (VZ)

Similar to AT&T, customers are dying to find out why their monthly cell phone bills are so high.

VZ search query results

Walt Disney (DIS)

To be fair, Disney does have a track record of leaving its characters orphaned or at least down one parent for their lifetime.

DIS search query results

Visa (V)

Certainly a diverse string of searches, though we’re sad Morgan Freeman’s name did not appear given his prevalence for voicing Visa commercials.

V search query results

The Bottom Line

While these searches can turn up some comical results, some are a good representation of how consumers perceive some of the largest companies on the planet. Though these queries are not at all likely to impact an investment decision, some of them can reveal some telling information that investors may find useful.


Options Trading For Beginners – 7 Options Trading Mistakes Beginners Can Avoid

Options are a great trading tool that can be utilized in all market conditions, either to generate income, produce profits, or hedge risk. There are several mistakes new traders make when they enter the world of options trading though. Options, when used incorrectly, can erode your account quickly, or in the worst case scenario create margin calls. Here are seven mistakes beginner options traders make, and how to avoid them.

1. Focusing on OTM Options

Options Trading Mistakes

Out of the money (OTM) call or put options are typically cheaper, so many traders view them as a “good deal.” While this is true in some cases, options are priced in such a way that you aren’t going to get a free lunch. The premium, or value of the option when you buy it, decays with time. Therefore, the price not only needs to move above (for a call option) or below (put option) your strike price, but it needs to do so before the option expires, and by enough to offset the cost of the option.

It can be difficult to consistently make money with this approach. There are times when trading OTM options is a valid strategy, but don’t get caught in the trap of thinking that just because the option is cheaper it’s a better deal than another option. Assess the probability that the underlying asset will exceed the strike price before expiry, based on historical tendencies, before buying OTM options.

Be sure to read our guide Options 101: American vs. European vs. Exotic

2. Too Finite an Approach

Options are very flexible, and can be used in all market conditions. But not all option strategies work in all market conditions. When an underlying asset is calm and barely moving, buying OTM call or put options isn’t likely to produce good results as long as the underlying market remains flat.

On the other hand, writing covered options (when you have a position in the underlying stock and write options against it) in this environment can produce extra income for you. There are also other strategies that are more complex, such as Iron Condors, which involve taking multiple positions and producing a profit if the price of the underlying doesn’t move much.

Just like stock traders are taught to diversify, options traders should also diversify the methods used. Implement different strategies for different market conditions, and for different stocks or assets based on their tendencies.

3. Not Having an Exit Plan

A major error for new option traders, and traders in all markets actually, is not having an exit plan. When you take a trade you are expecting to make money, but how much money? How will you decide the amount of profit that is appropriate? If it looks like your option is going to expire worthless do you sell it beforehand to recoup some of the cost, reducing your loss? Will you hold the option until expiry?

See also 4 Ways To Exit a Losing Trade

These are questions that need to be addressed before the trade, not during. Create a plan for what a realistic profit target is, based on the historical movement of the underlying asset. Determine how you will minimize risk, and when you will exit the trade if it is losing and looks like it won’t finish in the money.

4. Oblivious to Market Moving Events

Say you create an options trade based on quiet market condition, and you’ll profit as long as the underlying asset stays docile. You’ll want to check to see if any market moving events are due out in the stock during the time frame of your trade. An earnings release for example could throw a wrench in your plan, increasing volatility, changing market conditions and putting your “quiet times” strategy unnecessarily in jeopardy.

Be aware of what is happening in the markets you are trading. Major economic events such as Fed minutes or an earnings release can change market conditions quickly, and your strategy should accommodate for that. Monitor the economic calendar and earnings calendar and create a plan for how you will trade around major news events. You may also opt not to trade close to these events, thus removing the big unknown of how the market will react to the event.

5. Ignoring Consistent Gains in Favor of Home Runs

Making a huge gain on a trade is a nice feeling, but it is also hard to do. In hindsight it is easy to spot the home run trades, but in real-time it is much harder. Much of the time stocks do nothing (or nothing major), and it isn’t easy to pinpoint when one of them (of the thousands available) is about to explode.

But markets constantly move several percentage points within a matter of days. Therefore, making consistent smaller returns can be easier than making one huge return. While making 2% a week based on a consistent strategy isn’t as sexy as a 20% return, you’ll likely be able to rack up multiple 2% weeks before ever capturing a big winner.

Also, remember that every time you make a small and consistent gain you are building your capital. This produces compounding returns. On the other hand, every time you lose on a “home run” trade you are diminishing capital, reducing the amount of capital available for trades. Over time this has a very negative effect because it becomes harder and harder to recoup losses as position sizes decrease due to diminishing capital.

6. Trying to “Time” Legged Trades

Option strategies often require taking multiple options positions at the same time. Such trades require several transactions, which should all occur at the same time to attain the desired positioning. Some traders will make the transactions one at a time though, attempting to increase their profit slightly by getting one option on an uptick and another on a downtick, for example.

The problem is that you may end up missing your window to establish the position. If the price begins to run before you have established your positions you may be left exposed to unknown risk.

If you’re creating a position that requires multiple option trades, take them all at once. Don’t try to cherry pick your entry points. Even if it works it will only have a negligible effect on overall profitability, and could mess up the original strategy if the price moves against you as you are awaiting a better entry.

7. Not Covering Written Options

Writing options is a way to generate income, as you receive the premium from selling the option upfront; if the option expires worthless you get to keep the entire amount received.

The premium is the maximum profit though, and if the underlying asset goes against you, you potentially face large losses (this is why most option writers have a position in the underlying asset as well, called covered option writing). The mistake of the option writer is failing to lock in some of the premium when they have the chance.

Don’t view option writing as gambling: “I hope the option expires worthless so I can keep the whole premium.” Be actively involved, and realize conditions can change. If the option is very likely to expire worthless (far away from strike price) then you can sit back and relax. But if the outcome is unclear, don’t be afraid to close out the position early.

If you sold options at $2.00 and can get out of the trade when the premium is $0.40 that means you still get to keep 80% of the original premium you received (less commissions) – you still pocket $1.60 multiplied by the number of shares of shares you wrote options on. Keeping 80% is better than potentially having to fork over cash (or your stock if the option is covered) if the price goes against you before expiry.

The Bottom Line

Options are a great tool, usable in all market conditions, but they can be disastrous if a trader doesn’t understand how to implement these financial instruments properly. Diversify your strategies and prepare for potential changes in market conditions that may be driven by major news events. Know how you will exit trades, and focus on consistent returns over home run trades. If your position requires multiple option trades, execute them at the same time; failing to do so may jeopardize the strategy. When you write options, don’t be afraid to exit the trade and keep part of the premium, especially if there is still a question as to whether the option will expire worthless or not.


– World Stock Markets: Everything You Need to Know

For traders and investors, globalization can be a good thing. Today, the opportunities to buy stocks, bonds and other assets from around the world have never been greater. From Paris to Sub-Saharan Africa, investors of all sizes and walks now have the ability to capitalize on a multitude of investments. The best part is anyone with a simple brokerage account can access international stocks traded on their local exchanges. That said, it’s not a simple as just filling out a buy order and pressing submit.

Each exchange has its own rules and quirks. For a trader to be successful in the international space, it’s important to know the differences. Here we present the world’s biggest and most important stock exchanges.

Be sure to also read A Trader’s Guide to Understanding Business Cycles

New York Stock Exchange (NYSE)

They say if you can make it New York, you can make it anywhere. That holds true in the investment world as well. Case in point, the New York Stock Exchange (NYSE). Officially founded in 1817, the “Big Board” has served as the home to the world’s largest companies and the NYSE has been an innovator in the world’s financial markets. It created the idea of a stock ticker back in 1867.

LocationTime ZoneNormal HoursNumber Of StocksTotal Market Capitalization
New York City, New YorkEastern Standard Time (EST)9 am to 4 pm1,867$16.613 Trillion

Today, just under 1,900 companies worth roughly $17 trillion in market capitalization trade on the NYSE. Currently owned by Intercontinental Exchange (ICE), the NYSE continues to be the leading stock exchange in the world.

CompanyTickerMarket Cap
Exxon MobilXOM$435 Billion
Johnson & JohnsonJNJ$296 billion
Wells FargoWFC$270 Billion
General ElectricGE$265 Billion
ChevronCVX$244 Billion
Procter & GamblePG$219 Billion
J.P. MorganJPM$210 Billion
VerizonVZ$206 Billion
PfizerPFE$191 Billion
International Business MachinesIBM$189 Billion

NASDAQ OMX Stock Exchange

Technology has certainly changed the way Wall Street works, and a good bit of today’s technology came from the launch of the NASDAQ OMX Stock Exchange. Founded in 1971, as the National Association of Securities Dealers Automated Quotations, the NASDAQ was the world’s first electronic stock market and helped use the idea of penny trading with regards to bid/ask spreads. The NASDAQ’s innovation continued as it became the first exchange to start trading online and was the first to offer electronic order entering rather than via telephone. More recently, the exchange has created new cloud computing and wireless trading offerings.

LocationTime ZoneNormal HoursNumber Of StocksTotal Market Capitalization
New York City, New YorkEastern Standard Time (EST)Premarket Session- 4 am to 9:30 am, Normal Market Session- 9:30 am to 4 pm, Post Market Session 4 pm to 8 pm3400$8.5 Trillion

This history of technology has made the NASDAQ the place for many of the world’s top technology sector firms, and the very popular PowerShares QQQ NASDAQ Tracking ETF (QQQ) is thought of as a proxy for the tech sector. Today, the NASDAQ is home to 3,400 listed companies, representing 35 different countries equaling $8.5 trillion in market cap.

CompanyTickerMarket Cap
AppleAAPL$573 Billion
MicrosoftMSFT$346 Billion
GoogleGOOG, GOOGL$389 Billion
IntelINTC$154 billion
Amazon.comAMZN$158 Billion
Gilead SciencesGILD$136 Billion
QualcommQCOM$134 Billion
Cisco SystemsCSCO$130 Billion
FacebookFB$170 Billion
eBayEBAY$65 Billion

Tokyo Stock Exchange (Tōshō)

Called the “Gateway To Asia,” the Tokyo Stock Exchange is the major outlet in the Asia-Pacific for stock investors. Originally founded in 1878, the current form of the TSE was created in post-war Japan in 1949 after the nation’s regional exchanges merged. Between 1983 and 1990—when Japanese stocks were rising—the TSE accounted for over 60% of the world’s stock market capitalization. While the Japan bubble may have popped, the exchange is still one of the largest in the world.

Be sure to also download the Global Trading Times Cheat Sheet

LocationTime ZoneNormal HoursNumber Of StocksTotal Market Capitalization
Tokyo, JapanJapan Standard Time (JST)8 am to 1130 am, 12 pm to 5 pm2,292$4.5 Trillion

Today, the TSE is home to a total of 2,292 companies. These firms are separated by sub-exchanges, which are grouped as the First Section for large companies, the Second Section for mid-sized companies, and the Mothers section for high growth startup and emerging market stocks. Unlike U.S. exchanges, the TSE uses numbers to identify underlying stocks. As of November 2013, these firms represented a combined market capitalization of US $4.5 trillion.

CompanyTickerMarket Cap (¥)
Toyota Motor Corp7203¥187 Billion
Mitsubishi UFJ Financial8306¥83 Billion
Softbank Corp.9984¥88 Billion
Honda Motor7267¥63 Billion
Sumitomo Mitsui Financial8316¥56 Billion
Mizuho Financial Group8411¥48 Billion
Nippon Telegraph & Telephone9432¥71 Billion
Japan Tobacco2914¥66 Billion
Canon7751¥37 Billion
Hitachi6501¥35 Billion

London Stock Exchange (LSE)

The London Stock Exchange (LSE) is the largest stock exchange in Europe, and is one of the world’s oldest, having been officially founded in 1801. The exchange traces it origins back to the Royal Exchange founded in 1571 as well as series of commodities and stock brokerage operations that were conducted out of local coffeehouses. Today, the LSE is home to the majority of Europe’s stock, derivatives, bonds and ETF/ETP trading. Additionally, the LSE operates the Alternative Investment Market (AIM) as a sub-market for smaller companies to float shares amid a more flexible regulatory system than is applicable to the main LSE marketplace.

See also Options 101: American vs. European vs. Exotic

LocationTime ZoneNormal HoursNumber Of StocksTotal Market Capitalization
London, EnglandGreenwich Mean Time8 am to 4:30 pm2,938$3.89 Trillion

Currently, the LSE has around 2,938 companies from over 60 countries listed on its exchange – 1151 are located on the AIM, while 54 are placed on the LSE’s Professional Securities Market and Specialist Funds Market. All in all, this equals roughly $3.9 trillion worth of market cap.

CompanyTickerMarket Cap (£)
Royal Dutch ShellRDSA,RDSB£135 Billion
HSBCHSBA£129 Billion
BPBP£85 Billion
Vodafone GroupVOD£83 Billion
GlaxoSmithKlineGSK£73 Billion
British American TobaccoBATS£69 Billion
SABMillerSAB£53 Billion
DiageoDGE£50 Billion
BG GroupBG£49 Billion
Rio Tinto GroupRIO£44 Billion

Shanghai Stock Exchange

As China has grown in economic significance, so has the number of stocks domiciled in the nation. The Shanghai Stock Exchange is one of the two main exchanges located in the emerging market – the other being the Shenzhen Stock Exchange (SZSE). While the Shanghai Stock Exchange can trace its origins back to 1866, it wasn’t until 1990 that the SSE was re-established and operations began as we know them today.

Currently, the SSE has around 900 different stocks trading on its exchange as well as various bonds and mutual funds. However, the kicker for investors is that most of these stocks are off-limits to non-Chinese citizens. The exchange consists of two shares classes: “A” shares and “B” shares. A shares are priced in the local renminbi yuan currency and are only available to domestic investors and those who have Qualified Foreign Institutional Investor (QFII) status. B shares, which are priced in U.S. dollars, are available to both domestic and foreign investors.

That means much of the SSE’s $2.8 trillion worth of market cap is off limits to most investors. However, there are some ways—such as the new db X-trackers Harvest China ETF (ASHR) – that allow traders and investors to bet on these A Shares.

Hong Kong Stock Exchange (SEHK)

For investors wanting to really trade Chinese stocks, they must hop a ferry over to neighboring Hong Kong and place their bets on the Hong Kong Stock Exchange (SEHK). The SEHK originally took off when the Association of Stockbrokers in Hong Kong was established back in 1891. It was in the 1970s that the four main Hong Kong exchanges merged to form the SEHK.

LocationTime ZoneNormal HoursNumber Of StocksTotal Market Capitalization
Central, Victoria City, Hong KongHong Kong TimeMorning Session – 9:30 am to 12 pm,Afternoon Session – 1:30 pm to 4 pm1615$2.25 Trillion

As of the end of 2013, SEHK had a total of 1,615 listed companies. That includes 776 from mainland China as well as 102 from other nations. These H Shares are priced in Hong Kong dollars and are available to foreign investors. There are two main things to remember when looking at stocks on the SEHK. One is that many Hong Kong stocks – including those large and well known firms – can and do trade for less than HK$4 a share. Second, unlike U.S. stocks where you can by single shares, stocks on SEHK trade in predetermined lot sizes as set forth by the exchange.

CompanyTickerMarket Cap ($HK)
HSBC5$1.5 Trillion
AIA Group1299$473 Billion
Tencent700$1.14 Trillion
Sinopec386$183 Billion
ChinaLife2608$70 Billion
Wharf Holdings4$171 Billion
CLP Holdings2$160 Billion
PetroChina857$209 Billion
Hutchison Whampoa13$443 Billion
Lenovo Group992$112 Billion

Euronext

The Euronext is a newcomer in terms of the exchanges, having been created back in 2000 when the Amsterdam Exchange, Brussels Stock Exchange, and Paris Bourse merged. The basic idea was to create a single destination for the European Union’s financial markets. Later, Portugal’s major stock exchange was added to the mix. As such, the Euronext has become one of the region’s leading exchanges for stocks and other assets. That size and scope also includes derivatives via the integration of the London International Financial Futures and Options Exchange (LIFFE) back in 2001.

The Euronext later merged with the NYSE, though the two groups keep their exchanges separate. The Euronext is now owned by the Intercontinental Exchange (ICE).

See also 25 Bizarre Futures Contracts

LocationTime ZoneNormal HoursNumber Of StocksTotal Market Capitalization
Amsterdam, The NetherlandsCET/CEST9:00 am to 5:30 pm1300$3.7 Trillion

Currently, Euronext has just under 1,300 listings across its two major platforms. That includes some of Europe’s largest and most important firms. All in all, the Euronext has a total market cap of around $3.7 trillion.

CompanyTickerMarket Cap (€)
Total SAFP.PA€115 Billion
Anheuser-Busch INBEVABI.BR€133 Billion
SanofiSAN.PA€100 Billion
BNP ParibasBNP.PA€100 Billion
UnileverUNA.AS€N/A
ING GroepINGA.AS€N/A
LVMH Moet Hennessy Louis VuittonMC.PA€69 Billion
AXA SACS.PA€42 Billion
Air LiquideAI.PA€33 Billion
DANONE SABN.PA€32 Billion

Toronto Stock Exchange (TSX)

The origins of the Toronto Stock Exchange (TSX) began in 1852, when a group of Toronto businessmen formed the Association of Brokers. That group would later officially set-up the exchange during a meeting at a Freemason Lodge. The TSX was formally incorporated by an act of the Legislative Assembly of Ontario in 1878.

After a realignment of Canada’s major brokerage platforms, the TSX became the major exchange for the vast bulk of Canada’s senior equities. Junior shares and derivatives can still be traded on the nation’s other smaller exchanges, like the Canadian Venture Exchange and the Bourse de Montréal.

LocationTime ZoneNormal HoursNumber Of StocksTotal Market Capitalization
Toronto, CanadaEastern Standard Time9:00 am to 4:00 pm1,560$2.215 Trillion

Today, the TSX has roughly 1,560 different listings on its platform – including all of the major Canadian banks. Additionally, the TSX is seen as the world’s commodities exchange, as more stocks in the mining, oil & gas and natural resources sectors are listed here than any other stock exchange. All in all, the TSX has a total market cap of $2.215 trillion.

Be sure to read The Single Most Important Report for Commodity Traders: COT Explained

CompanyTickerMarket Cap (CAD)
Royal Bank CanadaRY.TO$112 Billion
Toronto-Dominion BankTD.TO$101 Billion
Bank of Nova ScotiaBNS.TO$87 Billion
Suncor EnergySU.TO$65 Billion
Canadian National RailwaysCNR.TO$58 Billion
Canadian Natural ResourcesCNQ.TO$52 Billion
Bank of MontrealBMO.TO$52 Billion
EnbridgeENB.TO$42 Billion
Valeant PharmaceuticalsVRX.TO$43 Billion
Manulife Financial CorpMFC.TO$39 Billion

Frankfurt Stock Exchange (Deutsche Börse)

Representing the other half of Europe, the Deutsche Borse is the gateway to Germany as well as a leading provider of derivatives trading, clearing, settlement and custody services. The origins of the exchange head all the way back to the 9th century, when Emperor Louis the German set up a series of free trade fairs. By the mid-16th century Frankfurt had developed into a leading financial powerhouse and the Deutsche Borse was officially founded.

LocationTime ZoneNormal HoursNumber Of StocksTotal Market Capitalization
Frankfurt, GermanyCentral European Time9:00 am to 5:30 pm765$1.3 Trillion

Since the end of World War II, the Deutsche Boerse has flourished. Today, the Frankfurt Stock Exchange is used by more than 250 international trading institutions, and investors using the exchange represent 35% of the world’s total investment capital.

Overall, the Deutsche Boerse has nearly 800 different stocks listed on its exchange – representing about $1.3 trillion in total market cap.

CompanyTickerMarket Cap (€)
Bayer AGBAYN.DE€84 Billion
BASF SEBAS.DE€77 Billion
Siemens AktiengesellschaftSIE.DE€78 Billion
Daimler AGDAI.DE€72 Billion
Allianz SEALV.DE€59 Billion
SAP AGSAP.DE€69 Billion
Deutsche TelekomDTE.DE€55 Billion
Deutsche BankDBK.DE€26 Billion
BAYERISCHE MOTORENWERKE AG BMWBMW.DE€60 Billion
E.ON SEEOAN.DE€27 Billion

The Bottom Line

For investors, trading the world has never been easier. With a simple brokerage account, many of us now have access to stocks domiciled on local exchanges. Accessing these opportunities is easy once you understand some of the differences in the world’s leading stock exchanges. The preceding exchanges are the best ways for investors to get their feet wet in the international markets.


Options Trading – Ten Commandments of Options Trading

While most investors hold mutual funds, ETFs, stocks and bonds, sophisticated investors have increasingly relied on options to diversify and enhance returns. Options provide these traders and investors with a lot more flexibility when it comes to managing their portfolio by enabling them to decide how and when to buy.

In this article, we’ll take a look at ten rules that options traders should follow in order to limit risk and maximize reward.

10. Get Familiar with the Greeks

Trading options without knowing the lingo is like flying a plane without being able to read the instruments. The so-called Greeks provide essential insights into the sensitivity of option prices to changes in the underlying stock, which makes them absolutely essential when it comes to managing risk.

Options traders should at least be familiar with the basics:

  • Delta – Measures an option’s rate of change relative to the rate of change in the underlying stock (e.g. spot price value).
  • Vega – Measures an option’s sensitivity to volatility, which is especially important in straddles (e.g. volatility value).
  • Theta – Measures an option’s sensitivity to the passage of time, better known as the option’s time decay (e.g. time value).

9. Keep Emotion in Check

Inexperienced traders have a pesky tendency to buy high and sell low – it’s simply human nature. For instance, the NASDAQ was trading up over 85% in 1999 during the dot-com bubble and investors still poured some $2 billion per day into the market in February of 2000 at the very top, right before the bubble burst.

Options traders can keep emotions in check by following some tips:

  • Big Picture – Always be mindful of the larger macroeconomic picture and avoid buying assets that are clearly overpriced – even if everyone else is.
  • Always have a Plan – Traders should always have a plan for their trades in order to take out any possible emotion from buying or selling (see #8).
  • Prefer Bargains – If possible, always look for undervalued bargains instead of overpaying and hoping that others pile on at higher prices (see #6).

See Also: Ten Commandments of Futures Trading

8. Plan the Trade, Trade the Plan

The fact that investors sell winners too early and keep losers too long is so prevalent that economists have given it a name – “the disposition effect.” While the causes of the effect aren’t entirely certain, options traders can avoid them by creating a plan before entering a trade and then executing that plan without compromise.

Here are the steps to plan and execute trades:

  • Criteria – Set up specific criteria for a trade that must be met in order to avoid impulsively establishing a trade.
  • Entry Point – Determine the price you’re willing to pay to enter the trade and set an automatic order if necessary to abide by it.
  • Exit Point – Before entering the trade, determine the point at which you’d like to sell and/or conditions necessary to keep the trade open.

7. Mind the Double-Edged Sword

Leverage may be the greatest financial innovation of all time, but it has cost a lot of traders a lot of money. While most traders associate buying stock on margin with leverage, options trading provides its own kind of leverage with unique risk factors that should be carefully considered before entering trades.

Here are some important risks to consider:

  • Hidden Costs – Margin involves a very obvious cost up-front, but the costs of options are hidden in things like time decay.
  • Total Loss – Buying options may provide greater upside leverage, but the cost is the potential for a total loss of investment.

6. Hunt for the Best Bargains

Value investors like Warren Buffett have consistently outperformed the market for a reason: buying undervalued assets provides a better risk-reward profile. The same principles hold true for options trading where bargain trades can both limit downside and equate to greater upside potential over the long run.

Here are some tips for finding bargains in the options market:

  • Compare Volatility. Traders can determine if options are over or under priced by comparing the current implied volatility to recent IV trends. Low levels of IV mean that options may be undervalued by historical means.
  • Extrinsic Value. Traders can compare different options on the same stock to determine pricing, but it’s important to look at the extrinsic value rather than the intrinsic value to see what option is really cheaper.

5. Get the Timing Right

Timing is everything – particularly in the options market. Not only do options lose money over time – in what’s known as time decay – but also the leverage associated with options means that timing is equally important for profits. As a result, options traders should spend a lot of their research on properly timing the market.

Here are some tips for timing options trades:

  • Get Out Sooner – Options are decaying assets and the rate of decay increases as the expiration date approaches. So, if a predicted move doesn’t materialize, the best option is often selling sooner rather than later.
  • Buy Back Earlier – Don’t wait too long to buy back out-of-the-money short options to take risk off the table; often, if you can keep 80% of the initial gains, you should consider buying it back immediately.

See Also: 50 Blogs Every Serious Trader Should Read

4. Keep an Ear to the Ground

Company-specific and economic news can quickly change the market, which means that traders should always be monitoring their positions. For instance, employment reports can significantly influence major indices like the S&P 500 SPDR and the options trading on those indices – especially short-term options.

Here are some tips to keep in front of the news:

  • Economic Calendars – Keep a calendar of economic releases on hand and be aware of the major market movers that could influence positions, such as employment reports, GDP reports, or FOMC meetings.
  • Sign-up for News Alerts – Sign-up for automatic e-mail or SMS alerts for company-specific news and be aware of major release schedules for things like earnings or SEC filings in order to avoid any problems.
  • Have a Plan – Always have a plan in place for potentially bad news, including the price at which you’d like to sell or stop-loss points.

3. Seek out Liquidity

Liquidity isn’t very important until you need it. While many large-cap stocks are relatively liquid, the options market can prove very illiquid, especially when trading options that are very out-of-the-money or very in-the-money. LEAPS and other long-term options can also be relatively illiquid at times.

Here are some considerations to keep in mind:

  • Always Stay Liquid – The best way to avoid liquidity problems is to simply keep away from options that are very illiquid and stick to at-the-money or near-the-money options that tend to be more liquid.
  • Look at Open Interest – Options traders should generally seek out options with open interest of at least 50 times the number of contracts that they’d like to trade. For instance, 20 contracts should have open interest of at least 1,000 contracts in order to have enough liquidity.

2. Jump into Spreads

Many options traders use spreads in order to capitalize on certain price movements in the underlying stock while limiting risk. “Legging in” to spreads – that is entering different legs of the trade at different times – can be a dangerous game since the strategy can be ruined with a downtick and expose the trader to great risk.

Here are some tips to avoid legging in to spreads:

  • Simultaneous Execution – Many options brokers enable traders to not execute spreads unless a certain net debit or credit is achieved. In general, this is the safest way to ensure that you don’t accidentally leg into a spread.
  • Immediately Correct – Traders that have accidentally (or intentionally) legged into a spread should correct the trade sooner rather than later, since they may be exposed to unlimited risk in one direction.

1. Be Careful When Naked

Naked trading involves trading options based on the assumption that a trader owns the underlying stock when in reality they don’t own it. For instance, writing a call option without owning the underlying is trading naked. Most traders should avoid these types of situations given the unlimited downside risk to the trade.

Here are some tips to keep in mind:

  • Use Spreads Instead – Spreads can cap downside risks without the up-front expense of actually owning the underlying stock. For instance, writing short-term calls against a long-term LEAPS can provide a floor for losses.
  • Monitor Events – When trading naked, traders should watch for event risks, such as company-specific or economic news. These market-moving events can quickly turn a naked trade into steep losses.

The Bottom Line

Options provide sophisticated traders with a unique way to build specific strategies, but traders should take certain precautions to limit risk and maximize reward. The ten commandments of options trading listed above can help achieve these goals by avoiding many mistakes that novice (and expert) options traders make.