Welcome to the March 6th 2017 edition of Profit Effect’s investment newsletter Profit Talk
where you learn new ways to understand the latest market trends, gain strategy insights, and learn from the experts. My name is Rod Mahnami and I’m grateful that you’ve given me this opportunity to join you on your investment journey.
Well, I hope this market has been good to you. We’ve seen one of the most incredible up moves that I think I’ve experienced in the years I’ve been trading. We are told that equity markets don’t crash up. I will venture to say that there is probably more than a few short sellers caught in this move that would disagree with that statement. Since breaking above 20,000 in early February, the Dow Jones Industrial average has risen about 1000 points. And, that’s after rising nearly 2000 points since the election in November.
Those who are interested in joining this bull market, should it continue, will enjoy the topics covered in this issue. This edition of Profit Talk we’re going to take a look at a some techniques for finding and entering directional style investments. In particular, we’ll cover the details of one of my favorite trend trading setups I call the 8/89 Crossover. Also, I’ll introduce another debit style option strategy designed to take advantage of directional trading opportunities called a vertical debit spread.
We define something as a “Trend” trade when the primary criteria for entry comes from current price/trend relationship. Meaning, the analysis is based on what price is doing in the context of trend. Most often we use moving averages for reference when finding and planning trend trades.
My favorite trade set-ups for trend trading include what I call the 8/89 Crossover and the 20 EMA Zone. The process of creating and using the 20 EMA Zone trend trading entry setup was covered in the January 2nd, 2017 edition of Profit Talk called “Cash Flow Trading with ETFs”. This edition we’ll go through the steps regarding 8/89 Crossover bullish trend trade setup.
“Bullish” 8/89 Crossover
The premise behind the 8/89 Crossover bullish set-up is to find candidates that are currently in an uptrend but have experienced some recent weakness, bringing the price near to a substantial moving average. In this case the 89 period Exponential Moving Average (EMA).
The set up is as follows- while the “Big Picture” trend is in an uptrend, we want the fast 8 period EMA to cross above the slower 89 period EMA. Then when price “tests” an upsloping 89 EMA, ideally for the first time, we’re looking to enter a bullish position to join the trend.
Remember, the directional trading style professed here at Profit Effect is based on a contrarian view. We’re looking to buy on weakness in strong uptrends and sell on strength in down trends.
The test or “re-test” of the 89 EMA can include a zone surrounding the average that is no more than 1/2 of the average true range (ATR) of price. The price retest should be within the 89 EMA zone AND a demand area. Our risk defense point will be just below the demand area or 1 measure of average true range below the entry point for debit strategies. Our reward/risk ratio is 2:1 minimum, so our first profit target point is 2 X the distance between our entry point and our risk defense point.
Here is a list of the rules which govern the entry and exits for the 8/89 Crossover bullish setup:
1. Price must be above the larger “big picture” time frame’s 89 EMA average
2. The 8 EMA must be above the 89 EMA on the controlling time frame chart
3. Price must be within a zone around the 89 EMA no larger than ½ of an ATR each side of the average on the controlling time frame chart
4.The entry zone must be in conjunction with a demand zone
5.Risk defense point is just below the zone, no more than 1.1 X ATR maximum from entry
6.The first profit target is 2 X the distance between our entry point and risk defense point and our second target is 3 X that distance
Let’s go through how we can create an automatic scan to look for the correct scenario. Go the the scan page and select the Stock Hacker subtab if not already there. Choose the universe of stocks to scan through the “Scan in” menu at the top. Select from a personal list or look under the “Category” menu and select “All Optionable”. Create a minimum and maximum price and volume filter as always if using a broad list of unknowns. I generally start with filtering stocks that trade at $15 per share or higher with a minimum of 1,000,000 shares traded per day. (FIGURE 1) Remove any other filters or studies outside those for price and volume. Click on “Add study filer” button. Under the study drop down choose “Custom”. The Scanner Custom Filter window opens. Delete the default setting study.
Based on our list of rules the first thing we need to do is look for price trading above the 89 EMA on the big picture time frame. We’re using the daily chart for our controlling time frame so the weekly chart works for big picture at 5 X larger. So, change the “Aggregation” to Weekly. Click on the “Add condition” button to open the Edit Condition window. The condition we are looking for is for the close of price to be greater than the 89 EMA. Choose study and select MovAvgExponential and set it for 89. (FIGURE 2)Click save.
Ok, since we can’t mix time frames here we’ll click OK and save this, then add some other filters for our controlling chart criteria on the daily chart. Then select “Add study filter” and use the drop down to select custom. Make sure we’re on the correct time interval which is Daily. Delete the default study. Click on the “Add condition”. Our scenario is the 8 ema above the 89 ema. Select study and then MovAvgExponential and set it to 8 is greater than another study which is another MovAvgExponential set to 89. (FIGURE 3) Click Save to close that condition window.
Let’s add another condition to search for price that may be re-testing the 89 EMA. The simplest way to do this is to now look for price below the 8 EMA. So, we have big picture trend up, controlling time frame trend up but near term price weakness bringing it below the 8 period moving average. OK, so click “Add condition” and set it for looking for price that is less than or equal to a study of the the MovAvgExponential set to 8. (FIGURE 4) Click Save and Click OK to save the study.
Alright, let’s check if we’ve got this right. We have our volume and stock price filters. And our study to find close of price greater than the the 89 EMA on the weekly chart. Then our other study for the 8 EMA greater than the 89 EMA and a second condition that price is below the 8 EMA on the daily chart. (FIGURE 5) That looks good.
As in all these directional scans, we could check the IV Rank once we’ve picked the markets we’re going to enter and then choose one of the appropriate strategies per the IV Percentile Graph, either debit or credit. But, if we’re looking to trade directionally with a specific type of options strategy, we’d add the IV Percentile study and set the IV range settings for the option strategy we want to trade. This Profit Talk we’re going to cover the use of a vertical debit spread option strategy. This type of strategy works best if used in markets with IV Percentile values that are 40% or lower.
You can add a study that filters for market trading with an IV Percentile value that is 40% and below. Click the “add study filter button”. Use the drop down menu and select Volatility studies, under that menu choose the IV_Percentile” study. Set the parameters for 0 - 40. (FIGURE 6) You can save any custom scans you build by going to the drop down menu in the upper right corner and select “Save scan query”. Name and save it.
The scan can be found in the same drop down look under “Load scan query”. It will be under in the “Personal” section. OK, now click scan and see what comes back. OK, you can save the filtered symbols to a watchlist. Click on the disc icon at the top right corner list window. You can name it today’s date and 8/89 bullish, then click “save”. Then go to the chart page and bring up your saved list.
You need to place the 8 and 89 moving averages on your chart for the visual scan. Add study under “Quick study” then “Moving Averages” then “MovAvgTwoLines. Right click on one of them to edit them and set the periods to 8 and 89 and the average type to exponential. (FIGURE 7) Click OK to save.
You can link the watchlist to the chart by using the link icon and choosing the same color. (FIGURE 8) Once they’re linked, you simply click on the symbol and the chart will change to that symbol. Now go through and see where price is in relation to the 89 EMA and if a demand zone lines up with the average. We’re not looking to see if price is necessarily in the zone at this moment but just determining whether if it would prove worthy should it re-test the 89 EMA.
First, I like to sort the list with the highest volume markets at the top. Then, look for potential candidates based on the entry and exit rules of the trade. Does the 89 period average line up near a demand zone, is it upsloping? Does it make sense based on the supply and demand zones on the chart from a reward to risk prospective?
Also, given a choice, I prefer to go with the first test of the 89 period EMA. The first test has the high chance of working, though in a strong trend subsequent tests work as well.
Once you’ve narrowed down your selection to candidates which look like they will work you can set an alert to notify you when price gets to the entry point. Or, if it price has a chance of reaching the entry point the day of the scan, you can place a limit order to enter at the beginning of the zone.
Here’s how you can set an alert to notify us when price reaches our entry point. First find out the ATR of the underlying by adding a study. Go to “Add study” and choose “All studies” under the A-A you’ll see ATR, select that. 50% of that value which is ½ of an ATR we can add or subtract from the value of the 89 EMA to determine the alert or entry point. Ok, so we add that to the 89 ema value which determines our entry and alert price.
To set an alert go to the Market Watch page by clicking the tab at the top. Then enter the symbol you want to set the alert on. Now left-click on the what you want to trigger the alert. I like using “last price”. That will open up the alert window where you can set the parameters for the alert. Set the price at or below and how you want to be alerted.
If you want to be sent an email and/or test message, you can create custom notifications.
Click on the “gear” on the Setup tab at the right corner of the platform and choose “Application settings”. Then click on the “Notifications” tab. In this window you can set email addresses and/or a phone number to receive SMS messages.
Based on what I see among the list of candidates, I like the gold market represented by GLD. This market is in the zone as of Friday and if still trading here this week can be entered . Also, I like the China market ticker symbol FXI if price can make it down near the 89 period average and line up with this demand zone.
To take advantage of a directional move in the selected markets, let’s look at constructing a vertical debit spread.
Vertical Debit Spreads
The vertical debit spread is a great directional strategy to implement when the IV Percentile is 40% or less. These spreads profit from directional movement in-line with the delta exposure and from any rise in volatility that may occur. The spread is conducted using two options, one long option which is the profit driver. And, one short option is used as the offset or hedge. Vertical debit spreads do suffer from time decay, though much of it is offset by the short option and by the slower effect decay has on a longer term option.
Again, as in all directional trades and covered in previous Profit Talk editions, we want to keep the distance between our entry and risk defense point as small as possible but based on what’s true on the chart. We can’t make it small just to have it be small, that would create excessive risk defense triggers. We’re using either horizontal or moving average zones to define the entry areas of our directional trades. So, the best candidates are those with the most clearly defined demand/supply and the most room to run without interference from a counter zone. The risk profile is based solely on the chart analysis and the reward to risk ratio numbers. Narrow the field based on that criteria then make the final selection from that group.
Many of the concepts discussed today regarding the subject of directional trading were covered in detail in previous Profit Talk issues about directional trading. The specific issues covering the subject can be found by selecting the “Directional Trading” category on the E-Letter archive page.
When it comes to which option strategy to use for a directional trading opportunity there are several choices. In previous Profit Talk issues we’ve covered how to use a debit strategy I call “Free Trade”. That is a great strategy for participating in large price moves of the stock. This Profit Talk edition we’ll go over the use of another debit style option strategy called a vertical debit spread. These spreads are great for directional moves when you have a predetermined exit point for the trade. Which, in my opinion, should almost always be the case when trading.
Let’s go through the steps of constructing a bullish vertical debit spread on the gold bullion market represented by GLD. Go to the analyze page and “Add simulated trade” subtab. Also, make sure the correct symbol GLD is loaded in the left upper hand window..
The bullish version of a vertical debit spread consists of buying an ATM or ITM Call and selling an OTM Call at the top of the range or full profit exit point with 90 + days to expire. We never want to hold long options with less than 75-80 days in them, so 90 days is minimum. Add more days for expected hold time of trade.
Daily chart trades generally last a few days to a few weeks to a month max in most cases, so nearest to 100 days or more is good for this example. Ok, we’re looking for a long ITM or at the money option to buy, never OTM even just a little. Always default to ITM when trying to get ATM. I generally start with .55 - .60 deltas for my long option, but will change to a higher delta one if necessary. Left click on the Call side “ask” column of the strike with closest to .55 - .60 deltas to load the buy side leg. The short Call we want OTM at the top of the range or at our furthest away price target. Generally something in .25 - .30 delta range works for the short option. So, hold the ctrl key down and left click on the Call “bid” column of the Call you want to sell. (FIGURE 9)
The goal is to build the spread with a minimum of .25 deltas. Adjust the distance between and the positions of the long and short options to adjust the deltas. The further away you move the short strike the less deltas you subtract from your long strike. But, this also increases the buying power needed and the absolute risk in the trade.
Build the individual spread with somewhere between .25 - .35 deltas. Then put on the appropriate number of spreads to get as close as you can to the desired number of total deltas for the position. Move the short option back and forth and the long option deeper in the money if necessary to get .25 or more deltas per spread.
Once you have the option position constructed to your liking , adjust the lot size to get as close to our trade size risk allotment as possible as determined by the number of total number of deltas.
This is where the lessons learned in last week’s edition of Profit Talk called “Portfolio Objectives” will come into play. Calculate your max risk for each trade based on the trade size outlined in last week’s Profit Talk.
For example, if you are working with a $30,000 account and your risk tolerance amount is 1% per individual position, your max risk for the trade is $300. To calculate the number of deltas/shares that can be invested in the particular trade, divide the max risk amount, $300 in this example, by the zone size in dollars.
The zone size for the GLD trade is the entry point X 1.1 the “average true range” or ATR of GLD. The ATR is $1.21. I like to make sure the risk defense or stop point is at least 1 ATR away, plus 10% extra. So, thats 1.1 X $1.21 for a total zone size of $1.33. You can use this calculation or the size of the demand zone that is lining up with the entry point.
Take your total risk size in dollars and divide it by the zone size in dollars to determine how many deltas in total the position should have. Using GLD and the example account with a $300 max risk size and $1.33 zone size, allows for 225 deltas/shares total. The spread created is worth about .26 deltas, this means the “lot” size, that is the number of spreads that should be bought in this example is about 8. 225/26=8.
In regards to the profit targets. The maximum profit is capped at the short option strike price. That’s max profit. But, when directional trading, I always take at least some profit at the 2:1 profit point which is the entry point plus 2 x the zone size. The final target can be at the 3:1 point which is 3 x the zone size added to the entry point or use the max profit point which is the short strike price of $124 per share in his example.
To sum up the GLD trade. The idea with the 8/89 Crossover is to enter in a ½ an ATR size zone near the 89 period EMA. So, anywhere within ½ an ATR above or below the 89 ema is the zone or create a zone using the demand are that coincides with the 89 EMA. Once the entry price is determined the risk defense point and profit targets can be figured accordingly.
If price falls and reaches the risk defense point, the stock neutralization tactic can be used to “neutralize” the deltas for the position. The details of this technique was covered in the February 20th edition of Profit Talk called “Directional Trading Essentials”.
Using the technique for the example trade would entail selling shares to match the number of deltas the position is worth at the risk defense point. We don’t know the entry point yet but if it’s made at the top of the zone, which is ½ and ATR above the average, that makes an entry around $117.15 per share. Subtract the zone size of $1.33 and you’ve got a risk defense point that’s around $115.82 per share.
Use the risk graph to see what the delta value of the position will be at the risk defense price. In this example the deltas are around 199 at that point. To fully hedge this position and remove all of the directional risk, you would sell 199 shares of GLD to make the deltas near zero.
Once that is done the position won’t lose much if anything more and it won’t gain either. The hedge would need to be removed if the price turns around and starts going in favor of the position. I like to remove the hedge if the price turns and gets at least ¼ ATR back above the risk defense point. See full details in the 2/20/17 issue.
The main takeaway, are first and foremost, I constantly draw attention to the incredible important fact that Trend should be your friend. Use the power of trend to enhance your directional trading results. Use long term trend to determine trade direction. Enter during near term counter trend price moves.
Second, vertical debit spreads are a great strategy for capturing a directional price move. They have low capital requirements and defined risk. Meaning your risk is limited by what you pay for the spread. That’s the most you can lose on the trade no matter what happens to the stock.
Third, proper use of the risk to reward ratio metric provides huge advantages when directional trading.
As mentioned at the beginning of this issue, the market powered higher with some gusto this past week. The best thing to do in a powerful trend is to respect in ride it’s coattails. That means any weakness that brings market into the zone can be used to hop aboard.
You now have two different trend style setups to use for entering markets based on trend. The “20 EMA Zone” setup that was covered in the January 2nd edition of Profit Talk called “Cash Flow Trading with ETFs” and the “8/89 Crossover” setup covered in this edition. Either of these scans can be used to locate trade prospects.
The high impact reports expected out this coming week include:
Wednesday 3/8/17 - ADP Non-farm Employment Change report at 8:15 am eastern and the Crude Oil Inventory report at 10:30 am eastern
Thursday 3/9/17 - Unemployment Claims numbers are released at 8:30 am
Friday 3/10/17 - Average Hourly Earnings, Non-Farm Employment Change and the Unemployment rate numbers all being released at 8:30 am eastern.
I hope this has been helpful for you. If you have any questions or comments, please leave them below or reach out on social media. You can also email me directly with any questions or comments at firstname.lastname@example.org.
Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.