This week’s edition of Profit Talk we’ll look at the other side of the trading spectrum and venture into the realm of directional trading with options. Specifically, we’ll be looking at directional trading with debit style option strategies.
Welcome to the December 5th 2016 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.
We know that long term successful investing comes from well informed investors applying sound market strategies. Profit Talk was created to help you gain understanding about the investment strategies that work and how to successfully ignore the so called pundits and your own emotions in order to use the modern tools and market key indicators to make investment choices. Here you turn guesswork and chance investing into powerful and informed decision-making.
The previous two editions of Profit Talk we discussed implied volatility percentile and credit style options strategies. Specifically, we focused on the short Iron Condor strategy and how to use the risk graph to analyze credit type option positions.You’ve learned that selling options does provide a higher probability for profit compared to the traditional way of buying or shorting stocks. In return for this higher probability for profit, the option seller limits how much profit can be made on the trade.
This week’s edition of Profit Talk we’ll look at the other side of the trading spectrum and venture into the realm of directional trading with options. Specifically, we’ll be looking at directional trading with debit style option strategies. If you recall, although the particular style of a short Iron Condor we covered previously was a non-directional style strategy, credit strategies can be constructed that are directional. Remember, we can use option selling strategies to create bullish, bearish or neutral biased positions. But again, they have limited profit potential. For this reason, a trader may choose to use a debit style option position.
Debit style option positions can also be constructed to create bullish, bearish or neutral biased positions. But, unlike credit based strategies, debit style positions can be constructed that have unlimited gain. The trade off is, you have to be correct on price to make any profit on the trade. The good news is, you can create debit style positions to fit any degree of directional bias, including a neutral directional bias. However, the more directional your stand the bigger the reward when you are right.
Directional Trading Options
Using options to create directional positions offers great advantages compared to buying stock outright.. Two main benefits include reduced capital requirements and lower risk.
As covered previously, the option chain shows the statistical probability pure directional trading brings. This probability is about 50/50 as displayed by the ATM options. This means, simply buying or selling an asset has 50/50 chance of making a profit. When it comes to directional trading, the investor has two options available to use which may help overcome this obstacle.
The choices are to use either fundamental or technical analysis. Fundamental analysis involves study of the fundamental numbers of a company. This includes all the material facts about the company including; size of the the company, revenue, earnings, p/e ratio, earnings growth, etc. Technical analysis, or what is more commonly known as chart analysis, is the study of price and volume associated with the asset.
The Profit Effect philosophy ignores the fundamentals for the most part and focuses on technical or chart analysis. The reasons are pretty simple, good fundamental analysis takes a lot of knowledge to do well and a lot of time to perform the necessary tasks. Second, all that information shows up on the chart anyway. In fact, when it comes to price, ALL of the information is shown.. This includes both public and nonpublic information.
The stock market is an “open cry” style auction. Price is lead by the forces of supply & demand. As demand for an asset falls (people buying) compared to the supply (people selling) , price must fall in order to attract enough buyers for the amount of sellers. On the other hand, when demand for an asset outpaces the number sellers, the price must rise in order to incentify owners to sell. The fact is, there is no hiding from price. That truth and the time saving advantage, are the main reasons for using technical analysis versus fundamental analysis to make directional assumptions.
That being said, chart analysis can be a very complex subject and is the recipient of an infinite stream of information. The Profit Effect way is to ignore the noise and latest sell or buy signal fads, and stick to the facts when it comes to the study of price.
Study of Price
The price chart is a graphical display of the supply and demand forces at work. Ultimately, it’s a flowing history of investor emotion involving the particular asset. That is good news for investors because emotions do hold some predictive value.
Fear & greed associated with money and investing displays cyclical patterns. These patterns play out over and over again and reveal themselves in price which is displayed in graphical form on the chart. This fact is the basis for technical or “chart” analysis.The key to useful chart analysis is to break the information down to the essential facts about price behavior, or more accurately, people’s behavior in the market place. There are two key factors that must always be kept at the forefront when performing chart analysis. These factors are trend and supply & demand.
Trend
You’ve probably heard the term “the trend is your friend”. The power of trend has been well documented by successful traders for centuries. Although, the idea of using trend in your chart analysis may fall in and out of favor among the financial pundits, don’t let short term popular culture thinking steer you off course with your chart reading. Let me make something very clear, trend will NEVER go out of style when it comes to its influence on price. Trend is to price what the tide or prevailing current is to a body of water. A chart analyst who ignores trend is like a pilot of a ship ignoring the tide or prevailing current of the water they are navigating. Price is influenced by the same laws of physics that govern everything else in our universe. Remember Newton’s first law of motion, sometimes referred to as the law of inertia; an object in motion stays in motion with the same speed and in the same direction unless acted upon by an unbalanced force. These laws are true for price as well, because people are influenced by natural laws and price comes from people.
Another fundamental truth about trend and/or price behavior is it’s cyclical. Cycles occur throughout nature, we all know this and are affected by them. In addition these cycles are fractal. A fractal is a natural phenomenon or a mathematical set that exhibits a repeating pattern that displays at every scale. It is also known as expanding symmetry or evolving symmetry. This means the cycles repeat themselves over and over again within one another at different intervals.As a chart analyst, this simply means you must look at the price chart in different time intervals to get a better picture of the situation.
Let’s look at a candlestick style bar chart. Here is a daily chart (figure 1) . This time interval is set so each bar, or in this case each “candlestick” represents one trading day. You can set the time interval so the candlesticks represent one minute or one month and everything in between. Our job as a chart analyst involves viewing the chart in multiple time frames. This allows a broader view of the trend or the big picture situation.
Multiple time frame analysis, or “multi-framing” for short, typically involves analysis on 2 or 3 time frames. These include the big picture time frame, the controlling time frame and the precision entry time frame. The controlling time frame interval determines the big picture and the precision entry time interval selection. Choosing the controlling time frame comes first. The controlling time frame should be selected based on the planned hold time for the trade. The shorter the hold time the smaller the time interval used for the controlling time frame. Typically, for the big picture chart, we use a time frame that is about 3 to 5 times larger in time duration than the controlling time frame chart. This means if using a daily chart for the controlling time frame, the weekly chart would be used for the big picture time frame. One trading week equals 5 trading days. The precision entry time frame to use in this case would be ⅓ to ⅕ the size of the daily chart.
The normal trading day consists of 6.5 hours. This means a trader would use a 60 minute, 90 minute or 120 minute chart to make more precise entries. The precision entry time frame is optional except when intraday trading, which is often referred to as “daytrading”. This style of trading or any short term duration trading, greatly benefits from using the smaller time frame for precision entries. Outside of those situations, skipping the use of a smaller time frame and using the controlling and big picture time frame charts only is perfectly acceptable.
When it comes to the influence the particular time interval has on price, the longer duration time frame always carries more weight. For this reason, the main role the big picture time frame plays is in determining trend direction. This is a key part of technical analysis that many traders miss. The bigger picture trend direction is what determines the general directional bias of the prospective trade. This means, if looking for buying opportunities an investor would only look among markets that are in an uptrend on the big picture uptrend. If using a daily chart for the controlling time frame, you would look for markets that are in an uptrend on the weekly chart. Think of that big picture chart as the tide or prevailing current of market which results in the majority of directional movement associated in that market.
Determining trend direction in itself has been know to present quite a challenge for beginner chart readers. Although we could spend an entire Profit Talk lesson the intricacies of determining trend direction, I’m going to make it simple and easy for you. The goal at Profit Effect to is to teach modern tools and techniques to help you make quick and easy investment choices. This stuff does not have to be complicated and in my opinion, making it complicated does not make the analysis more accurate or useful. Complexity is not free.
The easiest and quickest way to determine trend direction is to use a moving average. This process is not only simple but can be more accurate because it eliminates any subjectivity. The practice of using a moving average to determine trend is completely objective. The only subjectivity is in choosing which moving average to use. This determination rests on the desired activity level of the trader and/or hold time of the trade.
The averages commonly used by traders include the 20 period average for the near term trend, either the 50 or 100 period average for the medium term trend and the 200 period for the long term trend. Once a time period is decided, simply look to see if price is trading above or below the specific average. Price trending above the average is uptrending. Price trending below the average is downtrending and price cutting back and forth across the average is range bound.
Since the Profit Effect style of trading involves the use of a larger time frame, typically, the 20 period exponential moving average is used on each time frame. This means that if using the daily chart for the controlling time frame and the weekly chart for the big picture time frame, the practice of using the 20 period average on the weekly results in a similar reading as using the 100 day on daily alone. Remember, the weekly is 5 times the duration of the daily chart. So, using a 100 period average on a daily is the same as a 20 period on the weekly. 5 X 20 = 100. Again, the biggest determining factor is based on personal preference and planned hold time of the trade. The most important component is to stay consistent, not which average is ultimately used for trend determination.
Supply & Demand Plus Contrarianism
The other key factor to consider when performing technical analysis is where the supply & demand areas are located. In the end supply and demand determine everything, even trend. The trend direction and momentum is determined by supply and demand. Uptrending markets are doing so because the buyers outnumber the willing sellers. Price must go up in order to incentify sellers to sell.
But, remember the price action is fractal, so these forces are at work in multiple time frames. This means during an uptrend on a larger time frame the smaller time frame of the same market will experience “mini” market crashes. These periods look like a complete meltdown on the smaller time frame, while on the larger time frame they appear as small pullbacks in an upward moving market. These counter trend phases or “pullbacks offer opportunity to hop aboard the prevailing trend.
This style of trading, is contrarian in nature, at least to the short term view. I consider the style, which is my style of directional trading to be what I call “short term contrarian and long term conformist”. Meaning, I ignore the short term “noise” of the market and follow the long term facts of the prevailing trend. I use that noise as opportunity. These pullbacks in price that occur in bigger picture uptrends or rallies in price that occur in big picture downtrends, can provide opportunity to join the current trend.
There are two key factors to consider.
First, is the crucial fact that the directional bias must be in line with the big picture trend. So, it’s never about just being contrarian and buying a stock because it has gone down or selling a stock because it’s gone up. It’s about being contrarian to the very near term direction but in line or conforming with the longer term view. That means buying a stock that has recently fallen in price but still remains in an uptrend on the big picture price. Or, shorting a stock that has recently rallied, but still remains in a downtrend on the big picture time frame.
The second factor is the entry must be made in or very near a supply or demand area. Never just buy a stock because it’s going down in the context of an uptrend or sell a stock because it’s going up in the context of a downtrend. On the controlling time frame, the entry point must line up with a demand area for going long in an uptrend or supply area when going short in a downtrend.
This style of trading simply stated involves buying stocks that are in a big picture uptrend when they pull back to a demand area on the controlling chart and selling stocks that are in a big picture downtrend when they rally up to a supply area.
Determining quality supply & demand zones is a combination of art & science and requires some study & practice in order to accel. This is a subject that will be covered at length in future Profit Talk issues.
In order to allow time to go over this week’s options strategy we won’t cover the details of how the demand zone and profit targets were determined. But instead, allow time for covering the process of creating an option position for taking the trade.
Strategy Focus
This week’s trade idea was derived using the exact analysis just outlined. The trade idea this week is a bullish trade, or a buy trade using the underlying company stock for Activision, ticker ATVI. This example was discovered using the analysis we just covered and consumed just a few minutes of time to find thanks to the modern tools available to us. Let’s look at the ATVI chart and review the desired parameters for entering a long trade.
As mentioned previously, when it comes to the various time frames, the larger duration charts carry more weight in regards to their influence on price and therefore their usefulness for anticipating future price behavior. That said, when it comes to non-directional trading and the use of credit style strategies, which profit from time decay and/or heightened states of volatility normalizing, the preferred chart to use for the controlling time frame is the daily chart. But, when it comes to pure directional trading, where profit is derived strictly from capturing a directional move, the preferred controlling chart for me is typically the weekly chart.
The weekly time frame is not covered much by people selling trading courses or investing newsletters. Probably because the results have a longer time horizon than daily charts and the trades take awhile to play out which makes them a bit boring. I have to say, boring doesn’t matter to me when I’m making money and when it comes to pure directional plays, the biggest profits usually come from using the weekly charts. Profit Effect is not in business to sell trading courses or investing newsletters. I’ve created the business to help individuals proft using stocks & options and pure directional plays perform better on the weekly chart.
Also, if you recall, at the beginning of this issue I stated that this week’s focus we’d turn to a debit based option strategy. Unlike credit based strategies which have limited upside profit potential, the strategy we’re using this edition has no such limit to profit. The strategy carries the ability for unlimited gain. This type of strategy is therefore very well suited for use with the weekly chart because they offer the potential for capturing larger price moves.
Let’s go to the chart and I’ll point out the how the candidate was selected as outlined by the chart analysis parameters previously covered.
We’re using the weekly chart as the controlling time frame.That means we use the monthly chart for the big picture, trend determining, chart. Using the 20 period moving average as our guide on the monthly chart, we see that ATVI is trading above the average. (Figure 2) This means it’s in an uptrend on that time frame. Armed with that information, jump to the controlling time frame, weekly chart, to determine the entry zone, the profit targets and the stop point or risk defense point. Determining these will be covered in depth in future Profit Talk issues. For now, I’ll lay out the numbers.
Here, on the weekly chart, we clearly see the near term weakness experienced by the Activision stock (Figure 3). However, the longer term trend is still up as shown by the monthly chart. The demand zone is located here starting at around $34.65 down to about $33.00 for a zone size of about $1.65. The risk defense or stop point is below $33.00 per share. The first profit target is at the base of these candles here which is about $40 per share. Target one brings a profit of about $425 per spread which is a return on the invested capital of about 38%.This represents a 2:1 reward to risk ratio because that distance is about twice the size or loss amount as depicted by the demand zone size. The second profit point is located at the weekly 20 period moving average which is currently $41.28. This target brings about $550 profit per spread and represents a return on investment of about 49%.
Ideally, the entry itself should be triggered while the stock price is inside of the demand zone or at least very close. However, the restraints placed by the timing of this newsletter prevented us the opportunity to enter when price was trading just about the zone as shown by the “wick” of this red candle here. Currently price is a few dollars of above the zone and if straight stock trading, entering the trade at this point would not be advisable. However, as is normally the case, using options to make the trade gives us an advantage which makes taking the trade here an acceptable risk. This is because the option position we’re going to use in this case gives us some wiggle room when it comes to price. In fact, if placing the trade now, the strategy provides us with zero risk of losing money all the way down to our risk defense point of $33 per share. Once again using options instead stock itself gives the knowledgeable investor the greatest advantages.
Now that we have price assumptions laid out, let’s look at constructing an option position designed to profit from these assumptions.
Free Trade
The option strategy spotlight in this edition of Profit Talk is on a debit style ratio spread I call “Free Trade”. In the previous edition of Profit Talk you learned about spreads. If you recall, a spread contains both a long (purchased) and short (sold) options. One is the profit driver and one is the hedge. If the profit driver is the short option, it’s a credit style style spread. If the profit driver is the long option it is a debit style spread.
A ratio spread uses an unequal number of long and short options to create the spread.
The “free trade” uses 1 long option and 2 short options.In truth this trade is not completely free, but this strategy can often times provide a way to take a directional shot without creating much of a debit if at all, and once in awhile even a small credit. Plus, the added benefit of having a large range for price to move and not lose any money. At the same time, you are positioning you to reap high profits should the trade move in the direction anticipated.
The bullish “Free Trade” spread is constructed through buying 1 ATM Call and selling 2 OTM Puts both with the same expiration of 90 days plus the planned hold time of the trade. Look to sell Puts that are selling for about ½ the price we’re paying for the Call. So, when selling two of them the cost of the Call is covered. The further away you can get with the Puts the more room price can move without incurring any loss on the trade should it not work out.
It looks likes this spread is coming in with a small credit of 25 cents (Figure 4).The 1 long option and 2 short options together equal 1 spread. Each spread represents 100 shares when it comes to the cost or in this case credit. This means you would receive $25 for each spread placed. The buying power used is just over $1,100.(Figure 5) The risk in the trade is the obligation to buy 200 shares at the strike price of the 2 short Puts. This makes the risk for each spread, the same as buying 200 shares at $33 each minus the credit.
In terms of the value fluctuation of this spread from directional movement in the stock price,it will behave much like owning 115 shares of stock. This means the spread will rise in profit about the same as owning $115 shares. This is shown by Delta here. (Figure 6). But, the option position carries distinct advantages.
Using this strategy instead of simply buying the stock provides two substantial benefits. First, you receive some price cushion before losing money on the trade. The stock is currently trading for $36.45 per share. If you bought the stock shares here you would lose money every penny lower from this price and you would also profit every penny higher. Using this spread, you would also gain profit with every penny higher, but you would not be at risk for losing any money until the price is below $33 per share.(Figure 7) This gives you a lot more room to be off on the entry and not suffer for it financially.
The second advantage over straight stock buying is the lower cash requirement or buying power used to place the trade. Using cash to buy 115 shares of this stock at $36.45 would cost $4,191.75. Using this spread to participate in the upside stock price movement as if you owned 115 shares, requires $1,131.43. This allows you to compound your profit potential by freeing up capital for diversifying across other trades investments. In addition, the lower capital requirement increases the ROI significantly on profitable trades.
This strategy does offer a few options for risk management if purchasing the 200 shares is not desired. However, simply closing the trade in advance of expiration for risk defense is not recommended for this strategy. This type of strategy will have a poor “real time” P&L which makes closing it early a lot uglier than it needs to be. Just like investing in the stock itself, this strategy should not be used on poor quality stocks or on a stock you would not be okay with owning.
The good news is, there are ways to manage the trade and avoid buying the shares, should that scenario come into play. In addition the risk can be limited to a comfortable amount through a variety of techniques. Also, options offer the ability to create cash flow from this position while waiting for the anticipated rise in share price. Both these subjects will be covered at length in future Profit Talk Editions.
Main Takeaways
The main takeaways when it comes to directional trading are:
First, trade direction should be is the same as trend direction on the big picture chart. Thats number one, always align trade direction with big picture trend direction.
Second, on countertrend moves, use supply or demand zones to join trend. So, be contrarian within the context of the bigger trend and always use supply and demand zones for entry placement
Third, use the most advantages strategy based on assumptions. That means the strategy that best compliments your market outlook based on your chart analysis
A Look Ahead
Looking ahead… the next edition of Profit Talk you’ll be introduced to another key component in a well rounded trading and investing strategy which is beta weighting. Modern tools have made the task of analyzing and managing the systemic risk your portfolio of positions carry. In plain english that means it’s a lot easier to analyze and manage your portfolio’s exposure to a market meltdown.
You’ll learn how a knowledgeable investor has the opportunity to use the modern tools to easily build and manage a truly diversified portfolio. Adding this insight to what you’ve learned up to this point paves the way for us to begin putting all these techniques to work for us in the markets. To that end, beginning with the next edition, I’ll be introducing regular weekly Profit Talk features such as a market recap and a market preview with the technical and fundamental outlook for the coming week. This information will help compliment the learning and I believe the results obtained from the weekly strategy and trade idea lessons.
I hope this has been helpful for you. 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.
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.
We know that long term successful investing comes from well informed investors applying sound market strategies. Profit Talk was created to help you gain understanding about the investment strategies that work and how to successfully ignore the so called pundits and your own emotions in order to use the modern tools and market key indicators to make investment choices. Here you turn guesswork and chance investing into powerful and informed decision-making.
The previous two editions of Profit Talk we discussed implied volatility percentile and credit style options strategies. Specifically, we focused on the short Iron Condor strategy and how to use the risk graph to analyze credit type option positions.You’ve learned that selling options does provide a higher probability for profit compared to the traditional way of buying or shorting stocks. In return for this higher probability for profit, the option seller limits how much profit can be made on the trade.
This week’s edition of Profit Talk we’ll look at the other side of the trading spectrum and venture into the realm of directional trading with options. Specifically, we’ll be looking at directional trading with debit style option strategies. If you recall, although the particular style of a short Iron Condor we covered previously was a non-directional style strategy, credit strategies can be constructed that are directional. Remember, we can use option selling strategies to create bullish, bearish or neutral biased positions. But again, they have limited profit potential. For this reason, a trader may choose to use a debit style option position.
Debit style option positions can also be constructed to create bullish, bearish or neutral biased positions. But, unlike credit based strategies, debit style positions can be constructed that have unlimited gain. The trade off is, you have to be correct on price to make any profit on the trade. The good news is, you can create debit style positions to fit any degree of directional bias, including a neutral directional bias. However, the more directional your stand the bigger the reward when you are right.
Directional Trading Options
Using options to create directional positions offers great advantages compared to buying stock outright.. Two main benefits include reduced capital requirements and lower risk.
As covered previously, the option chain shows the statistical probability pure directional trading brings. This probability is about 50/50 as displayed by the ATM options. This means, simply buying or selling an asset has 50/50 chance of making a profit. When it comes to directional trading, the investor has two options available to use which may help overcome this obstacle.
The choices are to use either fundamental or technical analysis. Fundamental analysis involves study of the fundamental numbers of a company. This includes all the material facts about the company including; size of the the company, revenue, earnings, p/e ratio, earnings growth, etc. Technical analysis, or what is more commonly known as chart analysis, is the study of price and volume associated with the asset.
The Profit Effect philosophy ignores the fundamentals for the most part and focuses on technical or chart analysis. The reasons are pretty simple, good fundamental analysis takes a lot of knowledge to do well and a lot of time to perform the necessary tasks. Second, all that information shows up on the chart anyway. In fact, when it comes to price, ALL of the information is shown.. This includes both public and nonpublic information.
The stock market is an “open cry” style auction. Price is lead by the forces of supply & demand. As demand for an asset falls (people buying) compared to the supply (people selling) , price must fall in order to attract enough buyers for the amount of sellers. On the other hand, when demand for an asset outpaces the number sellers, the price must rise in order to incentify owners to sell. The fact is, there is no hiding from price. That truth and the time saving advantage, are the main reasons for using technical analysis versus fundamental analysis to make directional assumptions.
That being said, chart analysis can be a very complex subject and is the recipient of an infinite stream of information. The Profit Effect way is to ignore the noise and latest sell or buy signal fads, and stick to the facts when it comes to the study of price.
Study of Price
The price chart is a graphical display of the supply and demand forces at work. Ultimately, it’s a flowing history of investor emotion involving the particular asset. That is good news for investors because emotions do hold some predictive value.
Fear & greed associated with money and investing displays cyclical patterns. These patterns play out over and over again and reveal themselves in price which is displayed in graphical form on the chart. This fact is the basis for technical or “chart” analysis.The key to useful chart analysis is to break the information down to the essential facts about price behavior, or more accurately, people’s behavior in the market place. There are two key factors that must always be kept at the forefront when performing chart analysis. These factors are trend and supply & demand.
Trend
You’ve probably heard the term “the trend is your friend”. The power of trend has been well documented by successful traders for centuries. Although, the idea of using trend in your chart analysis may fall in and out of favor among the financial pundits, don’t let short term popular culture thinking steer you off course with your chart reading. Let me make something very clear, trend will NEVER go out of style when it comes to its influence on price. Trend is to price what the tide or prevailing current is to a body of water. A chart analyst who ignores trend is like a pilot of a ship ignoring the tide or prevailing current of the water they are navigating. Price is influenced by the same laws of physics that govern everything else in our universe. Remember Newton’s first law of motion, sometimes referred to as the law of inertia; an object in motion stays in motion with the same speed and in the same direction unless acted upon by an unbalanced force. These laws are true for price as well, because people are influenced by natural laws and price comes from people.
Another fundamental truth about trend and/or price behavior is it’s cyclical. Cycles occur throughout nature, we all know this and are affected by them. In addition these cycles are fractal. A fractal is a natural phenomenon or a mathematical set that exhibits a repeating pattern that displays at every scale. It is also known as expanding symmetry or evolving symmetry. This means the cycles repeat themselves over and over again within one another at different intervals.As a chart analyst, this simply means you must look at the price chart in different time intervals to get a better picture of the situation.
Let’s look at a candlestick style bar chart. Here is a daily chart (figure 1) . This time interval is set so each bar, or in this case each “candlestick” represents one trading day. You can set the time interval so the candlesticks represent one minute or one month and everything in between. Our job as a chart analyst involves viewing the chart in multiple time frames. This allows a broader view of the trend or the big picture situation.
Multiple time frame analysis, or “multi-framing” for short, typically involves analysis on 2 or 3 time frames. These include the big picture time frame, the controlling time frame and the precision entry time frame. The controlling time frame interval determines the big picture and the precision entry time interval selection. Choosing the controlling time frame comes first. The controlling time frame should be selected based on the planned hold time for the trade. The shorter the hold time the smaller the time interval used for the controlling time frame. Typically, for the big picture chart, we use a time frame that is about 3 to 5 times larger in time duration than the controlling time frame chart. This means if using a daily chart for the controlling time frame, the weekly chart would be used for the big picture time frame. One trading week equals 5 trading days. The precision entry time frame to use in this case would be ⅓ to ⅕ the size of the daily chart.
The normal trading day consists of 6.5 hours. This means a trader would use a 60 minute, 90 minute or 120 minute chart to make more precise entries. The precision entry time frame is optional except when intraday trading, which is often referred to as “daytrading”. This style of trading or any short term duration trading, greatly benefits from using the smaller time frame for precision entries. Outside of those situations, skipping the use of a smaller time frame and using the controlling and big picture time frame charts only is perfectly acceptable.
When it comes to the influence the particular time interval has on price, the longer duration time frame always carries more weight. For this reason, the main role the big picture time frame plays is in determining trend direction. This is a key part of technical analysis that many traders miss. The bigger picture trend direction is what determines the general directional bias of the prospective trade. This means, if looking for buying opportunities an investor would only look among markets that are in an uptrend on the big picture uptrend. If using a daily chart for the controlling time frame, you would look for markets that are in an uptrend on the weekly chart. Think of that big picture chart as the tide or prevailing current of market which results in the majority of directional movement associated in that market.
Determining trend direction in itself has been know to present quite a challenge for beginner chart readers. Although we could spend an entire Profit Talk lesson the intricacies of determining trend direction, I’m going to make it simple and easy for you. The goal at Profit Effect to is to teach modern tools and techniques to help you make quick and easy investment choices. This stuff does not have to be complicated and in my opinion, making it complicated does not make the analysis more accurate or useful. Complexity is not free.
The easiest and quickest way to determine trend direction is to use a moving average. This process is not only simple but can be more accurate because it eliminates any subjectivity. The practice of using a moving average to determine trend is completely objective. The only subjectivity is in choosing which moving average to use. This determination rests on the desired activity level of the trader and/or hold time of the trade.
The averages commonly used by traders include the 20 period average for the near term trend, either the 50 or 100 period average for the medium term trend and the 200 period for the long term trend. Once a time period is decided, simply look to see if price is trading above or below the specific average. Price trending above the average is uptrending. Price trending below the average is downtrending and price cutting back and forth across the average is range bound.
Since the Profit Effect style of trading involves the use of a larger time frame, typically, the 20 period exponential moving average is used on each time frame. This means that if using the daily chart for the controlling time frame and the weekly chart for the big picture time frame, the practice of using the 20 period average on the weekly results in a similar reading as using the 100 day on daily alone. Remember, the weekly is 5 times the duration of the daily chart. So, using a 100 period average on a daily is the same as a 20 period on the weekly. 5 X 20 = 100. Again, the biggest determining factor is based on personal preference and planned hold time of the trade. The most important component is to stay consistent, not which average is ultimately used for trend determination.
Supply & Demand Plus Contrarianism
The other key factor to consider when performing technical analysis is where the supply & demand areas are located. In the end supply and demand determine everything, even trend. The trend direction and momentum is determined by supply and demand. Uptrending markets are doing so because the buyers outnumber the willing sellers. Price must go up in order to incentify sellers to sell.
But, remember the price action is fractal, so these forces are at work in multiple time frames. This means during an uptrend on a larger time frame the smaller time frame of the same market will experience “mini” market crashes. These periods look like a complete meltdown on the smaller time frame, while on the larger time frame they appear as small pullbacks in an upward moving market. These counter trend phases or “pullbacks offer opportunity to hop aboard the prevailing trend.
This style of trading, is contrarian in nature, at least to the short term view. I consider the style, which is my style of directional trading to be what I call “short term contrarian and long term conformist”. Meaning, I ignore the short term “noise” of the market and follow the long term facts of the prevailing trend. I use that noise as opportunity. These pullbacks in price that occur in bigger picture uptrends or rallies in price that occur in big picture downtrends, can provide opportunity to join the current trend.
There are two key factors to consider.
First, is the crucial fact that the directional bias must be in line with the big picture trend. So, it’s never about just being contrarian and buying a stock because it has gone down or selling a stock because it’s gone up. It’s about being contrarian to the very near term direction but in line or conforming with the longer term view. That means buying a stock that has recently fallen in price but still remains in an uptrend on the big picture price. Or, shorting a stock that has recently rallied, but still remains in a downtrend on the big picture time frame.
The second factor is the entry must be made in or very near a supply or demand area. Never just buy a stock because it’s going down in the context of an uptrend or sell a stock because it’s going up in the context of a downtrend. On the controlling time frame, the entry point must line up with a demand area for going long in an uptrend or supply area when going short in a downtrend.
This style of trading simply stated involves buying stocks that are in a big picture uptrend when they pull back to a demand area on the controlling chart and selling stocks that are in a big picture downtrend when they rally up to a supply area.
Determining quality supply & demand zones is a combination of art & science and requires some study & practice in order to accel. This is a subject that will be covered at length in future Profit Talk issues.
In order to allow time to go over this week’s options strategy we won’t cover the details of how the demand zone and profit targets were determined. But instead, allow time for covering the process of creating an option position for taking the trade.
Strategy Focus
This week’s trade idea was derived using the exact analysis just outlined. The trade idea this week is a bullish trade, or a buy trade using the underlying company stock for Activision, ticker ATVI. This example was discovered using the analysis we just covered and consumed just a few minutes of time to find thanks to the modern tools available to us. Let’s look at the ATVI chart and review the desired parameters for entering a long trade.
As mentioned previously, when it comes to the various time frames, the larger duration charts carry more weight in regards to their influence on price and therefore their usefulness for anticipating future price behavior. That said, when it comes to non-directional trading and the use of credit style strategies, which profit from time decay and/or heightened states of volatility normalizing, the preferred chart to use for the controlling time frame is the daily chart. But, when it comes to pure directional trading, where profit is derived strictly from capturing a directional move, the preferred controlling chart for me is typically the weekly chart.
The weekly time frame is not covered much by people selling trading courses or investing newsletters. Probably because the results have a longer time horizon than daily charts and the trades take awhile to play out which makes them a bit boring. I have to say, boring doesn’t matter to me when I’m making money and when it comes to pure directional plays, the biggest profits usually come from using the weekly charts. Profit Effect is not in business to sell trading courses or investing newsletters. I’ve created the business to help individuals proft using stocks & options and pure directional plays perform better on the weekly chart.
Also, if you recall, at the beginning of this issue I stated that this week’s focus we’d turn to a debit based option strategy. Unlike credit based strategies which have limited upside profit potential, the strategy we’re using this edition has no such limit to profit. The strategy carries the ability for unlimited gain. This type of strategy is therefore very well suited for use with the weekly chart because they offer the potential for capturing larger price moves.
Let’s go to the chart and I’ll point out the how the candidate was selected as outlined by the chart analysis parameters previously covered.
We’re using the weekly chart as the controlling time frame.That means we use the monthly chart for the big picture, trend determining, chart. Using the 20 period moving average as our guide on the monthly chart, we see that ATVI is trading above the average. (Figure 2) This means it’s in an uptrend on that time frame. Armed with that information, jump to the controlling time frame, weekly chart, to determine the entry zone, the profit targets and the stop point or risk defense point. Determining these will be covered in depth in future Profit Talk issues. For now, I’ll lay out the numbers.
Here, on the weekly chart, we clearly see the near term weakness experienced by the Activision stock (Figure 3). However, the longer term trend is still up as shown by the monthly chart. The demand zone is located here starting at around $34.65 down to about $33.00 for a zone size of about $1.65. The risk defense or stop point is below $33.00 per share. The first profit target is at the base of these candles here which is about $40 per share. Target one brings a profit of about $425 per spread which is a return on the invested capital of about 38%.This represents a 2:1 reward to risk ratio because that distance is about twice the size or loss amount as depicted by the demand zone size. The second profit point is located at the weekly 20 period moving average which is currently $41.28. This target brings about $550 profit per spread and represents a return on investment of about 49%.
Ideally, the entry itself should be triggered while the stock price is inside of the demand zone or at least very close. However, the restraints placed by the timing of this newsletter prevented us the opportunity to enter when price was trading just about the zone as shown by the “wick” of this red candle here. Currently price is a few dollars of above the zone and if straight stock trading, entering the trade at this point would not be advisable. However, as is normally the case, using options to make the trade gives us an advantage which makes taking the trade here an acceptable risk. This is because the option position we’re going to use in this case gives us some wiggle room when it comes to price. In fact, if placing the trade now, the strategy provides us with zero risk of losing money all the way down to our risk defense point of $33 per share. Once again using options instead stock itself gives the knowledgeable investor the greatest advantages.
Now that we have price assumptions laid out, let’s look at constructing an option position designed to profit from these assumptions.
Free Trade
The option strategy spotlight in this edition of Profit Talk is on a debit style ratio spread I call “Free Trade”. In the previous edition of Profit Talk you learned about spreads. If you recall, a spread contains both a long (purchased) and short (sold) options. One is the profit driver and one is the hedge. If the profit driver is the short option, it’s a credit style style spread. If the profit driver is the long option it is a debit style spread.
A ratio spread uses an unequal number of long and short options to create the spread.
The “free trade” uses 1 long option and 2 short options.In truth this trade is not completely free, but this strategy can often times provide a way to take a directional shot without creating much of a debit if at all, and once in awhile even a small credit. Plus, the added benefit of having a large range for price to move and not lose any money. At the same time, you are positioning you to reap high profits should the trade move in the direction anticipated.
The bullish “Free Trade” spread is constructed through buying 1 ATM Call and selling 2 OTM Puts both with the same expiration of 90 days plus the planned hold time of the trade. Look to sell Puts that are selling for about ½ the price we’re paying for the Call. So, when selling two of them the cost of the Call is covered. The further away you can get with the Puts the more room price can move without incurring any loss on the trade should it not work out.
It looks likes this spread is coming in with a small credit of 25 cents (Figure 4).The 1 long option and 2 short options together equal 1 spread. Each spread represents 100 shares when it comes to the cost or in this case credit. This means you would receive $25 for each spread placed. The buying power used is just over $1,100.(Figure 5) The risk in the trade is the obligation to buy 200 shares at the strike price of the 2 short Puts. This makes the risk for each spread, the same as buying 200 shares at $33 each minus the credit.
In terms of the value fluctuation of this spread from directional movement in the stock price,it will behave much like owning 115 shares of stock. This means the spread will rise in profit about the same as owning $115 shares. This is shown by Delta here. (Figure 6). But, the option position carries distinct advantages.
Using this strategy instead of simply buying the stock provides two substantial benefits. First, you receive some price cushion before losing money on the trade. The stock is currently trading for $36.45 per share. If you bought the stock shares here you would lose money every penny lower from this price and you would also profit every penny higher. Using this spread, you would also gain profit with every penny higher, but you would not be at risk for losing any money until the price is below $33 per share.(Figure 7) This gives you a lot more room to be off on the entry and not suffer for it financially.
The second advantage over straight stock buying is the lower cash requirement or buying power used to place the trade. Using cash to buy 115 shares of this stock at $36.45 would cost $4,191.75. Using this spread to participate in the upside stock price movement as if you owned 115 shares, requires $1,131.43. This allows you to compound your profit potential by freeing up capital for diversifying across other trades investments. In addition, the lower capital requirement increases the ROI significantly on profitable trades.
This strategy does offer a few options for risk management if purchasing the 200 shares is not desired. However, simply closing the trade in advance of expiration for risk defense is not recommended for this strategy. This type of strategy will have a poor “real time” P&L which makes closing it early a lot uglier than it needs to be. Just like investing in the stock itself, this strategy should not be used on poor quality stocks or on a stock you would not be okay with owning.
The good news is, there are ways to manage the trade and avoid buying the shares, should that scenario come into play. In addition the risk can be limited to a comfortable amount through a variety of techniques. Also, options offer the ability to create cash flow from this position while waiting for the anticipated rise in share price. Both these subjects will be covered at length in future Profit Talk Editions.
Main Takeaways
The main takeaways when it comes to directional trading are:
First, trade direction should be is the same as trend direction on the big picture chart. Thats number one, always align trade direction with big picture trend direction.
Second, on countertrend moves, use supply or demand zones to join trend. So, be contrarian within the context of the bigger trend and always use supply and demand zones for entry placement
Third, use the most advantages strategy based on assumptions. That means the strategy that best compliments your market outlook based on your chart analysis
A Look Ahead
Looking ahead… the next edition of Profit Talk you’ll be introduced to another key component in a well rounded trading and investing strategy which is beta weighting. Modern tools have made the task of analyzing and managing the systemic risk your portfolio of positions carry. In plain english that means it’s a lot easier to analyze and manage your portfolio’s exposure to a market meltdown.
You’ll learn how a knowledgeable investor has the opportunity to use the modern tools to easily build and manage a truly diversified portfolio. Adding this insight to what you’ve learned up to this point paves the way for us to begin putting all these techniques to work for us in the markets. To that end, beginning with the next edition, I’ll be introducing regular weekly Profit Talk features such as a market recap and a market preview with the technical and fundamental outlook for the coming week. This information will help compliment the learning and I believe the results obtained from the weekly strategy and trade idea lessons.
I hope this has been helpful for you. 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.
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