Most Profitable Stock Picking System

The most profitable stock picking system for a retail trader like you and me is going to involve finding stocks that move.  The beauty of the life of the options trader is that we don't care which direction the movement comes (so long as we forecast it correctly).  We are much more concerned with the size and frequency of movement instead (unless you are trading binary options, which only require the direction of movement to be correct).

How Do I Pick Stocks That Have Big Movement

Although it really isn't all that helpful for it's originally intended purpose as a measure of risk for making efficient portfolios, Beta is a well established statistic which describes the variability of a stock relative to the broader stock market.  That being said, doesn't it seem that using beta might suit our needs for finding stocks of high variability?

Why Beta Still Matters to the Cash Options Trading Investor

Even though beta has been more or less written off as a measure of portfolio risk, resigned to the dust bin of efficient portfolio design, to the options trader it measures (historically) EXACTLY the metric the retail options investor is looking for: volatility.  Beta, simply stated, measures the historical variation in a stock relative to the broader market.  For example, a stock with a Beta of 2.0 would be expected to move twice as far as the broader market on any given day.  Similarly, a stock with a Beta of 0.5 would be expected to move 50% as far as the broader market in a given day.

So What Sort of Beta Should A Good Options Trader Select?

Oddly enough, the most profitable stock picking system for the retail options trading investor would be (drum roll please): stocks with a relatively high beta.  A stock which moves a higher percentage relative to the market is likely to have greater swings in options pricing.  Greater swings in options pricing inevitably opens the door for a small cash options investor to capture a significant portion of those swings (incidentally, the short seller of options prefers to trade in low Beta stocks... because those stocks are less likely to move, allowing the holder of the short seller's contracts to expire out of the money - so the short seller gets to keep the premium for themselves... but thats a topic for another day).  The point is that stocks with larger percentage swings on a daily, weekly, monthly, etc. basis will likely have a greater probability of providing profitable entry and exit points for options trading.

The Most Profitable Stock Picking System Involves More Than Just Beta

Finding the most profitable stock picking system for options trading isn't just about Beta, and we'll talk more about that later.  What I hope I have accomplished here is getting you (as a cash options trading investor) to stop thinking about trying o find "stocks that are going up" and instead turn your attention to a more profitable enterprise: finding stocks that are "going to MOVE"

Cash Is King for the Options Trading Icon

In options trading Rule #1 is: Cash - IS - King

Sums it up, doesn't it?  Why is it that such a simple concept get so easily lost amongst day traders.  Aggressive and smart people are humbled over and over again by the market.  WHY?

Simple: Because they forgot rule #1: Cash-IS-King

I have seen far too many traders get greedy and take on positions far larger than their ability to manage or properly capitalize with COLD-HARD-CASH.  Why is it that traders insist on getting greedy and either abandon their established trading limits or simply fail to establish good limits at all?  Does the average day trader forget that there are bigger fish in the sea who can easily take out weaker leveraged positions?  Face it, unless you have huge amounts of capital to work with, margin-style leverage is only going to get you completely wiped out.  Leave the margin trading for the big fish.  The good news is you don't have to use margin to create leverage.  It is really possible to leverage your buying power with options, paid for with CASH.  Have I mentioned Cash-Is-King?

Consider the example of a forex margin account.  A typical forex margin account (like here) will allow you to trade using up to 400:1 leverage (on maintenance margin after initial 200:1 margin position).  Sounds great doesn't it?  A one cent change in an exchange rate turns into as much as $2 in profit per dollar of capital invested.  Where's the problem in that?

The Devil In Margin Trading Is the Margin Call

What is a margin call?  Think of it as catching a big wave on a surf-board and then finding out you're actually riding a tsunami into the ground.  The math isn't all that complicated but the gist is this: the same rules that apply to gains in a margin account apply to losses as well... except for one thing.  If your trades are going badly and your equity (cash + net securities value) falls below a certain level (called the maintenance margin), your broker can (legally and without notice) begin selling any and all of your positions to satisfy margin requirements.  Basically, they can wipe out your entire account... AND if the position has gone badly enough, you may still have unpaid losses!

Ok So Margin Trading Isn't All Peaches and Cream - How Do I Create Leverage Using Cash Options?

Now you're starting to ask the right questions.  A lever, from the time of Archimedes to the present, has always been a tool for a person to do more work than can be done using the body alone.  A lever in day trading stocks allows a trader to purchase or control vastly more buying power than they would otherwise be able to get with cash alone.  We've already discussed how this is done with margin (a margin stock account allows 2:1 leverage max).  Another way to create leverage is by using cash stock options.

How Do Cash Options Create Leverage?

A stock option is defined as the right to buy a particular stock on or before a specified time for a specific price. An option is a CONTRACT between the buyer and the seller of the option.  The SELLER of the option is paid a PREMIUM for the risk exposure they are taking in committing to being the short side of the contract.  The premium paid by the buyer of the contract relative to the actual share price of the underlying stock determines the leverage.

Think of it this way - a person with $1000 can buy 100 shares of a stock that has a share price of $10/share.
An options trader on the other hand might be able to buy 100 call contracts (a call contract typically represents right to buy 100 shares) for $0.10/share ($10 per 100 shares) giving the trader right to buy (control) of 10000 shares.  This represents buying power leverage of 100:1 versus an outright cash stock purchase. 

Now who knows what the terms of the strike price and expiration date are of the options contract.  That's not the point here.  The point here is to demonstrate that options create buying power leverage for the cash options trader (long side).  The seller of the call contract(s) is a different matter entirely.  They may be closing out a position, hedging a position they already have, or making a (naked) gamble that the stock will go down and they'll never have to pony up the actual shares of stock.

I hope you can now see why options trading using purchased cash options is the small capital trader's way to create leverage - remember rule #1: Cash-Is-King.

Establishing Your Comfort Zone for Options Trading

Establishing your options trading "comfort zone" is the most important step to take before taking the plunge and making trades.  What kind of "comfort zone" am I talking about?  I am talking about making trades using options contracts which require no further attention on your part and give you the ability to walk away from the computer terminal and not look back.  And oh, by the way, the reason you'll have this confidence is that you aren't worried about losing money on the trade - the only concern you have with the trade is WHEN you are going to get your PROFITS on the trade.  THAT'S what I mean when I talk about a COMFORT ZONE in options trading.

When I started writing this blog I made some assumptions about how much you know about options trading.  I have assumed that you know the basics of put and call contracts, and what circumstances (market direction) make them profitable.  If you haven't got a clue about options trading, this blog probably isn't the place for you: it'd probably be best if you picked up a beginner's book to get the basics first.

For those of you still reading, what do you think will give you the most confidence in making options trades?  Want to know the biggest secret? Would you believe there is one critical advantage you can have over nearly every other trader in the market - a critical advantage that will MAKE YOU MONEY in options trading.

The Critical Advantage in Options Trading Is CONFIDENCE

How do you get the kind of confidence I am talking about?  It is way easier than you think.  While you may think the market is extremely intimidating and full of sharks and schisters trying to steal your money (it IS intimidating, and there ARE sharks, and they ARE trying to steal your money), the truth of the matter is that the vast majority of traders are under MUCH GREATER PRESSURE than you are.  Taking advantage of the pressures that others are under is HOW YOU CAN BE COMPENSATED IN THIS MARKET. Once you understand what gives other traders heartburn (and avoid doing what they do) you can build the kind of confidence you need to start making trades AND THEN WALKING AWAY... WAITING FOR THE MONEY TO COME IN.

Why Do Other Option Traders Feel So Much Pressure

That's the million dollar question, isn't it?  Look at yourself.  What pressure are you under?  Do you have overwhelming bills to pay?  Did you lose your job?  Do you have medical bills?  What anchors are you carrying around in your life?  Want to know the secret to successful options trading?

TRADERS WITHOUT ANCHORS MAKE MONEY CONSISTENTLY.

But wait, you say - if traders are making money then they don't have anchors like bills and such.  WRONG!
The anchors causing you worry OUTSIDE YOUR TRADING ACCOUNT have to be cut FIRST. 

The First Principal of Successful Options Trading Is Trading Without Anchors

Consistent successful options trading involves taking monetary risks that can result in TOTAL LOSSES. The successful trader understands this and ONLY TRADES MONEY HE IS WILLING TO LOSE. Yes, WILLING is bolded in the prior paragraph.  We are talking about contracts which (if they expire out of the money) are WORTHLESS.  If you can't accept the risk of 100% losses DON'T TRADE OPTIONS.  This principal also applies to pressures OUTSIDE your account as well... Which leads to my second fundamental principal of successful options trading.

SUCCESSFUL OPTIONS TRADERS DON'T TRADE WITH THE MORTGAGE MONEY.

Trading With Money That Is Borrowed or Isn't Free to Lose Is Sure to Be Lost

Does that make it clear enough?  Trading with money designated for basic suvival needs (food, shelter, health) is A HUGE ANCHOR. Successful options traders are TRADING WITHOUT ANCHORS. If you are trading money that has an achor attached to it you are at a HUGE DISADVANTAGE in the market, and on average YOU WILL LOSE.

I will write more later, but your mind should be pretty well stirring now.  If you've already traded options (and lost money), you ought to beginning to figure out why by now.  More soon.

How Options Trading Is Like New England Weather

From the title, "How Options Trading Is Like New England Weather" you ought to have a pretty good idea about where I am going with this post.  What we're talking about is getting a price you like for the securities you want, in this case options contracts.

An Options Trader Must Be Disciplined

The retail options trader has to be very patient and disciplined in trading. What this means is establishing a minimum or maximum price to pay for a options contract and not wavering until the entry point is reached (or walking away if missed).  It's that simple.  Preservation of investing capital demands committing to purchasing a security at a pre-determined price or set of market conditions (based on your observations of the market and comfort level) and not wavering from that commitment.  Likewise, immediately after acquiring the contract(s) the well disciplined trader already has an exit price in mind and sets a trading exit point with their broker to automatically execute once the criteria has been met.

Automatic Exit Transactions Reduces Anxiety

Setting automatic transactions reduces the duration of the holding period of the options contract, and likewise maintains disciplined entry and exit strategies (reducing a trader's stress and number of ulcers).  Second guessing is not an option (pardon any pun) for the options trader. The goal of this options trading tutorial is to get you thinking about determining what YOUR conditions for being comfortable entering and exiting the market will be.

Some factors you will need to consider are
What option contracts will you trade?
How much capital are you willing to commit to each position?
What is the minimum number of days to expiration you need to feel comfortable?
What is the maximum premium on the contract you are willing to pay?
What is the maximum spread between bid and ask you are willing to accept?
What is the minimum profit you are willing to wait for?
What are the market conditions (light volume? heavy volume? big dip pre-market? earnings announcements? dividend ex-date?) you require in order to feel comfortable buying an options contract?

The answers to these questions will help you determine which contracts to purchase, how much to pay, how much to sell for, and how long you will hold the contracts.

There is no guarantee of success with options trading, but the greater effort you put into narrowing down which market conditions and trading patterns you are willing to work on, the better your chances of making successful, repeatable profits from trading.

So How Does New England Weather Relate to Options Pricing?

Now back to the original title of this post: "How Options Trading Is Like New England Weather" - the answer to that is simple: Options trading is like New England weather in that if you haven't gotten the price you like to buy or sell a contract, chances are all you need to do is wait a few minutes because the prices (like the weather) will continuously change.  Eventually if you wait long enough, you'll either get your price, or the contract will expire.  No sense worrying about it.  You should be trading with money you can afford to lose.. so you your approach to exit pricing should be ambivalence - so long as you bought your contract at a price you were comfortable with in the first place (which you also should have waited for... like New England weather).

I hope this gives you an idea of ONE WAY to think about options pricing and trading discipline.

Options Trading Tutorial - Surveying the Underlying Economics

Welcome to my options trading tutorial on blogspot. I wanted to jot down some thoughts on how I identify and exploit trading opportunities in the derivatives market to make a few extra bucks every month. Options trading isn't for everyone, and the strategy / style of trading I discuss here honestly requires a lot of confidence and patience in the face of an adverse market.

Options Trading in an Adversarial Market

Right now is an extremely adversarial trading market. The fundamental economics of the global economy are screaming "SLOWDOWN/CONTRACTION IMMINENT" however the largest global governments are throwing the kitchen sick at the problem of global macro-economic depression in an effort to keep the economy going. Successful trading requires being able to gauge the direction of the market at a given point of time, entering the market quickly, setting modest profit targets, and exiting the market before it has a chance to react to your exit strategy.

Key Terms in an Options Trading Tutorial

I'm going to assume you know the basic options trading terms. In the previous paragraph I have described the basic macro-economic picture in simplified terms. Two opposing forces: declining asset values due to real estate and bond market bubbles against government central banks pumping those same asset values up as fast as they can to prevent global economic melt-down.

Cash Is King in an Uncertain Market

What is the best place to be in a market with two extremely large and diametrically opposing forces? Clearly the answer is to be in cash as much as possible and trade into and out of the market with as short duration of trades as possible. In the simplest terms, duration is the length time holding an investment position prior to returning to cash. In an extremely dangerous market like today, duration is measured in days (and preferably - in minutes). This is not the time to be caught "holding the bag" when the market falls out from underneath you.

Having said that, given that economic prosperity and growth is really in all of our best interests, it behooves us to hope that the economy grows and the stock market goes up. The problem is that our pragmatic side knows that double digit global unemployment, overwhelming debt, and an ever widening gap between rich and poor leads to only one conclusion: civil unrest and economic collapse.

The wisest minds in finance and economics know these fundamental facts, and certainly some of those minds work on the trading floors of the biggest banks in the world. They HAVE to know that trading the short side of the market (expecting the market to go down) is the most obvious and profitable trade. The problem lies in that should they make all the money possible betting against the market and the governments and economies of the world they will likely lose their independence and be nationalized, their assets seized, and cushy lifestyles traded in for lynchings and bondage (or worse!).

To Shear or Skin a Sheep, That Is the Question

Whether to shear or skin the sheep, that is the question powerhouse banking interests have to ask these days. Multiple times over the last 30 years trading firms have gained a cumulative trillions of dollars of wealth and kept it for themselves. These trillions have changed hands at the expense of the blind money in the market - away from small investors, to 401Ks, to pension and or mutual funds and into the hands of high net worth individuals, hedge funds, and multinational banks.

The game today has gotten so out of hand it seems to have come to the point of revolution. We've recently seen riots in Greece, which standing on it's own may not seem like a big deal, but we're less than a year from seeing the same level of unrest and or violence in Spain, Portugal, Ireland, and the UK. It is not entirely out of the realm of speculation that riots in California and other debt swollen states are possible.

Adversaries Become Strange Bedfellows When Disparity Reaches the Point of Violence

A wise banker sees this writing on the wall and ultimately can't help but be co-opted by the governments determined to prevent their own overthrow then. That's the underlying economic theory (call it speculation if you wish) behind this options trading tutorial / trading strategy. Banks and governments have to work hand in hand to make it LOOK as though "all is well" long enough to fool the people so subjugated into believing the illusion. The trick is to keep just enough people (the mid-middle class basically) feeling just content enough to prevent uprising.

We'll talk next post about the likely market movements associated with this scenario of overwhelmingly negative economic fundamentals combined with a coordinated central banking intervention strategy.