Top-Down Analysis

The stock market is made up of over 20,000 publicly traded companies. Navigating through this large number of stocks can seem overwhelming just because there is some much information to take in. One simple approach to finding your next trade is called the “top-down” analysis. You begin by looking at the overall market by using technical analysis. What you are looking for is momentum or direction. The market is divided into 10 different sectors. Using these sectors will help you identify the industry group a specific stock is trading in. Find the sector that is the strongest and then drill down into that sector to find the strongest stock. As you practice this approach, you should get better over time, and with the help of technology, you should be able to complete this analysis in only a few minutes. This will save you time and energy and should get you to your next trade faster. This approach has an additional benefit; If you find yourself in a bullish or bearish market, meaning the market is climbing or falling in a direction, you should also find the sector with this same behavior, as well the stock with this same behavior. This is called “trading the trend.” This theory helps in timing the overall market, sector, and stock direction, creating directional alignment with or potential trade. It is not a bad strategy to simply follow the current momentum! This approach makes perfect sense when you are looking to apply a simple strategy, which should answer the question, “What stock should I buy?”

Portfolio Deltas Simplified

Our family has a dog named Hans who loves retrieving tennis balls. Hans will pester you night and day to throw him the ball. And if there happens to be more than one tennis ball lying around, he will put as many as he can into his mouth. One ball is easy for Hans to manage. But, if there is more than one ball, Hans begins to lose focus and, with each additional ball, it becomes more complicated for him to keep them in his mouth. The same can apply for those who trade the markets. One trade is easy to focus on, but adding more positions, with varying sizes, can make trading much more difficult to manage.

Delta is the rate of change. That definition is what one will often hear when talking about options. It has little meaning to the novice investor. Delta may be better understood by thinking of it in terms of shares of stock. Consider the following: if you own 77 shares of stock and the stock goes up a dollar, you would have made $77 dollars. If you own an option with 77 deltas, and the stock goes up a dollar, you would also make the same $77 dollars. So, a better working definition of delta is the number of shares you are trading. If you have multiple contracts in a trade, then your deltas would be multiplied (5 contracts x 80 deltas = total of 400 deltas.) That trade has 400 deltas, or would act like your trading 400 shares. The more shares one holds, the more deltas the portfolio has. So, delta can be thought of as the amount of risk or exposure to the market. If you are trading 1,000 deltas in a portfolio, you would have considerably more risk in your account than if you were only trading 100 deltas, so the larger the portfolio’s deltas are, the more the portfolio is exposed to market movement. Therefore, managing deltas is of the upmost importance to the individual trader.

Knowing when the markets are overbought and oversold can be pivotal points of interest for your total deltas. If markets are at tops, reducing deltas may help reduce the risk to a portfolio. How does the individual trader shrink the number of deltas one holds in a portfolio? Exiting trades and placing bearish trades that come with negative deltas will both reduce deltas and exposure to market conditions. If the markets have found a level of support and the markets are expected to go up, adding deltas to a portfolio may add to your returns.
In the end, a delta is a quick an easy way to view your portfolio and a mathematical value that quickly shows the amount of risk that one has to their portfolio. If Hans could talk, he would tell you one ball provides more focus, more enjoyment and less anxiety. And like one ball, a portfolio delta provides a single number, better focus and clarity to your bottom line.

Vertical Spreads and Alice

In Lewis Carroll’s Alice in Wonderland, Alice asks; “Would you tell me, please, which way I ought to go from here? That depends a good deal on where you want to get to. I don’t much care where – Then it doesn’t matter which way you go.” Vertical spreads would agree with Alice, we don’t care much where the trade goes. Stocks will go up, down or sideways, up a little or down little. Of the five directions a stock may move, verticals will benefit the trader in 4 out of 5 of those possible directions. Like Alice, it doesn’t really matter where the stock goes.
Which is easier, picking where the stock will go or where it won’t go? The answer is where it won’t go; you will be right 4 out of 5 times. Most strategies face much harsher odds. Trying to pick where the stock will go will be correct only 1 out of 5 times. Verticals are much more forgiving. Let’s look at a hypothetical trade. XYZ stock is trading in a range between $100 and $110. The stock has run up to $110 resistance on low volume and seems to be turning over with a current value of $108. The trade will be to sell out of the money calls at $112 with another call bought at $113 as a hedge. The purpose of this trade is to have both options expire worthless. The $112 call is the reason for the trade, the $113 is for insurance against the unlikely event the stock changes direction, breaks resistance and moves above the $113 dollar value. Selling about 30 days before expiration will provide little time for the trade to achieve $112 value. If all goes according to plan, the trade will achieve success if the stock remains below the $112 value.

Stock price at expiration

Success or Failure

$114

Fail

$112

Success

$110

Success

$108

Success

$106

Success

$104

Success

$102

Success

As you can see from the chart above, most scenarios will prove successful with only one situation where the trade would fail. This is considered a high probability trade. If the stock trades anywhere below $112, this vertical spread will be at max profit. As long as the trade stays in the $10 range between support and resistance the trade will be profitable. Like Alice’s comment “I don’t much care where,” verticals tend to work the same way. When setting up verticals, we pick the time frame, the situations where the stock price may go, and where the stock price may not go. Verticals have flexible rules, plenty of setups, and a lot of solutions.

Lessons Learned from a Professional Poker Player

How do the same professional poker players find themselves sitting around the same final tournament table each year? Do the good cards naturally fall into their hands? They must be luckier than the rest of us. Or, can we learn a few things from these professional card players? Below is a list of skills that these players have that could transfer to any stock and option traders.

Ability to adapt is a skill that is necessary to a poker player, as well as participants trading in the stock market. Conditions change and hundreds of new factors will cause the topography of markets to change. Knowing how to navigate the new and ever-changing landscape is essential to successful trading. Simply put, trade the trends. A trader’s ability to observe market conditions when trends change and adapt to these new conditions is the key to success. Holding to old beliefs after markets have changed is the best way to lose money. Be flexible and have the ability to adapt when conditions change.

Varying the size of your bet can help put the odds in your favor. Placing larger bets when using higher-probability strategies or when conditions mathematically are in your favor will allow larger size wins when you are right and can help pay for smaller losses when you are wrong.
Emotional control is essential to investing, like it is in professional poker. Trading is a long-term battle. What happens in a single trade is of little meaning to your portfolio unless it causes the trader to give up. Focusing on your goals and eliminating your emotions when making decisions is crucial to success. Of course, it’s easy to be happy when right and sad when wrong, but making decisions should be void of emotions. Trading plans can help overcome emotions and keep them at a distance. Following rules can minimize anxiety and the feeling of being out of control.

Attention to detail is the last skill we’ll discuss. Poker players are like sponges; they watch everything. Every bit of information they can obtain from what each player does with the cards dealt, to how much money every player has, to which players raise and which players check, is important. Like poker players, we should know the markets and sectors, current market conditions, market cycles, and how the market behaves at each level of support and resistance. Traders should be students of history. In the end, we absorb all relevant information, focus on what matters most (trends, reward and risk, and mix of bullish and bearish trades) and ignore the less important. Trade your plans and follow your rules, and you will feel more confident having a systematic approach to the ever-changing market. There is much to be learned from these professional card players. As we develop their skills, we will be prepared when we find ourselves and our portfolios sitting in the big game.

Lemonade Stands and Liquidity

June is upon us, and the hot weather has sprouted young entrepreneurs in the form of lemonade stands popping-up all across the neighborhood. My boys are part of this business cycle, and are reaping the rewards of my neighbor’s loose change. One of the boys exclaimed “Dad, we are cleaning it up out there” pointing to the curb where there business venture begins each day. I didn’t have the heart to tell them the hard truth. The truth is, like all business ventures, there is a financial cost to things like; sugar, lemons, ice, and plastic cups. If I was to tell them that the first 25 cups sold, barely cover the cost of operations, they might have a change of heart. Sitting in the sun for the hottest part of the day just too breakeven doesn’t seem to have the same entrepreneurial appeal.

Options work the same way! If we choose to do business by placing calls and puts while forgetting entry and exit costs in the form of bid and ask spreads, we, like the kids on my street, may naïvely feel to exclaim, we are cleaning up! When In reality, we haven’t begun to breakeven. See the table below, notice the various cost of doing business for at-the-money options 30 days out on some popular stock’s options. Cost column indicates costs that vary between the bid and ask prices depending on their liquidity. The more the options are traded daily, the tighter the bid ask spread might be. But if one doesn’t pay attention to slippage (difference between bid and ask prices) they might be having to dig themselves out of a deep hole. As a general rule, I try to never place trades with bid/ask spreads greater than 10% of the ask price. So, if we use AAPL as an example, the ask price is $2.10, and ten percent of that price would be .21 cents. Since the bid ask difference is .04 cents, this trade would be fine. Looking at HAE, the costs are 70% which is too great to incur and we would be best to go elsewhere.

Stock Bid Ask Cost
AAPL 2.06 2.10 1.9%
AMZN 17.65 18.20 3.0%
SPY 2.31 2.35 1.7%
HAE 2.00 6.70 70%

So, enjoy the summer and remember, costs are costs, and keeping costs low is always good business. Trading stocks that have high option liquidity and low costs is good business.