Sunday, September 25, 2011

How to Be a Private Trader

Here's the updated trading plan document, combining "How I Trade" with "How to Be a Private Trader." It will be available from the menu bar under the latter title. Enjoy!

(In writing this essay, I’ve assumed that the reader has a basic knowledge of stock and options trading. As much as I loathe the titles of the Dummies books, two good resources for getting a start in those subjects: Stock Investing For Dummies, and Trading Options For Dummies.)

Contents

Private Trader
Strategies
Base Holdings
Trend Trading
Charts
Market Direction
The Trend
Trading Rules
Choices
Trade Sizing
Resources
Trader’s Mind
Posting Schedule
Housekeeping

The Private Trader

No one will hand you a certificate that proclaims you to be a private trader.

No one will give you a nameplate for your office door and a key to the official Private Trader Executive Elevator in order to mark your bona fides.

There's no Master of Private Trading degree from Harvard. There's no Private Trading Standards Board enforcing good practices.

You lack the support systems that lawyers and doctors and MBAs and plumbers and electricians enjoy. As a private trader, you set the rules, you enforce the standards and your certification lies between your ears.

Private trading is very much an Ayn Rand sort of activity. Or perhaps it's like Kwai Chang Caine, the Shao Lin priest, wandering alone through the American Old West.

To be a private trader is to be one of the freest people on Earth, and one of the most self-responsible.

You're on your own.

The simplest definition: A private trader is someone who (1) trades (2) on his or her own account.

To trade is to actively manage your money. Many people, perhaps most, watched their retirement accounts sink at a nauseating pace in 2008, and responded by not opening their account statements.

The traders, by contrast, responded by moving money out of stocks and into bonds or cash, and then moved back into stocks after the decline had ended. "Buy and hold" is not a strategy for private trading.

The private trader is neither a "master of the universe" for some Wall Street firm, nor a broker, nor a pension fund manager, but rather an individual entrepreneur seeking profit in the markets on his or her own account.

A private trader can be a day trader, flipping positions as the price changes minute by minute, but can also work to capture the stately monthly moves. The private trader can trade stocks and their options, but also futures, forex currencies, even bonds and mutual funds in a retirement account. And the trading account can be huge, running into the hundreds of thousands of dollars, or a modest nest egg of under $5,000.

It's not the size of the trading or the object traded that's important. What counts is the trade itself.

I've known many people who paper trade, and many more who trade in their dreams. I've known only a few willing to sit down and embrace risk in the act of trading for profit. Only those in that final group can truly call themselves private traders.

A private trader needs three things: Some money, a trading plan, and the discipline to follow the plan. And a bit of attitude helps.

From those simple elements comes the possibility, at least, of financial independence.

How much money? At least US $5,000. Most brokerages require $3,000 at a minimum, and it’s good to have some cushion over that. Don’t have $5,000? If you can set aside $96.15 a week, you’ll have that much money at this time next year.

Get rid of cable TV, and that takes care of one week. And most of us -- me, certainly -- waste $13.74 a day. Find a way to end that waste in the remaining three weeks, and you’ll have your trading fund in no time.

Further down, I’ll describe my trading plan. But honestly, there are as many plans as there are traders. The way I trade won’t necessarily match your resources or your temperament. By writing your own plan, you can make it something that’s not only easy, but a pleasure to follow.

My plan has all the elements of any trading plan: Rules for sizing trades (how much money to risk each time), rules for entering positions, and rules for exiting positions. That’s all it takes. What’s important is a well crafted definition of the circumstances on the charts and in the markets that trigger the rules.

In writing trading rules, precision counts.

Discipline is the hardest part. Traders tend to be romantic optimists. We fall in love with our holdings, and when they threaten to cause us loss, we think, “If only I wait a little bit more, things will get better. I’ll love this position again”

Discipline means getting into a trade only when it meet the requirements of your plan, and getting out when the plan says you must.

Strategies

"Wait a bit, Tyek," Farad'n said. "There are wheels within wheels here." --Children of Dune, by Frank Herbert.

What kind of trade are you placing today? If you’re like me, you will have already, in your mind, attached a label that in a word or two defines its characteristics and also limits how you think about the trade.

Short-term vs. long term, dividends vs. capital gains, high risk vs. safe -- they’re a convenient short hand, but I’ve come to the conclusion that by limiting my thinking about a trade, those labels are enemies of profit.

It is hard to be nimble in exiting a position once you think of it as “long term”. Or to close a “dividend” position whose capital losses have wiped out a year’s worth of income. Or leave a “safe” position whose chart suggests a decline is imminent.

Many labels are backward looking to an extent, and all pretend to have a knowledge of the future. A stock is labeled “safe” if it makes only small daily moves, the label’s presumption is that the characteristic will continue into the future.

And once a trader starts labeling, then the logical step is to have separate rules for each type of trade.

Eventually, the trader ends up trading the stereotype rather than the reality.

Label-Free Trading

My answer to labels is replace them with a trading plan that organizes all trades into a single conceptual structure.

It begins with a base holding. I have a huge preference for covered calls as a base holding because the strategy is both conservative and flexible, allowing, potentially, a lot downside protection and accommodating both rising and falling prices.

However, covered calls aren’t the whole show. A base holding can be long calls or puts, or options spreads, such as iron condors, which are profitable if a stock stays within a certain range, or calendar spreads, which are most profitable if the stock stays at the strike price.

In addition to the base holdings, I hold insurance positions. If a base holding is in danger of suffering a loss, I will, as I deem appropriate, insure against the loss by buying deep out-of-the-money puts (or calls, if the base position in bearish).

Base holdings don’t need to be directional plays. They can be agnostic as to the course of the market. Insurance positions will always be directional.

Base Holdings

In this discussion I’ll describe one of my base holdings strategies: In-the-money covered calls.

For information on how to structure other sorts of base holdings, an excellent and comprehensive reference is The Bible of Option Strategies: The Definitive Guide to Practical Trading Strategies, by Guy Cohen.

In structuring a covered call, I buy shares of a stock or exchange-traded fund, in 100-share lots, and sell in-the-money calls for the next nearest expiration month. The premium for selling the call provides income, and also lowers the basis on the stock, decreasing the chances of a capital loss.

An in-the-money call is one whose strike price is less than the current market price, the mark. It has a substantially higher premium than an out-of-the-money call.

There are many, many books for covered call novices. A good place to start is Show Me the Money: Covered Calls & Naked Puts for a Monthly Cash Income, by Ronald Groenke. He has tons of useful information, although his writing style may be a turn-off for some readers.

In trading covered calls, I’m looking for high-volume stocks, 5 million shares a day or more, on average.

I’m happiest with stocks whose strike prices are a dollar apart, as this gives me more flexibility in structuring the covered call.

And I give preference to stocks whose fundamentals and analyst rankings are neutral to bullish. For my own trading, I use Zacks ratings as my standard, selecting, in order of preference, stocks rated from 1 (strong buy) to 3 (neutral).

I select the strike price by going out from the current price by about four or five times the 10-day average true range, a method that gives me some adjustment for volatility. The average true range measures the amount of dollars and cents the stock price moves on average in a day.

I have a lot of give on how far out I go. Four or five times approximates the old “one strike in the money” rule from back in the days when strike prices, mostly, were $5 apart. But it’s not set in stone.

I then do two calculations: One shows the premium return (if I keep the stock), and the other the return if the call is exercised (requiring me to sell the stock at the strike price).

The calculation formulas are:

  • Premium return: Option premium divided by stock purchase price.
  • If-exercised return: Option premium plus ((strike price - stock purchase price) divided by stock purchase price)

I’m looking for a premium return of at least 15% for the month, and an if-exercised return of at least 1%. Annualizing the figures, I want to be able to make a maximum return of 180% a year and a minimum return of 12%. Try to get that from your bank’s CD or your Treasury bonds.

”Greed, for lack of a better word, is good.” --Gordon Gekko.

My actual practice runs backward from the way I described it. I scan the list of optionable stocks, throw out those with insufficient returns, sort the remainder by the Zacks rating (1 to 3) and trading volume, and then work down the list picking the stocks whose returns are highest within each rating. It takes about an hour, once a month.

I’ve found that I can easily manage a dozen covered call positions, and I suspect I could go as high as 25 before feeling a bit stressed.

Aside from the monthly selection of stocks for covered calls, the management consists of looking at the stock prices for my covered call holdings each day, and opening or closing directional trades placed as insurance.

It can easily be done in half an hour each day.

Trend Trading

In any class that teaches trading, the instructor will, unfailingly, at some point intone with the solemnity that accompanies great wisdom: “The trend is your friend.”

At that point, unfailingly, veteran consumers of trading instruction all smirk or groan.

I’m here to tell you that the trend is your friend only if you can figure out which direction the trend is taking.

For the trend is a fickle friend, and just as you’ve open a position to follow the trend to profits and glory, the trend will turn on you with a snarl, sending you plummeting into losses and the Slough of Despond.

I divide my price-trend strategy into three classes. All require an opinion of the overall direction of the market and a determination of the trend. In addition, I also use a covered call strategy that relies on option volatility rather than trend.

In my trading I use the concepts of phase and trend: Bull phase, bear phase and neutral phase. I don't think of stocks themselves as being inherently bullish or bearish. They are constantly changing, and today's bull stock can be tomorrow's bear stock with a single rumor or news release.

Moreover, phases contain phases within them. The six-month price rise contains lots of shorter-term declines. The current phase depends upon how closely the trader is looking.

A phase and a trend are two different beasts.

A phase is derived from technical signals on the chart -- it is an artificial contruct, an overlay, that imposes an arbitrary structure on prices. Under my system, bull phase means the price is trading above the 20-day price channel, and bear phase means the price is below the channel.

A trend, by contrast, is purely a matter of a price and its position relative to other prices. In the trend, only the price exists. There is none other.

A series of higher highs and higher lows is a rising trend, or a bull trend. A series of lower highs and lower lows is a falling trend, or a bear trend.

It is not only possible, but common to have a bear trend within a bull phase, or a bull trend within a bear phase.

Wheels within wheels.

How are phases and trends used in practical trading? They represent different degrees of persuasiveness. A phase shouts, “Hey! I’m real! Take this trade!”. A trend whispers, “You might want to check this out. There may well be something to it.”

Charts

My initial analysis is done on six-month charts showing one candlestick or price bar per day, with further analysis done on intraday charts: half-hour for stocks and exchange-traded funds, and one hour for currencies.

The daily chart is overlaid with the 20-day Donchian price channel and is used along with two indicators: The 10-day average true range (ATR) and 10-day average directional index (ADX). Both were invented by J. Welles Wilder Jr., a prolific developer of ways to analyze stock prices. He well deserves to be called the Thomas Edison of technical trading.

The intraday charts have no overlays or subsidiary indicators.

The average true range provides the average daily movement of a stock for the past 14 trading days. It is an extremely useful gauge of volatility.

The average directional index measures the strength of a stock’s trendiness -- the higher the ADX, the stronger the trend.

(Note that the price-channel period under my prior trading rules was 55 days, and the ATR and ADX periods were 14 days. I’ve reduced them to capture shorter-term moves -- for higher velocity trading.)

Market Direction

There is no single way of forming an opinion of the broad direction of the market. One method is to use a simple 200-day/50-day moving average cross-over applied to SPY, the exchange-traded fund that tracks the S&P 500.

If the 50-day average is above the 200, then I am bullish the market; if below, then bearish.

Or, for a more short-term view, a 50/20 cross or 40/10 cross can be used.

Another method is to look at a month or week chart -- each bar represents one month or one week -- and determine if it is making higher highs and higher lows, or lower highs and lower lows. The former is bullish; the latter is bearish.

I set great store by Elliott Wave analysis, as practiced by Robert Prechter at Elliott Wave International. His opinion of the market direction at the Minor Wave level influences my thinking greatly. See his book, Elliott Wave Principle, for a detailed explanation of his methods.

An opinion should not be formed by reading the daily market reports by The Associated Press, Reuters, Bloomberg, or any other news organizations that begins stories with premises such as “The market fell on fear that Greece will default on its debt” or some such. The markets move on a complex set of decisions that are unknowable in their totality, and even in their broad outlines.

My rule, then, is to rely on technical signals, not news reports.

The Trend

An uptrend is a series of higher highs and higher lows. A downtrend is a series of lower highers and lower lows. If the price pattern meets neither of those criteria, then the price is either in a sideways trend or a state of unknowable confusion.

It is the nature of price movements that they contain trends within trends. However, by looking at a chart, it is relatively easy to pick out the major reversal points. So rather than trying to define strict rules governing what constitutes a significant reversal, I adhere to the Supreme Court’s principle, first applied to pornography: I know a significant price reversal when I see it.

I find it useful to mark the trend on the chart by drawing a line, connect the lows for an uptrend, or the highs for a downtrend.

Trading Rules

Class A Trades: Price Channel Breakouts

Entry into a position is signaled when the price breaks beyond the boundaries of the 20-day Donchian price channel.

Single options, option vertical spreads and stock shares are suitable vehicles for the strategy.

In the best case, a Class A position will be opened on the day the price breaks beyond the channel. However, if the price is trending upward after already breaking beyond the channel, then the entry day’s channel level is used as the breakout level.

Class B Trades: Congestion Breakout

This class of strategy is used to capture the breakout of a price from a sideways trend, which traders often refer to as congestion.

Single options, option vertical spreads and stock shares are suitable vehicles for the strategy.

Determine the boundaries of the sideways channel by drawing horizontal lines through the highs and the lows. The breakout levels are at an offset beyond those lines. One way of determining the offset is to determine the width of the channel by subtracting the lowest low from the highest high, and then applying a percentage, such as 23.6. The formula: (High - Low)/0.236.

Class A and B Rules

I always like to know how I’m going to get out before I get into a risky position. The first rule of life: Know Your Exits.

Exits:

Determine a stop/loss interval as a multiple of the average true range. I generally use the range itself for stocks and one-half the range for currencies. However, I will at times use smaller intervals to produce tighter stops.

Apply that interval to furthest point beyond the breakout level for the initial stop/loss, and trail the price as it moves further of the price channel, maintaining that interval.

Entries:

Determine a breakout level, as discussed below in separate sections for each class.

If yes, then can the position be opened at a stock price beyond the breakout level?

If yes, then is the trend in the direction of the breakout on both the primary (mainly daily) and intraday (hourly for stock, half-hourly for currencies)?

If yes, then open the position..

Class C Trades: Sidewinders

This class of strategy is used to capture profits from an ongoing sideways trend.

Iron condors, which earn a profit if a stock price remains within a range, are a suitable vehicle for this strategy. Single options, option vertical spreads and stock shares can be used to capture individual legs of the fluctuations within sideways range, treating them as alternating bull trends and bear trends.

Exits:

The stop/loss is set at an offset beyond the boundaries. One way of determining the offset is to determine the width of the channel by subtracting the lowest low from the highest high, and then applying a percentage, such as 23.6. The formula: (High - Low)/0.236.

Entries:

Is the price about midway between the boundaries of the range?

If yes, then open the position.

Choices

In trading, opportunities always outnumber available dollars. So, how to choose?

I give a lot of weight to realities on the chart (rather than stories on the message boards, machinations of analysts, Cramer's enthusiasms or other noise that pervades the agora).

1) I give preference to trades that are new breakouts. That means I'll have a chance to ride more of the trend than would otherwise be the case. Also, the longer a trend continues, the more money that is drawn to it and the less money there is on the sidelines to provide further fuel for the trend.

2) From among the new breakouts, I tend to throw out any that will be announcing earnings within the next 30 days. Earnings plays can be interesting, but they are essentially unknowable prior to the event. If I can’t estimate the odds, then I’m not interested.

3) I tend to favor higher volumes over lower (greater liquidity), higher volatility over lower (greater opportunity), and a higher average directional index reading over lower (greater momentum).

4) I don't give a lot of weight to a company's financials and other fundamentals, since generally I don't stay in these positions long enough for them to matter much. I do like to avoid real stinkers, such as companies with really high debt levels as compared to equity, or with negative return on equity.

I don't mechanically take every trade as its offered. Some are too expensive -- the minimum unit (a share or an options contract) exposes me to outsized risks. In some, the price broke out of the price channel, but without a lot of conviction. Sometimes, I'm suspicious of recent news.

When decision time comes, ultimately, I look at the chart and trust my instincts. Sometimes a chart just looks right. Sometimes it doesn't. I've been studying charts for 30 years, and I've found the queasy feeling in my stomach can be a pretty good market analyst.

Trade Sizing

Nothing is more important to the trader than trade sizing: Risking the proper amount of money on each position. Too little, and your profits get eaten by commissions. Too much, and if the trade heads south, you’re left with too few resources to trade another day.

I calculate my trade sizes as "units". A unit is 1% of the total funds I have available for trading, both committed to positions and uncommitted.

I then adjust that unit for the historical volatility of the position by dividing it by the 10-day average true range (ATR).

Sometimes, the adjustment can give outsize results. So for price-channel trades, in no case will a unit be more than 2% of total funds. This is the "double unit rule". (If low volatility triggers this rule, I often reconsider the trade. Volatility is the mother of profit.)

For example, assume a trader has $100,000 in his or her account and wants to open a position in SPY.

The base unit size is 100,000/100, or $1,000.

The ATR on SPY is 1.3048. So, 1,000/1.3048 = $766, and that’s how much the trader can risk on the trade.

Assume a trade, instead, on a less volatile issue, such KEY.

The ATR is 0.1986, and 1,000/0.1986 = $5,035.

However, under the double-unit rule, no position can exceed $2,000, and so the trader can buy $2,000 worth of KEY.

It is almost impossible, of course, to hit the size precisely in actual trading, but I come as close as possible, rounding down.

But what does risk mean?

If I enter a trade for $1,000 and place a stop/loss 2% below the entry point, do I have $20 at risk ($1,000 x 0.02), or do I have $1,000 at risk (the whole amount)?

I calculate that risk by the amount of money I would lose if the position disappears entirely. I was in the market during the 1987 crash. I know what can happen in a day.

But, there’s a case to be made for the stop/loss method of calculating risk. I mean, 1987 was more than 20 years ago, and nothing like it has happened since (if you ignore the so-called Flash Crash, which had no lasting impact).

Does a trader live in constant fear of such a rare event? That’s like refusing to take a luxury cruise because of vivid memories of the Titanic.

The whole position method of calculating risk allow for greater diversification, and therefore greater security. But by accepting a greater limit on risk, the trader inevitably gives up greater opportunities for profit. Risk and gain are proportional to one another.

The stop/loss method of calculating risk provides economies of scale for trades in stocks and options (although not in forex). It also allows the trader to carry fewer positions on the book in order to be fully invested. This has the benefit of reducing the span of control, something that’s always problem when a trader has many positions.

If I were to adopt the stop/loss method -- and I may down the line -- I would protect myself by limiting market exposure in all positions to a fraction of my total trading funds, say one-third or one-half.

One final note: Although I limit my risk on option positions to 1%, I use a 4% limit for the stocks that underly my covered calls. Since the trading fees for shares are constant no matter how few or many shares are involved, the rule is: The more the shares the cheaper the fees.

Resources

Here is my reading list for new private traders. Some of these are a bit old, but they still have value.

Short-Term Trading in the New Stock Market", by Toni Turner. Good for perspective on trading the way I do it -- open a position, close it and don't hang around for sad farewells. Some nice introductory material on technical analysis, as well.

When you feel more comfortable getting deeper into technical analysis, this book is a good survey of the many methods used: Technical Analysis Explained, by Martin Pring.

All the basics of stock options, and more: Options as a Strategic Investment, by Lawrence G. McMillan. It's a huge door-stopper, but what a pool of great information. The discussion of in-the-money covered calls in Chapter 2 was a real eye opener for me.

For day-to-day reference, to keep you focused on the difference between an iron condor and a bull put spread, The Bible of Option Strategies: The Definitive Guide to Practical Trading Strategies, by Guy Cohen.

Novice strategies: Show Me the Money: Covered Calls & Naked Puts for a Monthly Cash Income, by Ronald Groenke, covers techniques that are generally considered to be suitable for options novices. They can be most profitable of techniques.

And for a deep look at options, their nature and underlying math theory, Option Volatility and Pricing: Advanced Strategies and Techniques, by Sheldon Natenberg.

Also, covering similar ground from a different point of view, The Volatility Edge in Options Trading: New Technical Strategies for Investing in Unstable Markets, by Jeff Augen.

Fundamental analysis as practiced by Warren Buffett: Buffetology, by Mary Buffett. My style of trading differs wildly from his buy-and-hold (actually, his buy-and-own, since he often takes a seat on the Board of Directors), but he has a useful perspective on what it is that underlies the symbols that we trade.

Basically, the Buffetts and other fundamentalists provide the sea in which private traders swim. Read it critically. Think about what's to like and not like about Buffet's approach.

(There are many, many books about Buffett’s strategy. This one isn’t necessarily the pick of the crop. My advice: Buy one Buffett book and read it. Then formulate your own strategy.)

The Chicago Board of Options Exchange has a huge amount of knowledge and free online courses regarding options.

The education company InvesTools has excellent programs (although they are expensive) and the broker ThinkOrSwim has awesome discussions on Wednesday and Friday after market close.

Trader's Mind

More than any of the other tools, a private trader must develop the right mind. It's a way of thinking that says

  • Details matter
  • Results measure success
  • Failures are education
  • To win is to act

The last item is a bit obscure. It means that if you quit trading after the shock of a failure, then you'll never have another success. You've got to be acting -- trading -- in order to win.

The true private trader takes counsel from Conan the Barbarian (or was it Friedrich Nietzsche?): “That which does not wipe out our trading capital us makes us stronger.”

Or as my poker-playing ancestors in Oklahoma used to say, "You cain't win if you ain't playin'".

That's my take on how to become a private trader. No one gets there in a single step. But it's well worth the journey.

Posting Schedule

Generally, I start posting each day after the New York currency markets open, at 8 a.m. Eastern.

Forex: I scan the currency, generally the 54 pairs that have 20% margin under U.S. government regulations. I discuss any positions I see that are candidates for one of my three trade classes.

Indicators: These are exchange-traded funds that help give me an overall impression of where the markets are going. These include stock index funds, bond funds, commodity funds and global currency and emerging markets funds.

Watches: Midway through the trading day, I scan the charts of liquid stocks and exchange-traded funds. If I find any that meet my criteria for trading, then I’ll do a separate write-up, with the headline consisting of the ticker symbol followed by the word “Watch” (as in NFLX Watch for Netflix).

The day ends with the Almanac, almost always posted within 15 minutes of the market close at 4 p.m. Eastern.

Housekeeping

All content on Tim Bovee, Private Trader is copyright 2009-2011 by Timothy K. Bovee. All rights reserved.

Quotations of up to 200 words each are allowed. No need for permission, but please let me know what you've used. See the next paragraph for how to get in touch.

Please send all correspondence, including requests for permission to republish content, to the email address or mailing address that appears in the Contact section on the left sidebar.

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