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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Profitable markets are those markets that provide opportunity for making good returns on investmentsOptions on Indexes and Exchange-Traded Funds An index option is an option that represents a specific indexa group of items that collectively make up the index. We have already discussed the index markets and exchange-traded funds. Options on indexes and ETFs fluctuate with market conditions. Broad-based indexes cover a wide range of industries and companies. Narrow-based indexes cover stocks in one industry or economic sector. Index options allow investors to trade in a specific industry group or market without having to buy all the stocks individually. The index is calculated as the average change of the stock price of each stock in the index. Each index has a specific mathematical calculation to determine the price change, up or down. An index or ETF option is an option that is tied directly to the change in the value of the index or exchange-traded fund. Index options make up a very large segment of the options that are traded. Why are so many options traded on indexes? The explosive growth in index trading has occurred in recent years due to the increase in both the number of indexes and the number of traders who have become familiar with index trading. The philosophy of an index is that a group of stocksa portfoliowill diversify the risk of owning just one stock. Hence, an index of stocks will better replicate what is happening in an industry or the market as a whole. This allows an investor or trader to participate in the movement of a specific industry, both to the upside and to the downside. It appears that index and ETF options will continue to proliferate and trading volume will increase in many of the instruments. A word of caution: A number of these instruments do not have much liquidity. However, used wisely, index options can be an important instrument in your trading arsenal. Also, it is important to understand the difference between the way ETF options and index options settle. Namely, exchange-traded funds, which can be bought and sold like stocks, settle for shares. Cash indexes cannot be bought or sold. They settle for cash. Liquidity Liquidity is the ease with which a financial instrument can be traded. It can be defined as the volume of trading activity that enables a trader to buy or sell a security or derivative and receive fair value for it. A high volume of people trading a market is needed to make it rewarding. Liquidity provides the opportunity to move in and out of positions without difficulty. For example, at-the-money options often have excellent liquidity because they have a better chance of being profitable than out-of-the-money options. Therefore, they are easier to trade and many traders focus solely on the at-the-money contract. When I first started trading, I visited the exchanges. A friend who was a floor trader walked me from one pit to another. In one pit, there were two guys sitting around reading the newspaper. Was there a lot of opportunity there? I didnt think so. I figured when an order hits that pit, everyone probably starts laughing at the poor sucker who placed it. Then I checked out the bond pit. There were 500 people fighting for an order. I quickly recognized that the bond market had high liquidity and plenty of opportunity. I went to the natural gas pit at the New York Mercantile Exchange. It was a madhouse. There were 200 people in a pit 10 feet wide (prior to moving to their new state-of-the-art building), yelling and screaming. I couldnt understand a thing they were saying, but once again I recognized high liquidity. To this day, I look for pits where there are plenty of people playing the game because plenty of players equals opportunity. How can you avoid illiquid markets? Well, since you probably dont have the ability to actually visit an exchange, you can still check out the liquidity of a market by reviewing the markets volume to see how many shares or contracts have been traded. Both The Wall Street Journal and Investors Business Daily report volume changes. It is vital for a trader to ascertain whether trading volume is high or low, increasing or decreasing. Its hard to quantify just how much volume is enough to qualify a market as one with liquidity. However, as a rule of thumb, I prefer to look for stocks that are trading at least 300,000 shares every day. Futures markets vary widely, and it is best to monitor activity daily and pick a market that trades many more contracts than you trade. Since there are no absolutes, there are situations when this rule can be tossed out the window in exchange for common sense. But until you have enough experience, this may be a good rule of thumb to follow. Bottom line, a plentiful number of buyers and sellers and an elevated volume of trading activity provide high liquidity, which gives traders the opportunity to move in and out of a market with ease. Illiquid markets can make the process much more difficult and more costly. Volatility Profitable markets are those markets that provide opportunity for making good returns on investments. Obviously, some markets are more traderfriendly than others. Opportunity in a market is contingent on a number of factors. Volatility is one of the most important and misunderstood of these factors. It measures the amount by which an underlying asset is expected to fluctuate in a given period of time. In more simple terms, volatility can be thought of as the speed of the change in the market. There are two basic kinds of volatility: implied and historical. Historical volatility, often referred to as actual or statistical volatility, is computed using past stock prices. It can be calculated by using the standard deviation of a stocks price changes from close-to-close of trading going back a given number of days (10, 20, 90, etc.). High or low historical volatility also gives traders a clue as to the type of strategy that can best be implemented to optimize profits in a specific market. That is, strategies that work well in volatile markets will not generate big profits in a lowvolatility environment. A variety of indicators, such as Bollinger bands, can be used to create historical volatility computations that are graphed on a chart. Implied volatility (IV) is another type of volatility. It is calculated by using the actual market price of an option and an option pricing model (Black-Scholes for stocks and indexes; Black for futures). If the premium of an option increases without a corresponding change in the price of the underlying asset, the options implied volatility will have increased also. Overpricing and undervaluing an options premium can be caused by an inaccurate perception of the future movement in the price of an asset. For example, if implied volatility rises significantly for no reason (and there is no increase in historical volatility), the option may be overpriced. Traders can take advantage of changes in implied volatility by applying specific option strategies. Note: Since volatility is such a complex issue, my partner, Tom Gentile, and I wrote an entire book on the subject entitled The Volatility Course (John Wiley & Sons, 2002). If you are going to trade options, you owe it to yourself to develop a strong understanding of volatility. Options-Trading Discipline Proper money management and patience in options trading are the cornerstones to success. The key to this winning combination is discipline. Now, discipline is not something that we apply only during the hours of trading, opening it up like bottled water at the opening bell and storing it away at the closing. Discipline is a way of life, a method of thinking. It is, most of all, an approach. If you have a consistent and methodical system, discipline leads to profits in trading. On the one hand, it means taking a quick, predefined loss because it is often better to exit a losing position rather than letting the losses pile up. On the other hand, discipline is holding your options position if you are winning, and not adjusting an options position when it is working in your favor. It also entails doing a significant amount of preparatory work before market hours. This includes getting ready and situated before initiating a trade so that, in a focused state, you can monitor market events as they unfold. Discipline can sometimes have a negative sound, but the way to freedom and prosperity is an organized, focused, and responsive process of trading. With that, and an arsenal of low-risk/high-profit options strategies, profits can indeed flow profusely. The consistent disciplined application of these strategies is essential to our success as professional traders. Plan your trade and trade your plan. Finally, as option traders, in order to improve in the discipline arena we must identify and either change or rid ourselves of anything in our mental environment that doesnt contribute to the strictest execution of our well-planned trading approach. We have to stay focused on what we need to learn and do the work that is necessary. Your belief in what is possible will continue to evolve as a function of your propensity to adapt. CONCLUSION Almost every successful trader I know has an area of expertise. For some, it is trading futures. Others like trading commodities. Some traders specialize in trading the Nasdaq 100 QQQs. My experience is mostly related to stock options. Initially, traders tend to explore a large number of different vehicles and then narrow down their focus to a specific instrument and a small number of winning strategies. Hopefully, this chapter has provided you with a better idea of what financial instruments are available for trading today and how they differ from one another. We discussed a number of different underlying assets including stocks, futures, exchange-traded funds, indexes, and options. All can be used in creating and implementing options trading strategies. At this point, the readers should also understand that a futures contract is significantly different from an options contract. While both represent agreements between two parties, the contracts are structured in ways that are considerably different from one another. From here, we focus more on options and, in later chapters, discuss specific trading strategies that work in a variety of different market scenarios. |
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