The Perfect System, Part VI

In this instalment, I would like to address questions from my young friend Oskar Syahbana who wrote:

[…] I spent 2 years on equity market (exclusively stocks) and made my (rather small) fortune using fundamental analysis. Lately I'm very interested on using options as my investment instruments and stumbled upon quite a problem. Usually on FA, I'm holding the stocks for months if not years (the shortest being 5 months) but that can't be practised in Options (because the premium is very expensive) so I'm looking into Techincal analysis for shorter holding periods.

I'm usually trading using triple crossed MA, Full stochastic, MACD, and RSI for my indicators and facing a lot of whipsaw. Do you mind on sharing your ideas on what indicator should I use?

Second and probably the last question on my first email is, do we need to master technical analysis on trading options? Couldn't we just apply options strategy (butterfly, strangle, simple straddle, or more advanced technique) without knowing the direction of the underlying securities?

Thank you very much ;-)

Oskar Syahbana

If I was a young person with a nice job and disposable income but not much time to dedicate to trading or options, I would simply put my savings into index shares (such as the SPX) and contribute monthly, preferable within a 401K or IRA and not worry about the ups and downs of the markets, even if the DOW goes down to 5000, as some Elliott wave analysts insist will happen. Eventually, the market will recover and more than make up for the losses within the next 30 years. Buying routinely serves as a dollar cost averaging approach that will serve a young person well.

To perform well in the markets means that you exceed the SPX performance, which is not easy to do, since most mutual funds fail to meet or exceed that standard. Presumably one goes into the “game” to perform better than the SPX, most investors do not meet that standard. I went into it because I like control, because I love learning, and because I have a unrelenting desire to succeed, to exceed expectations and I cannot help myself but persevere in the face of failure. If you feel that way, you have what it takes, and success will come to you “unexpected in common hours” as Earl Nightingale would say.

In the early 90’s I read Peter Lynch’s book “Beating the Street” and learned about Fundamental Analysis, and used to laugh when John Murphy would come up on CNBC and discuss technical analysis. How could you predict stock movements based on a bunch of charts? Ridiculous I thought! In does days I was invested in Microsoft, Staples, Amgen and a bunch of companies with solid performance. I just did not understand why a stock would go down after stellar profits and was frustrated to see that no stock would go up in a straight line. This is when I begun to take Technical Analysis seriously. Today, I have come to believe that all form of analysis simply increase your chances of success, but will not protect you against unexpected news, such as the drop that AAPL suffered in Sept 2000 when the stock went from $62 to $24 in only a few days. The Fundamentals in a company can be ruined overnight. What is worse, there is no amount of Technical Analysis that would prepare you for such an event. After 9/11/2001, only a year later, many stocks fell strongly, but most bounced back rather strongly until corruption scandals broke out in 2002.

So go ahead, learn all the Technical Analysis and Fundamental Analysis that you like, they are all good to trigger you into buying a stock, but understand that only by taking profits on a timely fashion will you be able to retain your profits. Otherwise, the buy and hold of index shares for years will serve your purpose, even if another 9/11 shows up. If you hold a stock for 5 years (as I did my AAPL shares), you’d probably be totally unable to make the decision to exit part of your position at the very top. If you have seen the “deal no deal” TV show, you’ll realize that it is in human nature not to abandon a potential gain, no matter how slim the probability of success (or further success in this case).

Options are extremely difficult to trade because it assumes a knowledge most people don’t have. Yes, it is very unlikely that Fundamental Analysis will guide you appropriately through the daily moves in stock price. Despite the enormous leverage of options, It is extremely difficult to accurately predict where would a stock be in 3 months. Most structured position trading (such as spreads, butterflies and the like) require that you stay in a trade for up to 3 months. If you could buy leaps for up to 5 years and the stock move strongly up in the first 3 months will not register much of a profit, because you pay so much for the time premium in the option. So whether you forecast the movement of a stock in the next few months to years using Fundamental Analysis or Elliott wave analysis, and even if you are proven right, your returns may be meager indeed, simply because of the cost of the time value. Spreading options is a good approach in those situations, but you will not benefit from early movement in the stock. You may do well using this approach, but only if you can disconnect yourself from the daily fluctuations in the price of the stock, and if you are prepared to lose all of the capital in your options, if the stock goes in the exact opposite direction.

In the last 12 months or so, I have learned the PCCRC approach and implement it successfully. I have learned what to look for to avoid loosing trades, and feel now comfortable placing all of my trading capital in this form of trading, but that confidence has not come overnight. I have been trading options since 1995, and only since September 2002 have I been seriously studying and learning all that I could read about options. I tried a variety of trading styles searching for the holly grail of trading: Reproducibly profiting month after month, regardless of market conditions. If you could see my old posts in the Optionetics boards, you will see my frustration and believe that such a holly grail did not exist. Yet, I had no alternative but to keep going. Fundamental analysis can be certainly an approach to trading PCCRC, but you have to understand the basics about greeks and implied volatility. In the preceding articles in this series, I have discussed these item. What underlying stocks and triggers you use to trade is up to you, but I would suggest that stocks such as RIMM, AAPL and GOOG that jump strongly after earnings are prime candidates for this strategy. Their earnings were certainly stellar and we can envision these stocks performing well in the next few months into the next reporting season. The decline in volatility after earnings works in our favor, as the long straddle portion of our trade is relatively cheap at this time. Next, I will enter PCCRC’s on AAPL, GOOG and RIMM in my training version of IB, for demonstration purposes. I already had positions in these stocks, so I won’t enter new real trades on these stocks. Please do NOT trade the same trades with your own money, these trades are for demonstration only, intended to give you a learning opportunity. I hope you enjoy the experience.