July 2008 Letters To The Editor
The editors of S&C invite readers to submit their opinions and information on subjects relating to technical analysis and this magazine. This column is our means of communication with our readers. Is there something you would like to know more (or less) about? Tell us about it. Without a source of new ideas and subjects coming from our readers, this magazine would not exist.
Address your correspondence to: Editor, STOCKS & COMMODITIES, 4757 California Ave. SW, Seattle, WA 98116-4499, or E-mail to editor@traders.com. All letters become the property of Technical Analysis, Inc. Letter-writers must include their full name and address for verification. Letters may be edited for length or clarity. The opinions expressed in this column do not necessarily represent those of the magazine. -Editor
OPTIONS: THE MISSING LINK
Editor,
In the May 2008 STOCKS & COMMODITIES article "Options: The Missing Link," author Martha Stokes makes some good points about the dangers of option trading and the necessity of understanding the basics of stock trading. But the article also contains some statements that are likely to confuse people who are not well-versed in option strategies.
For example, in the last paragraph of the section "Smaller capital base = more risks," Stokes states, "If the stock moves up then the sell option expires worthless, but the buy option makes money and vice versa." However, in a straddle, the trader is either a) buying a call and buying a put, or b) selling a call and selling a put. There is no such thing as a "buy option" and "sell option" within the same straddle. You're either buying both options or selling both options.
If what the author really means is that a long call is the equivalent of buying stock and a long put is the equivalent of selling stock (this is apparently what she's getting at), she needs to state the issue differently, so as not to confuse people who may not have a firm foundation in options.
Another example is at the bottom of page 18 in the last paragraph before the "Implied volatility" section. The author states: "...they would only use straddles in the impending direction with which the stock agrees...." Straddles, by their nature, are nondirectional strategies, so it is impossible to use a straddle in an "impending direction." If you're buying a straddle (buy call and buy put), you're betting that the underlying stock is going to make a big move within a certain amount of time, but you have no opinion on the direction of that move. If you're selling a straddle (sell call and sell put) you're betting that the underlying will continue to move sideways within a range over a certain period.
Again, the way this is stated in the article is only going to confuse people who are trying to come to grips with a more secure understanding of options.
David H. James, CFA
Martha Stokes replies:
I agree with you that the passages you mention from my May 2008 article were confusing and need clarification. I attempted to keep this article within a limited number of words and tried to avoid a lengthy discussion of option strategies detail, since the subject matter was about technical analysis for options. I apologize if this caused a lack of explanation. Let me clarify.
Since options can be confusing for novices (that is, those with less than three years of experience), I teach my students to use the following terms:
Long a call or long a put: You open a position by either buying a call or buying a put. By using a call, you are intending to go long in the stock, since your analysis of the stock chart indicates that the stock is going to move up in price. By using a put, you are intending to go short in a stock, since your analysis of the stock chart indicates the stock is going to move down. You should always think in terms of what the ultimate outcome could be, which is that the option could be exercised and you would take a long or short position in the stock, depending on which option you held.
Option writer (selling a call or put): You open a position by either selling a call or selling a put. Another way to look at option writing is that you are acting as a broker for the stock. Sometimes thinking about it in this way makes it easier for novices. So you are obligated to either sell stock if the short call option is exercised or buy stock if the short put option is exercised. Always think of the ultimate outcome that could occur if you are assigned. That way, you are aware of what position you are trading the underlying stock.
Spreads: You are either long, or a writer, or doing both at the same time for some option strategies, such as spreads. There are numerous variations on spreads, so I will name a few:
Bull/bear call spread: You are both a buyer and a writer. You
are buying a call and you are writing a call.
Bull/bear put spread: You buy a put and write a put. So you
are both a buyer and a writer.
Collar: You buy a protective put and you write a covered call.
Strangle: Buying a call and a put or writing a call and a put
with an out-of-the-money strike price.
Straddle: Buying a call and buying a put or writing a call and
writing a put for the same strike price.
Calendar: Buying an option and then writing an option in a different
expiration month.
There are numerous other option strategies that also involve both holding and writing at the same time in three to four different open positions.
It was my intention in the article to explain that when a stock is moving sideways, which occurs 40-50% of the time in the markets these days, using a straddle in which you are buying a call and buying a put is not an ideal strategy to use. This is because it places you in both a long and a short at the same time. (In the article, I was referring only to being long a straddle, not writing one.)
This strategy appeals to novices because they believe they can't lose. They are hoping that the stock will either move up significantly or move down significantly (meaning many points), and the gain from whichever premium increases in relation to the stock price action will be sufficient to make a good profit. The theory behind this option strategy is that the trader "has no opinion" about the direction the stock will take, but believes it will move many points up or down.
First, not having an opinion when you are trading is not a good idea. One should always know the market condition and have sufficiently analyzed the stock or other trading instrument to be able to make a decisive, confident decision. Second, from where does an option trader derive the opinion that the stock will move many points when it breaks out of the sideways pattern? How does the trader determine how many points it will move if he or she has no opinion about the direction it will take? What levels of resistance or support is the trader using to calculate the impending moves both up and down? The truth is that most novices don't even think about any of these aspects of technical analysis before entering a straddle.
I have taught thousands of students for over a decade and I know that a lack of opinion is not really what occurs with novices. What actually causes novices to use a buy call/buy put straddle is that they don't know what the stock is going to do and they are hoping it will do something. This ultimately leads to losses.
My point in writing the article was the following: If you are able to read stock charts with skill, you would seldom, if ever, use a straddle. This is because you would not be "without an opinion" of what the stock would do. You would know the point potential, the potential for velocity behind the move, the duration of the move, and so on. Most novice traders who use long call/put straddles simply lack the education and the confidence that comes from being properly trained.
A well-trained technical analyst will have a good idea which way the stock will go as it breaks out of a sideways or consolidation price pattern. Studying such things as the angle of ascent; price compression patterns; volume surge and spike patterns; and accumulation or distribution patterns that occur during sideways and consolidation patterns all assist in this analysis and provide reliable information about the direction the stock will likely take. With that information, using a straddle is no longer the best choice for an option trade. Here's why: When you use a straddle, you will always have one position that ends up being worthless. But you can also end up with both contracts being worthless.
In theory, straddles sound wonderful. There is the appeal of the lower risk, since at least one side will make you money. But the statistics for option traders show otherwise: 90% of all option traders lose money on a regular basis.
That's not a good statistic to have. Retail traders are an important part of any financial market, so if they consistently lose money, it eventually causes problems for that market. If more option traders learned technical analysis, the option markets would be stronger, because when more option traders are successful, more traders will want to trade options.
That was really the point of my May 2008 article. Thank you for writing and commenting. I hope I have clarified any statements that readers could have found confusing.
TEMA HEIKIN ASHI CODE FOR THINKORSWIM?
Editor,
I am interested in getting code for the moving average crossover discussed in the May 2008 S&C ("The Quest For Reliable Crossovers" by Sylvain Vervoort) for the thinkorswim platform. Please advise.
Jibin Thomas
Try contacting the company's technical support for code. Unfortunately, we are not able to provide techniques for all the various platforms.--Editor
THE QUEST OF RELIABLE CROSSOVERS
Editor,
I look forward to reading your magazine each month. I found the article "The Quest For Reliable Crossovers" in the May 2008 issue of STOCKS & COMMODITIES to be very interesting.
However, I was disappointed to find I was not able to run the strategy for reliable crossovers using the code provided in the Traders' Tips section for Wealth-Lab Pro version 5.0. I copied and pasted the code directly from your website into Wealth-Lab Pro 5.0. The program generated several errors and, after communicating with the programmers at Wealth-Lab.com about the script, I found out that the TEMA indicator is not available in version 5.0 of Fidelity's Wealth-Lab.
I would like to have a version of the strategy that works with Wealth-Lab Pro 5.0 or 4.5.35. Would this be possible?
Cheryl Semff
Thank you for writing. In our monthly Traders' Tips feature, the code is provided by the software developers themselves, not by us, and unfortunately, we do not have the resources to perform individual programming tasks. In the case of the May 2008 Traders' Tips column, in the Wealth-Lab contribution, the version used appears to be Wealth-Lab Pro 5.1, judging by the screen capture in Figure 5 on page 71.
I would recommend that you communicate with other Wealth-Lab users via their forums to see if others experienced similar problems.--Editor
ERRATA: JUNE 2008 TRADERS' TIPS
The captions that appeared beneath the Aspen Graphics figures in the
June 2008 Traders' Tips section were incorrect. The correct captions are
as follows:
FIGURE 12: ASPEN GRAPHICS, ETF TIMING MODEL. Here is the Gardner timing model overlaid on a candlestick chart of IGM. It displays the bars on which to enter and exit a position, as well as the price points for setting the limits.
FIGURE 13: ASPEN GRAPHICS, ETF TIMING MODEL. Here is another way of looking at the same time period for IGM. An Aspen color rule is used to indicate which bars offer good entry and exit points according to the timing model.
We regret this error.--Editor