Trading

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Trading Investing in Stocks Options
Michael J. Radzicki, Ph.D. mjradz_at_wpi.edu http/
/www.michaeljosephradzicki.com/

• Department of Social Science Policy Studies
• Worcester Polytechnic Institute

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Outline Of My Talk

• Hierarchy of Stock Options Price Movement
• Some Basic Macroeconomics
• Inter-Market Analysis
• Sector Rotation
• Market Breadth
• Trading Investing
• Options

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Hierarchy of Stock Options Price Movement

• Economy
• Actions of central bank(s)
• Fiscal policy
• Markets
• Currency Markets
• Commodity Markets
• Bond Market
• Stock Market
• Sectors
• Industry Groups
• Individual Stock Prices
• Individual Stock Option Prices

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Some Basic Macroeconomics

• Gurus John Maynard Keynes, Hyman Minsky, Abba
  Lerner, Warren Mosler L. Randall Wray

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Some Basic Macroeconomics

• Capitalist economies have a trend a cycle(s)

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Some Basic Macroeconomics

• Trend due to self-reinforcing processes
• Supply Side
• Population Growth
• Technological Innovation Ideas
• Capital Accumulation
• Demand Side
• Fiscal Policy

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Some Basic Macroeconomics

• Cycle (primarily) due to
• Consumption Spending
• Since 1980, due to consumer credit
• Investment and the dynamics of its financing
• Which includes speculation (a self-reinforcing
  process)
• Countercyclical Government Spending

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Some Basic Macroeconomics

• Inflation/deflation and involuntary unemployment
  are the traditional evils that policymakers try
  to combat
• Other evils exist too
• Capitalist economies are often demand
  constrained
• Which results in unused production capacity
• In both the long and short runs

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Some Basic Macroeconomics

• Minskys Theory of the Cycle
• Investment spending its financing is the key
• Hedge Firms/Sectors
• Speculative Firms/Sectors
• Ponzi Firms/Sectors

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Some Basic Macroeconomics

• Central banks in capitalist economies are said to
  (implicitly) follow a Taylor Rule
• It Inft rt a(Inft- Inft) b(yt yt)
• It Target Federal Funds Rate
• Inft Rate of inflation (measured by GDP
  deflator)
• Inft Desired rate of inflation
• rt Real interest rate consistent with full
  employment (usually thought to be 2)
• yt Real GDP
• yt Potential real GDP

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Some Basic Macroeconomics
U.S. Economy Private Sector Balance Govt
Budget Current Account
Fed Funds Target Rate Bond Purchases Sales
Taylor Rule, Current Account Exchange Rates
Federal Reserve System Open Market Committee
Economy of the Rest of the World
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Some Basic Macroeconomics

• During the expansion phase of the cycle (fearing
  inflation) the Fed starts to raise the Federal
  Funds rate target
• The term structure of interest rates responds
• Generally speaking, rising interest rates fear
  of inflation
• Drives bond yields up and thus bond prices down
• Slows the housing market thus household sector
  spending
• Slows the economy (and thus slows earnings
  growth) maybe
• Drives stock prices down
• Drives commodity prices up
• Can strengthen (or weaken) the dollar

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SP 500 PE Ratio Moves Opposite of the Federal
Funds Rate
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Some Basic Macroeconomics

• But fiscal policy cannot be ignored!
• Actually, the quantity of money in the economy is
  determined by fiscal policy
• Monetary policy simply consists of setting the
  federal funds rate
• Lerner-Mosler-Wray story

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Some Basic Macroeconomics

• Levy-Kalecki Profits Equation
• Gross After Tax Profits (Includes Interest, Rent
  Dividends)
• Investment Spending Consumption Out of Profits
  - Saving Out of Wages
• Govt Spending Govt Tax Revenue
• Exports - Imports

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Some Basic Macroeconomics

• Thus
• Gross After Tax Profits Investment Spending
  Consumption Out of Profits Saving Out of Wages
  -
• Govt Spending Govt Tax Revenue -
• Exports - Imports 0

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Some Basic Macroeconomics

• That is
• Saving Out of Profits Saving Out of Wages -
• Budget Deficit/Surplus -
• Trade Deficit/Surplus 0

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Some Basic Macroeconomics

• That is
• Private Sector Balance -
• Current Account Balance
• Government Sector Balance

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Some Basic Macroeconomics

• Currently
• Private Sector Balance (2 of DPI) -
• Current Account Balance (-6 of DPI)
• Government Sector Balance (4 of DPI)

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Some Basic Macroeconomics

• Other Levy-Kalecki Profits Equation Relationships
  
• The Unemployment Rate closely tracks the Private
  Sector Balance
• When the private sector goes into deficit it
  reduces the unemployment rate but also
  accumulates debt
• The Value of the Dollar closely tracks the
  Government Sector Balance
• As the budget deficit increases, the value of the
  dollar falls

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Some Basic Macroeconomics

• Thus, any private sector surplus (i.e., any
  accumulation of wealth by the private sector)
  coupled with any current account deficit must be
  offset by a government sector deficit and vice
  versa!
• So, how loud should we applaud the federal budget
  surpluses during the late 1990s?
• Government surpluses are deflationary and
  directly associated with the loss of private
  sector wealth
• Which is bad for stock prices
• Which decouples the relationship between stock
  bond prices

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Inter-Market Analysis

• Guru is John Murphy
• http//stockcharts.com/charts/performance/Intermar
  ket.html
• 2004. Intermarket Analysis Profiting from Global
  Market Relationships. Hoboken, NJ John Wiley
  Sons, Inc.
• 1991. Intermarket Technical Analysis Trading
  Strategies for the Global Stock, Bond, Commodity,
  and Currency Markets. Hoboken, NJ John Wiley
  Sons, Inc.

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Inter-Market Analysis

• Three key relationships
• U.S. Dollar Commodities gt Negative
• Commodities Bonds gt Negative
• Bonds Stocks gt Positive (Unless Deflation)
• Bond market typically leads stock market by 6-8
  months

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Inter-Market Analysis
Source StockCharts.com
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Inter-Market Analysis
Source StockCharts.com
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Inter-Market Analysis
Source StockCharts.com
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Inter-Market Analysis
Source StockCharts.com
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Inter-Market Analysis

• Main idea
• If youre going to successfully trade stocks and
  stock options, you have to pay attention to the
  bond, commodities and currency markets
• Therefore, you also have to pay attention to the
  economy, fiscal monetary policy, and to world
  events

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Sector Rotation

• Guru is Sam Stovall of Standard Poors
• http//www.businessweek.com/investor/list/stovall_
  toc01.htm
• 1996. Sector Investing. McGraw-Hill.
• 1995. Standard Poors Guide to Sector
  Investing. McGraw-Hill.
• Murphy Cramer are into it too!

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Sector Rotation
Source StockCharts.com
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Sector Rotation

• Over the macroeconomic cycle, institutions move
  money out of certain sectors and into other
  sectors
• Thus, a good investing/trading strategy is to
  follow the institutional money to the hot sectors
• http//stockcharts.com/charts/Carpet/

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Sector Rotation Relative Strength
Source StockCharts.com
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Sector Rotation Relative Strength
Source StockCharts.com
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Market Breadth

• Gurus are Greg Morris John Murphy
• Morris, Gregory L. 2006. The Complete Guide to
  Market Breadth Indicators. New York The
  McGraw-Hill Companies.

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Market Breadth

• Advance/Decline Indicators
• New High/New Low Indicators
• Up Volume/Down Volume Indicators
• McClellan Indicators
• Vix
• Technical analysis applied to the main indices

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Market Breadth

• Not every close of the SP 500 below its 200 day
  EMA signals a bear market, however every bear
  market starts with a close of the SP 500 below
  its 200 day EMA.
• If the 50 day EMA of the SP 500 crosses below
  its 200 day EMA the odds of a bear market
  increases
• Called a death cross
• Opposite is called a golden cross

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Market Breadth
50 Day EMA
200 Day EMA
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Market Breadth

• Weekly Moving Average Cross-Over System (from
  John Murphy)
• 13 Week EMA 34 Week EMA
• Works best on SP 500
• SP crossed briefly then recovered
• NASDAQ has crossed

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Market Breadth
Bear
See Next Slide
34 Week EMA
13 Week EMA
False Signal (Quickly Corrected)
Bull
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Market Breadth
Convergence But No Cross
Small Cross Recovery
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Market Breadth

• SP 500 100 Day (20 Week) 400 Day (20 Month)
  Exponential Moving Averages
• Closing below the 100 Day EMA is a minor sell
  signal (bearish)
• Closing below the 400 Day EMA is a major sell
  signal (bearish)
• 400 Day EMA is major area of support

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Market Breadth
400 Day EMA ProvidesSupport
Bullish
Minor Bearish
400 Day EMA
Major Bearish
100 Day EMA
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Market Breadth
Bullish
Bullish
Bollinger Bands -2
400 Day EMA
Bearish
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Trading Investing

• Generally speaking, its better not to trade
  against the market
• Bull market Buy stocks call options
• Bear market Sell stocks short buy put options

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Trading Vs Investing

• Select Your Style
• Scalping
• Day Trading
• Swing Trading
• Intermediate Position Trading
• Long Term Position Trading
• Investing

As you move from micro scalping to investing, you
hold your positions longer (thus tying-up your
capital longer) can earn more on each trade.
But you must also know more about why a stock is
moving Financial Economy (news, earnings,
splits, fundamentals, etc.) Real Economy (FDA
approval, new products, mergers acquisitions,
etc.).
Pattern Day Trading Rule Applies
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Trading Investing

• Three Tools Required for Trading Investing
• A method for finding stocks options to buy
  sell
• A trading platform for timing entries to, and
  exits from, trades
• A method strategy for executing trades
• Broker
• Trading Plan

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Finding Stocks Options to Trade

• Stock Shepherding
• Stock Screeners
• Business Week (Free)
• http//prosearch.businessweek.com/businessweek/gen
  eral_free_search.html?modeadvanced
• Short Term Stock Selector (Free Cost)
• http//home.flash.net/hesler/
• Neural net picks stocks to swing trade
• HotScans (Cost)
• http//www.marketgauge.com/
• Market Carpets Heat Maps

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Trading Platforms

• Technical trading is nothing more than support
  resistance!
• http//www.stockconsultant.com/
• Need a charting program to identify support
  resistance levels thus to time entries exits
• http//www.marketbrowser.com/mbzzzq2.asp (Free)
• http//www.bigcharts.com/ (Free)
• http//www.tradestation.com/ (My Personal Choice)

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Trading Platforms

• Like the economy, individual stock prices have a
  trend a cycle
• Up-Trend Higher highs higher lows
• Bullish Buy stocks Buy call options
• Down-Trend Lower highs lower lows
• Bearish Sell stocks short, Buy put options
• No Trend Price just oscillates
• Neutral Sell call options on stocks you own

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Trading Platforms

• Must identify up-trend, down-trend, or no trend
• Plotting stock price data
• Line plots
• Western bar plots
• Japanese candle sticks

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Trading Platforms

• Apply Well-Known Technical Indicators to the
  Stock Price Data
• Moving Averages Trend Lines
• Shows changes in trends
• ADX Average Directional Index
• Shows the strength of a trend
• Oscillators
• E.g., RSI Fast Slow Stochastics
• Shows over-bought over-sold conditions i.e.,
  when a stock price will reverse
• An Indicator that Utilizes Elements of Both the
  Trend the Cycle
• MACD Moving Average Convergence Divergence

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Fundamental Investing

• Growth Investing
• Guru is Cramer (among many others)
• http//www.thestreet.com/
• http//www.cramerwatch.org/
• Main Idea
• P/E Price (/Share) / Earnings (/Share)

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Fundamental Investing

• P/E Multiple M
• M E P
• Find stocks that have a lower M and a higher
  historical growth rate of E than the average firm
  in the SP 500
• PEG useful

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Fundamental Investing

• But
• M Expected Future (E) Expected Future (P)
• So, should try to predict future earnings growth
  too
• Conference calls
• Analysts
• New product introductions
• Small debt
• Better sales margins, lower costs than rivals
• Secular or cyclical stock?

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Fundamental Investing

• Value Investing
• Guru is Warren Buffet
• http//www.coattailinvestor.com/
• Main Idea Analyze a company determine its
  intrinsic value. When its share price drops below
  that value gt buy.
• Bible is Security Analysis by Graham Dodd
• Must know basic accounting

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Method Strategy for Executing Trades

• Broker
• Keys to selecting a good broker
• Cash margin accounts
• Trading Plan
• Money management
• Risk-Reward Ratios
• Order entry exit strategies
• Order types
• Setting stops

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Example

• http//scansstaging.marketgauge.com/login.asp?reas
  ondenied_emptyscript_name/Scans/OpeningRange.as
  ppath_info/Scans/OpeningRange.aspfid8969
• Paper Trading
• http//simulator.investopedia.com/

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Options

• Derivative markets are exploding!
• Options provide leverage (a small percentage move
  in the underlying asset means a large percentage
  move in the value of the corresponding option)
  a way to manage risk
• Options require a smaller outlay of capital
• Many options strategies are quite simple some
  are complex

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Options

• Some options strategies only work if the
  underlying asset moves in a particular direction
• Some options strategies only work if the
  underlying asset moves in either direction
• Some options strategies only work if the
  underlying asset doesnt move

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Options

• An option is a contract that gives the owner the
  right, but not the obligation, to buy/sell an
  underlying asset (e.g., 100 shares of stock) at
  a particular price (the strike price) by a
  particular date (the expiration date).
• Its an asset
• Two types of option contracts
• Calls Puts
• Two styles of options contracts
• American style European style

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Options

• The writer of an option has the obligation (a
  liability) to buy/sell an underlying asset (e.g.,
  100 shares of stock) at a particular price (the
  strike price) by a particular date (the
  expiration date).
• This obligation will not need to be fulfilled
  unless the strike price is passed

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Options

• A contract has two parties a buyer a seller

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Options

• Time decay
• Ice cube melting on a sidewalk
• Options Valuation
• Time value
• Intrinsic value
• ITM, ATM, OTM
• Volatility
• Other factors

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Options

• Simple strategies
• Buy a call instead of the underlying stock
• Buy a put instead of shorting the underlying
  stock
• Buy/Write or Rent Your Stock
• Write a (naked) put to purchase a stock you feel
  is currently over valued

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Options

• Free information on options
• http//www.888options.com/
• http//biz.yahoo.com/opt/education.html