Saturday, January 24, 2009

3 Trading Horizons Of Options Trading

Have you ever lost money trading stock options?

Chances are good that you tried to apply the 3 trading horizons of stock trading to options trading and then got yourself hurt real bad.

There are 3 time horizons or what we call trading horizons in stock trading and they are; Long Term, Mid Term and Short Term. Long term horizon in stock trading means the buying and holding of stocks for 3 to 5 years, or sometimes longer. This is ideal for value investing in the long term prospects of a company. Mid term investing in stock trading is the buying and holding of stocks for 6 months to a year or two. Most stock investors use a mid term view to invest in new growth stocks which are expected to perform well in the immediate year. Short term investing in stock trading is the buying and holding of stocks for 3 to 6 months. These are stocks of companies that are expected to make a breakthrough in their industries. However, do these notions of investing apply in options trading? Not at all!

The truth is this: Stock Options are derivative instruments that have very short contractual lives! In fact, the longest expiration for exchange traded stock options rarely exceed 1 year! On top of that, the extrinsic value, or what we call time value, built into every stock options contract decays as expiration draws nearer, diminishing the value of your options even if the underlying stock remain stagnant. Due to these characteristics, stock options are trading instruments, not investing instruments, and have much shorter trading horizons than if you trade stocks. This is also why options trading is associated so closely with technical analysis these days because technical analysis is extremely useful in identifying short term trends or reversal of trends.

So, how is the long term, mid term and short term trading horizon defined for options trading?

In Options Trading, long term horizon is the buying of options with expiration of up to 1 year in order to speculate a long term rally or ditch in the underlying stock. Typically, long term charts on monthly time periods are used to identify such trends. Mid term horizon is the buying and holding of monthly options all the way to their expiration, each trade lasting no more than a month. Charts on weekly time periods are particularly useful for identifying mid term trading opportunities. Short term horizon lasts from 3 to 15 days in order to speculate a quick short term surge or ditch in the underlying stock and typically uses short term daily time period charts to identify trading opportunities.

From the above definitions, it is clear that stock options, as a short term trading or hedging instrument, is useless for anyone who is investing in the long term horizon defined for stock trading. Therefore, before you decide to completely replace your stock investing with options trading, first decide if trading stock options allow you to trade the way you always have with stocks. If it doesn’t, it is time for you to either stick with stock investing or learn a trading system which is perfectly suited for options trading.

By Jason Ng

Jason Ng is the Founder and Chief Option Strategist of Masters 'O' Equity Asset Management ( ) and author of . He is a fund manager specializing in options trading and his revolutionary Star Trading System has helped thousands.

3 Reasons Why Stocks Move

For years, I have been asked this same question over and over again, “Why does stocks move?”.

For most people, the reason why stocks move has been a mystery. In fact, there are people who believed that someone is controlling these movements behind the scene playing against them! There are even people who believe that stocks move mainly due to good fundamentals. Well, look at it this way, if there is this big institution playing against you and taking all your money away from you, why aren’t all the financial institutions making money year after year? Why are so many funds closed down every year? If stocks move just because the business fundamentals are good and that the business makes sense, then why do good stocks fall at all?

The truth is this; stocks do not move based on what is happening in the world right now but based on expectations of future events! These expectations create a temporary imbalance in the number of buyers and sellers, moving prices. When there are more buyers and fewer sellers, sellers will hold off selling until prices have been bid up higher. When there are more sellers than buyers, sellers will continuously lower their asking price in order to entice buyers to pick up their stocks. Those dynamics create the ups and downs in the stock market.

What do “expectations” in the stock market really mean? To put it simply, you would avoid driving along a road that is expected to be congested, right? You wouldn’t go all the way down the road and see the congestion before deciding what to do, will you? That is the same decision making dynamic in the stock markets. The real issue here is what kind of expectations drives that temporary imbalance in the number of buyers and sellers which moves stock prices? That brings us to the 3 reasons why stock prices move at all.

Reason 1: Earnings Expectation

Have you ever wondered why a lot of stocks actually fall after releasing good earnings? Well, that’s because along with every earnings release comes earnings guidance! Earnings guidance is the estimated earnings for the following quarter. If the next quarter is guided lower and the stock is expected to fall when the time comes, wouldn’t you start selling today while prices are still high? That’s the same theory behind the congested road scenario mentioned above. Similarly, if earnings guidance is great, the stock continues to move higher. This is what the stock market call “pricing in” the future earnings.

Reason 2: Dividends Expectation

Dividends are an extremely important reason to own stocks. For stocks that never pay a dividend, this is not really a concern but for stocks which have been paying a steady dividend, changes in the expected dividends yield can cast doubts on the future profitability of the company, thus resulting in a sell off today. Similarly, if expectations of future dividends are raised, future profitability of the company can be expected to be better, resulting in a rally today.

Reason 3: How Much Investor Are Willing To Pay For Those Earnings & Dividends

Yes, now that you know that earnings expectations and dividends expectations creates the conditions by which stock prices might change, the only question which remains is how much would such a change be? Just as you might wish to pay a different price for your burger down the street under different economic conditions, the amount of money investors are willing to pay for future earnings and dividends also differ under different economic conditions. When the economy is looking upbeat and everyone’s optimistic, you might be willing to pay a higher price for the same expected future earnings. Conversely, when the economy is looking sour and everyone’s pessimistic, you might want to pay a lower price for that same earnings outlook. All these are reflected in what the stock market call “multiples” or the full name being “Price Earnings Multiples” or “PE ratio”. The PE ratio tells you how many times above earnings is the current stock price and represents the amount of money investors are willing to pay for that earnings outlook. Under good economic conditions, investors may be willing to pay up to 100 times earnings while bad economic conditions may justify only a 50 times earnings.

When times are good and higher prices are justified for the same earnings, the stock market is in a period of “Multiples Expansion”. Conversely, when times are bad and lower prices are warranted for those same earnings, we call it a period of “Multiples Contraction”. Understanding which period the stock market is in will result in tremendous profitability trading stock options which can profit both ways.

These 3 factors interact in the minds of traders and investors all the time. Sometimes when earnings guidance is higher for the next quarter in a poor economic condition, stock prices might still fall as investors may be willing to pay only a much lesser price for that earnings. So, next time you try to make sense of why stocks are moving the way they are, think in terms of these 3 factors and you will definitely see the light.

by Jason Ng

Jason Ng is the Founder and Chief Option Strategist of Masters 'O' Equity Asset Management ( ) and author of a free Options Trading education site . He is a fund manager specializing in options trading and his revolutionary Star Trading System has helped thousands.

Monday, January 29, 2007

Markets Remain Stagnant as FOMC Looms Ahead!

FUNDAMENTAL ANALYSISMarkets closed marginally up as investors sit on the only day of the week without any critical economic releases. Such is the typical behavior just days before every FOMC releases. Even though it is almost certain that interest rates are going to stay stagnant, investors are expecting the Feds to put on a hawkish stand about future interest rate movements, leaving a lot of investors on the fence, waiting to see the initial reactions to the release. Yesterday's trading volume is the lowest so far for 2007 and CBOE's equity put call ratio remained relatively stagnant. Is this the fabled calm before the storm?TECHNICAL ANALYSISMarkets closed sideways yesterday as both the Dow and the Nasdaq composite struggled to stage a rebound. The Dow closed sideways but traded above its 30 days moving average support level for whole of the day to close right on top of it again. This is again a healthy sign that the support level for the Dow is strong and investor sentiments remain bullish inclined. This gave the Dow a high chance of rebounding off this level to form yet another step in its staircase formation and therefore yet another historical high. This little consolidation has also helped the Dow get off its short term overbought condition, thereby giving it more headroom for growth in the short term. The Nasdaq composite is, again, slightly more shaky. Even though it has been trading sideways these 2 trading days, it has closed right below its 50 days moving average support level in a fashion which almost transforms the support level into a resistance level which is hard to break upwards from. Over the last 6 trading days, the Nasdaq composite has closed just slightly below its 50 days moving average for 5 of these days. Even though support and resistance level analysis is not a precise science and such situations are common, it still does cast a hawkish shadow. One reassurance at this point is that the Nasdaq composite is forming yet another "Black & White Brothers" candlestick formation. (Please read my post on 21 Dec 2006 for explanations... ) This is a high probability bullish formation, even though it failed to effect a rebound on 21 Dec, it still does have a large string of successes going back. So, it seems like the week has just begun today! Traders, take your positions, and....