Chapter 4 – Spotting Market Extremes and Trading Opportunities
Once you notice that a stock you are following has dropped or gone up way beyond its normal trading range and there was no special good or bad news to back it up in particular, it is time to get technical to confirm your “gut feeling”.
Chapter 5 – What are technical indicators?
In Costco’s (COST) chart below, you can see the clear signals Bollinger Bands give you. When the stock is touching the top of the Bands, with no significant news or event causing it, the stock is overbought. Similarly, when the stock is touching the lower Band without any significant news or event, it is oversold, one might want to initiate a trade here
Keltner channels and Bollinger Bands are both volatility based studies and appear to be the same at first. However, once you combine them, you come up with a potent combination.
When Bollinger Bands are moving wild and free (except earnings), they give amazing opportunities for new trade setups. That is when I put on most of my trades. When Bollinger Bands get squeezed inside the Keltner Channels, it indicates a period of low volatility. It is best not to take any trade during this time
Regardless of market direction, if the ADX is sloping upward, it indicates the current trend is very strong, and this means “do not put on that contrarian trade”. Staying on the sidelines is usually a good idea
If RSI is above 70 or 30, that doesn’t mean you should put on a mean-reversion trade immediately. It just indicates that the stock is trading at a price extreme and an exhaustion of the current trend is imminent. What you need to watch out for is RSI changing directions
Chapter 6 – Let us talk options
If you pull up an Option Chain, you will notice that there are a lot of strike prices. In the image below, Amazon (AMZN) is trading at $1739, but there are all these strike prices you can see, and each has its own delta. Delta means the amount that an option’s value will change when the corresponding stock goes up or down by $1
Chapter 7 – Avoiding time decay with a simple strategy
As I mentioned earlier, an Option’s price is based on several factors. One of these factors is called extrinsic value or time value. And the other one is called intrinsic value. With Amazon (AMZN) trading at $1742.42 in the image below, all call options shown which are below $1742.42 will have an intrinsic value. Notice that the $1740 call has an intrinsic value of $2.42. Finding intrinsic value is simple. Just subtract current price with the strike price and you will get your answer
We don’t need to buy a call as 1 trade and sell another call as a separate trade to create our vertical. The nice thing about this call vertical is that the Time Decay of the long call is cancelled out by the Time Decay of the short call (i.e. the one you sold).
This is how a Bull Call Spread order looks like on two of my favorite trading platforms:
Chapter 8 – A Bonus strategy (Credit Spreads)
To learn about credit spreads, let us use GOOG (Google) as an example. In the chart below, GOOG is trading at $1189, and is already touching the bottom of the Bollinger Bands. Further, this was one of those days where DOW tanked $300. GOOG had no bad news of its own, it just got dragged down with the market, that’s all. At this point, we could either simply buy a $1190 – $1195 bull call spread
If you look at the Put option chain on the right side, you will notice that an $1130 Put is selling for $2200. We can sell a $1130 Put and take in a credit of $2200! On top of that, check out the column called “Prob. OTM”, the chance of GOOG going down that much is approx. 30%, which means we have a theoretical probability of almost 70% to win on this trade
Chapter 9 – Putting it into Action – Trade Examples
For our first example, we will look at a picture-perfect trade using Bollinger Bands, where the stock touches the lower band, bounces back and heads all the way up to the upper band. I chose this example to demonstrate something special about debit spreads.
It is time to put on a trade. With the stock at $1667 we buy the $1670 call and simultaneously sell a $1680 call. All we end up paying is $550. And if we are right, we will double our money in 32 days or less.
The extreme price movement which happened in this case is not required at all! All we needed was a $10 move. That is the beauty of debit spreads. All you need is for the stock to expire at or above your short call and you make 100% profit!
In this example we will take a bearish position on GOOG after it touches the upper Bollinger Band.
All our criteria have been met. It is time to put on a trade. With the stock at $1093 we buy the $1095 put and simultaneously sell a $1085 put. Our cost for this trade is $430. And if we are right, we will double our money in 31 days or less.
Fast forward 31 days and something interesting has happened. Notice that GOOG did drop like a rock to $970 in the next 20 days, but it creeped back all the way to $1055 by the time expiration rolled around. That was only $30 below our short strike. Not a problem, we still won!
QUIZ: Would you take a trade here?
This is NFLX on 1/4/2019. Would you take a contrarian trade here?
Let us fast forward a month and see what happened. That would have been a total loser. As you can see NFLX kept grinding up until the earnings on 1/17 with no signs of stopping.
By the time the trade showed up on our radar, the stock is already down $100 from its high of $1778. But you can never catch the top or the bottom. The trade does fit into our criteria, so we will see how it plays out.
With the stock at $1668 we buy the $1665 put and simultaneously sell a $1655 put. We end up paying $465 for this trade. And if we are right, we will double our money in 30 days or less.
Fast forward 30 days and the market did drop at first but whipsawed back up to $1590. But our position was full profitable at this point.
It appears that the stock does fit all our criteria. With the stock at $1675 we buy the $1675 put and we simultaneously sell a $1665 put.
We end up paying $443 for this trade. And if we are right, we will double our money in 30 days or less as usual.
The ADX although flat was way too low. A low ADX means the market is calm and has no trend. It was my fault, I ignored that because I was bored and was looking for a new trade. Never trade out of boredom! Your mind will start seeing trade ideas which don’t exist. I usually put on new trades only once a month. Maybe twice if I get lucky. But no more than that
So far, I have showed you different debit spreads. For this final example, I will show you a credit spread. The trade criteria are the same. The mechanics are slightly different and the risk to reward ratio is different too, which I will explain in the trade analysis later.
With NFLX at $353, we sell a $340 PUT and buy a $330 PUT for a net credit of $257. Note that this time we take in a credit when opening this trade
We just need to wait. Fast forward to expiration, and NFLX climbed back up again, all the way to $373, which is above our short strike of $340. This makes our trade a 100% winner.