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Friday, November 30, 2007

Bank of America (BAC)

Ok, the first thought is probably that I have to be insane for bringing up a financial right now, of all times, but follow me on this one.

I'm going to start some introductory buying with BAC in December, on the rally seasonal date (December 4th). Now I've had this listed in my portfolio for a while, but haven't nibbled on it again and my stock purchases are a bit of a 'process'. When I buy a stock, it's either under "Introductory Buy", "Accumulate", "Pair off", or "Distribute (Which is rare)". To make a long story longer, I'm buying for the first time in a long time, so I'm beginning at step one; "Introductory Buy". This means just nibbles, or under 1% of my account.

Ok. Why?

1) I'm a firm believer in a modified version of Dollar Based Investing / Accumulation. The financials are getting hit hard right now. Really hard. So it's a great time to look for great deals and values on stocks. But since I do not believe that the crisis is fully over, I'm not going to just jump in with both feet. Thus, the 'nibbles' from my account. It's sort of like real estate speculation. You start buying when you believe the cycle is coming to an end. Not exactly at the end, since bottom and top picking is exceedingly difficult. I then wait for the market to tell me when to put it into 'accumulation' status.

2) Bank of America has a great history on the dividend route. They've been paying regular, steady dividends since . . . oh, I don't know . . . 1903!! They've been rock steady through some of the worst times this country has seen; thus they qualify under the "established corporation" route. Their dividend growth rate is 13.44 %, which is way above inflation and far enough ahead of taxes.

3) Their P/E right now is 10. That's right. 10. Their debt situation right now isn't hot, but they've been fueling growth with that debt. Their EPS is 4.66 and their PEG is 1.56. I fully expect to see lower prices with BAC, but I wanted to jump in with a little more while prices are where they are. I like the price, and volatility has been through the roof lately in this stock market, so no telling where we're going in the future, and I'm not smart (or dumb) enough to try to predict where we are going.

4) At this time of year, my DRIP is turned on, so any dividends we do receive will be reinvested. If that's on falling prices? Great. If it's on rising prices? Even better, since the market would then be telling me to put the stock into an "accumulation" status.

5) BAC is held 63% by institutions. This stock really shouldn't be going away any time soon. :)

P.S. - This purchase is not in the $500 Challenge Accounts that I run - just my normal portfolio.

Thursday, November 29, 2007

Know your Tool, when using Technical Analysis...

When it comes to investing and trading, there are multiple tools that people use. Oscillators. Stochastics. Seasonals. Commercial vs. Small Speculator Net Positions. RSI. Momentum.

The trick, is to know your tool. In other words, know the theory behind the tool, and use different tools that have different background theories to them, and that measure different things. Below I have listed how I view different tools. Others may have differing opinions. For example, they may feel that momentum tools and timing tools are really similar shades of the same thing. But the important point to keep in mind, is that different tools have different theories and measure different things when it comes to the markets. So you need to diversify your tools, and make sure that there is agreement among them when entering a market. Don't use two tools from the same category. They are really just measuring the same thing. Look to use different tools, from different categories.

Oscillators: These include tools that measure price strength and action in relation to previous days action. Tools such as RSI (Relative Strength Index), and the Commodity Channel Index, or the Williams %R. An oscillator is very good when it comes to measuring price and time together. The oscillators fatal flaw is that it does not account for the strength of the trend of the market. What is occurring within the markets 'bigger picture'. It generally only tends to account for information within the last 30 days. Some only count information that has occurred in the last 10 days. Thus many bad sell signals can be given in a bull market, and vice versa. It is best to take oscillators signals that agree with the major trend (since trends tend to continue) or when a host of tool with non-oscillator theories are in agreement with more than one type of oscillator.

Timing: This would include any tool that measures when it is a good time to enter the market. Seasonal indicators would fit into this slot, as well as some pure cyclical tools. Timing tools are very similar to oscillators, except their weakness is that they pay no attention to price. A timing tool simply tells you when it may be a good time to enter the market. But all true entrances into the market should be based on two things. Time, as well as price.

Accumulation: Ok, so it's pretty obvious that the Accumulation / Distribution Tool would fit into this category. But what does Accumulation / Distribution measure? Volume and Price. But why? It's a determination to see (generally when divergence occurs, but other signals can be given) as to when the net buyers or sellers may be gaining control of a certain time period. When one understands the 'why' of a Accumulation tool, their power becomes clear. Another tool that should be put into this category is that of COT Data with Commodity Futures, or any Insider tools when considering the stock market. As well as any tools based off of Open Interest and Volume. Their signals can happen up to two weeks before a move so they are not good at entrance timing. The advantage however, is that such an early clue is usually extremely accurate that something is about to happen, and to use other tools at your disposal.

Trend and Momentum: This would obviously include the "Momentum Indcator", but it would also include tools such as the MACD, in addition to the ADX trend strength tool. Moving averages, trend lines and tools based off support and resistance would fall into this category. The old motto fits in here "The Trend is your friend, never fight the trend". Always look to be a buyer in a bull market, and take buy signals, but not necessarily sell signals. The same would be true in a bear market. Look to be a seller in a bear market, and take all of the sell signals, since trends tend to continue and it is unbelievably difficult to pick market tops and bottoms.

Now do we see why it is a bad idea to use two tools such as RSI and Williams %R together? They are really differing shades of the same thing. It'd be much better to look for agreement between a Seasonal Date, Accumulation / Distribution, ADX, and RSI.

So know your tool. And always look for agreement between tools that measure different things.

Wednesday, November 28, 2007

Seasonals Part II: When Seasonal Tendencies "Work backwards"

We finished up yesterday talking about when the market moves in exactly opposite move of a seasonal pattern. We call this a "contra-seasonal move." And obviously, this doesn't make the investor or trader any money.

But again, the question we have to ask ourselves is why do contra-seasonal moves happen? The happen due to outside forces forcing the market to move opposite to their normal seasonal patterns. With the stock market at the current moment, we are in the middle of a contra-seasonal move. And what is causing this? The sub-prime mess. This crisis is strong enough to make a pattern that is extremely regular, and extremely strong to move in the opposite direction, and there is no telling how long it will last.

There is a bright side. These types of moves do not happen very often. But when they do one must pay attention. It's telling us that the whatever is unfolding in the market at the current time is news-worthy enough to cause the market to abandon all normal patterns. Later, I will talk about how to only buy into a market once it has confirmed that the seasonal pattern is a good one. Therefore, we can usually avoid getting entangled in a contra-seasonal move. For example, this year I was telling everyone that I was awaiting the November rally so I could start buying again. But the November seasonal rally never came. Instead, we had a contra-seasonal move. But since I do not buy until the market would have confirmed that the seasonal move was going to be a good one, I have not lost any money in recent purchases this month.

Tuesday, November 27, 2007

How to Use Seasonal Tendencies: Part I

The other day we discussed the strengths and weaknesses of Seasonal data. Now we'll discuss how to use Seasonal tendencies so that we recognize the strengths, use them, but do not ignore the weaknesses.

One of those weaknesses is that seasonal tendencies change. The markets are not what they were 50 years ago. The same things do not affect them. Therefore, an entire seasonal average may cease to function, and new ones may arise. So the question arises, how can we combat this weakness? Since it takes years for the mathematical averages to allow a new seasonal move to become evident.

Moore Research Center Inc, is a wonderful site that provides data to combat this problem. Here's a free example of one of their charts.

This is a wonderful chart to explore together how to properly use seasonal data.

Notice first of all, that MRCI charts out the 5 year average, and 10 year average. This is extremely helpful to combat our problem of changing seasonal tendencies. By plotting out different averages, we understand if a tendency that shows up on the 30 year average, is a move with a lot of history behind it, but if it is also on the 5 year average, than this demonstrates that the forces that work towards such a move are still in play and relevant. In fact, MRCI often plots out the 30, 15 and 5 year averages. When these averages all point to the same move, then we understand that this is a seasonal move that is still very relevant and possible.

Does this guarantee us the move?

No. If you notice this chart, the seasonal tendency was for the DOW Jones Industrial Average to move higher beginning on November 1st. Does this mean that seasonals hold no value, and again, it's just hit and miss? No. I'll continue tommorow with a discussion in order to understand how to use seasonal tendencies in trading and investing.

Monday, November 26, 2007

When and why seasonal tendencies may not work ...

Seasonal data is a wonderful indication of future tendencies. When we speak of "Seasonals" we are speaking of the wikipedia definition. That is, "inclination for markets to follow consistent patterns from one year to the next." They can give you exact entrance dates, as well exact exit dates. They can give you a clue as to the strength of a move, and are very reliable. Why do seasonals work? What is the underlying theory that drives seasonal tendencies? Seasonals work because of fundamental reasons. At X time of the year, demand becomes very high for X commodity, and the price rises, or vice versa. One such example is the Soy complex, and is related to a trade that I performed this year. Around July 15th, Soybeans, Soybean Oil, and Soybean Meal typically fall. Sharply, and strongly. So every trader should make use of Seasonal data, and seasonal inclinations. On November 1st, to December 25th, Seasonally speaking, the stock market moves higher. Consumer confidence is higher due to the holidays, and companies are bringing in higher profits due to consumer spending. So seasonals are fantastic tool at your disposal.

Except when they don't work.

Smile

From November 1st to December 25th is one of the most regular, strongest, seasonal tendencies there is in the stock market. But look at the stock market this year. Nada. So . . . what are we saying? Are they worthless? Hit or miss? Is there any way to tell when a seasonal tendency will work, or not work? Some traders try out seasonals, a trade goes completely opposite, and they write them off having no value. Is there a value to seasonal trading?

Yes, there is. But first we have to go back to a very vital question that we examined before. Why do seasonal tendencies work? This will helps us to see when we should pay attention to seasonal data, and when we can dismiss it as being of less importance.

When you look at a Seasonal chart, such as you will find at the Seasonalcharts.com, you are looking at a securities price, averaged out over a number of years. Think about that. That statement gives you the reason why seasonal tendencies may not work this year. It's the very mathematical theory of how averages work, and what a mean average is. In each year, that is not exactly what happened. You are not looking at charts of what occurred each year. You are looking at the mean average of what occurred over 30 years. That's an extremely vital point to keep in mind.

An average, for those of us who forget

1+2+3+4 = 10

The sum total of adding four numbers together, divided by the numbers we used in the set would give us the average. We used four numbers, so we divide 10 / 4. The mean average of that set is 2.5

In order to create a more and more accurate seasonal chart? You need new data. Which means what is occuring this year. And here's a little secret that many people don't know.

Seasonal tendencies change.

There it is. The seasonal tendency that was tried and true 50 years ago? May not even exist any longer. New market forces come into play, which affects supply and demand, and the seasonal tendency may completely reverse from what it used to be. But people 50 years ago did not know that. They could only use the Seasonal data of the years that came before. If they continued to trade such a tendency, they'd lose money year after year, because it takes many accumulated years to compile a mean average seasonal chart. This is a slow process, and why it's hard to note.

So what's the trick? How can we recognize that weakness in Seasonal charts and Seasonal tendencies, but still use the strengths that seasonals give us?

This is the topic I will begin to explore further. But before becoming familiar with any tool that you will use in your trading career, it is vital to understand:

1) The underlying theory of how the tool is constructed.
2) The underlying theory of what the tool measures.
3) The underlying weaknesses that such a theory has.

Friday, November 23, 2007

The eternal fight between fundamental and technical analysis.

There are a few schools of analysis when it comes to trying to identify what the market is telling us about price and time.

Fundamental Analysis.

Technical Analysis.

To sum it up as briefly as possible, Fundamental Analysis looks at what fundamentally moves the market such as news, analyzing supply and demand and can include such things as looking as seasonal pressures that markets face. Fundamentalists study factors that affect the securities value in the 'here and now'

Technical Analysis looks to the charts that are plotted through time and price - to determine what the price is trying to tell us about the market. Technical analysts do not attempt to measure a security's intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity. Chart patterns, oscillators and the like are used by technical traders. Technical analysts believe that the historical performance of stocks and markets are indications of future performance.

Each has it's strengths and weaknesses. Sometimes, those strengths and weaknesses, or the underlying theory behind fundamental analysis and underlying theory behind technical analysis are a bit at odds with one another. This leads to a dichotomy and two schools of thought; that one method is better than the other. Ones argue why fundamental analysis "won't" work. Which is dumb, because ones have made a lot of money using it. Others argue why technical analysis "won't" work. Larry Williams would argue with that one. That man currently holds the record for his ability to turn a fortune within the span of one year in the futures markets. He did so using technical analysis. But the argument and war rages on.

Which to my mind, is just silly.

There is no 'one way' to trade the markets. Why?

Because in the end, both theories have strengths. They both work well, given certain circumstances. I'm the kind of person that looks for strength, and then tries to capitalize on that strength. I recognize the weakness, and learn to work with it. This principle has served me well whether it's trading the markets, or dealing with my fellow man.

So in the end, I have learned to use technical analysis to identify my entrance to a market. In other words, when I pull the trigger and put my buy order in, at what price should I be filled? On what day should I look for my entrance. Technical analysis excels in assisting you to do this.

I use fundamental analysis to look for a good market to enter to begin with, or if I should steer clear.

I'm not a smart enough guy to use one method alone. I figure it's better to stack the deck in my favor. Smile

Wednesday, November 21, 2007

$500 Challenge Accounts: Whats the Roadmap

In the Art of War, Sun Tzu once wrote:

"Now the general who wins a battle makes many calculations in his temple ere the battle is fought. The general who loses a battle makes but few calculations beforehand. Thus do many calculations lead to victory, and few calculations to defeat: how much more no calculation at all! It is by attention to this point that I can foresee who is likely to win or lose."

In all portions of life, one must have a plan that fits in with their larger plan, which in the end, fits in with their general purpose for life. Making money in the markets is just one area that fits into the larger purpose. But that's a topic for another day. Wink The main thing to understand is that if you go at trying to make money in the markets without 'many calculations' - you will suffer defeat. This is even more true if your 'standing army' or account funding, is small.

So what's the "calculations" or plan for the $500 sub accounts that I have in order to make them grow? What are the goals? What are the steps to reach those goals? For now I'll deal with the short-term goals, though I already have the longer term steps in mind.

Short-term Goals (6 to 8 months):

* Regularly add $100 each month, to be split amongst the accounts. This is a must for the reasons that I have mentioned previously in this blog, due to money management and risk analysis calculations.

* Have the Sharebuilder account grow by an average of 4%. Not hard, since they pay me almost that in just interest. Wink This is so that this account can grow sufficiently by it's own for it's next stage of development.

* Not to trade the Futures Options account, until that account is at least looking at $800, and the risk is around $65.00 before commissions. There is a way to do this that I will go into as time goes on.

* After 6 options trades in the Futures account, feed 5% of the profits back into Sharebuilder Account. This is key, and it's something I haven't talked about much yet, but is integral to my overall strategy. You must have your more profitable accounts pay your other accounts. Why?

"The most powerful force in the universe is compound Interest"
- Albert Einstein

One of the things that people enjoy about 401k's, is that if you borrow money from them, you have to pay it back, with interest. You end up paying yourself the interest. I apply this technique to every aspect of my financial life. If I borrow money from my savings account that I wasn't planning on spending? I pay it back at 5% interest later. It stands to reason that you apply this principle when it comes to making money in the markets. Eventually, we'll get to the stage where I will demonstrate how to start having at least three different money making ventures, all paying each other. This is key. But that's a later goal. For right now - After 6 Futures Options trades, feed 5% of the profits back to the Sharebuilder account. Further down the road? We'll take 5% of our Sharebuilder account profits, and feed it back to our futures account. We're not just 'shuffling money' around. Because each of those accounts generate income on their own merit. Therefore - the profit that will be generated is spread about, and used to fund the other accounts.

* * *

This is not a recommendation of how to spend $500.00. The losses in trading can be very real, and depending on the investment vehicle, can exceed your initial investment. I am not a licensed trading advisor, or financial planner. But I do have 12 years of experience in trading and investing in these markets. The above experiment will be run for my own education, and education of other traders. The public $500.00 accounts do not reflect all of my investments and trading, and is run the way it is, due to the unique challenges that are presented to the small funded trader.

Tuesday, November 20, 2007

Second Enemy to the small funded trader ...

Yesterday I finished up my entry by asking the question: Why does being a small funded trader and / or investor limit the amount you can invest and trade, in your beginning months? This leads to the second enemy of the small funded trader and investor.

Commissions. A small funded trader is murdered by commissions. If you have an adequate amount in your account, then this really isn't a problem. If I buy 20 shares of Frontline Ltd (FRO) at $39.00, then I just spent $780.00 on purchasing Frontline stock. On average, I spend about $7.00 to get into the trade, and / or investment. Those commissions represent about 1% of my purchase.

But if I'm a small funded investor? Let's say I buy 2 shares of Frontline Ltd (FRO) at $39.00? Then I spend $78.00 to buy the stock? But now instead of 1%, my commissions are over 10% of that purchase. And if your are a small funded trader, you don't have that sort of money in your account to begin with. If you start out with $500.00 - then 10% of a stock purchase can easily represent almost how much your spent on the stock to begin with. And if you remember one of our money management principles? You remember that you shouldn't risk more than 3% of your account on any one trade.

1% of a purchase in a large account.

to

10% of a purchase in a small funded account.

Quite a big leap. You end up spending your money on the wrong thing. Paying your broker. Let's face it, if in your first few years, you make 8% on your money, you're doing very, very well for a new person. But you're paying over 10% of your account in fees just to 'play the game' as it were; instead of making your money work for you. If you're trying to invest, you just might break even with dividend payments. Although you must remember that you have to pay taxes on your gains - so even those gains are negated because you're paying too much money to your broker. If you're trying to trade a small funded account? That, in my professional opinion, is just nuts. Open-mouthed Because on average, it's about $7.00 in a trade, $7.00 out of a trade. So you have to have your shares move $14.00 before you can ever break even. Which just isn't realistic.

So are there any solutions? Well, this $500.00 challenge account is partially setup to educate new traders and investors as to what I have learned from the markets in the last 12 years. And if you have limited funds? Here's what my experience has taught me you have to think about:

1) You have to make what little money you have work for you. For example, Sharebuilder has a 7 day yield on your money (at the time of this writing) of approximately 4.40%. So even with limited funds, you can be earning a higher interest rate than inflation - and not paying your broker 10%.

2) You must, must, must regularly add funds to your account. This is the reason that I setup rule #2 for this challenge. The rule is that every month, I can contribute $100.00, that can be split amongst the $500.00 Challenge accounts however I choose. In other words, I can send $30.00 to Sharebuilder, $70.00 to optionsXpress; or $100.00 to optionsXpress, and nothing to Sharebuilder, etc. This makes sure that those accounts are growing so that I can maximize such limited funds, with some techniques I'll demonstrate as time passes.

In the end, it really comes back to money management. Risk. Reward. Cost. Growth. And you can't forget that as a small-funded trader - you'll be eaten alive by commissions.

Monday, November 19, 2007

The first enemy of the small funded trader ...

If you try to start out trading with limited funds, you are stacking the deck against you. Why?

First of all, it's simple money management.

In order to see how 'good' or successful and profitable a system or method of trading is, you need at least a hundred trades. The more, the better. Why? Because at different times, the market will behave differently. Starting in 2001, we entered a bear market. So a method that performed well in 2001 in a bear market, may not have worked so well beginning in a sideways market; from 2002 to 2006. And naturally, it's easy to get a system to work in a bull market, such as has been enjoyed since 2006. But as the last 7 years prove? Markets change. Trends change. A sector that's hot today, is cold tommorow. Therefore, to thoroughly test out a method of trading you need at least one hundred trades.

Enters the problem for the small funded trader. He or she doesn't have enough money in his account to have one hundred trades. They'd be lucky to have enough in his account for 10. So he or she may begin to look to horrendous areas to trade with, since he has so little; such as .pk - pinkslip companies; and offer him no dividends. Not that there aren't good penny stocks out there. But do they thoroughly investigate penny stocks? Or simply buy a .pk stock because they "read" something about it on the internet? He or she leaves the realm of the investor and trader, and enters the world of the gambler. Worse yet, they believe it is impossible to start out small, and build wealth. They come to believe that you must start out with $300,000 to trade and invest with the big companies.

Nothing could be further from the truth. This is what I propose to demonstrate with the $500.00 Challenge. It is possible to start out with limited funds and build wealth by investing and trading. Provided you understand a few things.

1) Having limited funds is an automatic negative to your money management strategy. Therefore, you must use a method that looks to greatly limit risk, and is highly accurate.

2) You must be patient. My goal with the $500 Challenge Accounts is to get them to a sizeable amount ($300,000.00). In the beginning, there will be months with nothing going on.

3) You must add capital to your accounts on a regular basis. In the beginning, this should be at least $100.00 per month. This does not mean that you must trade or invest that capital. I'll get into why you shouldn't be trading or investing limited capital tommorow. But you must work to increase your capital so that you battle against point #1.

What is another enemy of the small funded trader and why does this limit trading and investing in the beginning? I'll get into that tomorrow.

Sunday, November 18, 2007

$500 Challenge Accounts: Account Change Notice

Received a notice in the mail the other day.

Sometime ago, OptionsXpress merged with Xpresstrade. Now, any Xpresstrade accounts will be merged with the OptionsXpress platform. At this point, it doesn't look like there will be any major changes, other than having to get used to a new platform, and signing in on a different page. The added bonus is that in addition to trading Futures Options, this account will be able to trade stocks, bonds and ETF's. The merger and change in platform takes place on November 30th.

Saturday, November 17, 2007

Money Management: Strategies

Of course, that isn't all there is to money management. What I posted over the last few days, are merely the principles, behind which a money management strategy is built. There are many money management strategies that are built on those principles.

Personally, I just switched from a basic system, to a combination of Fixed Ratio and Kelly's, and my trade management works with a 'sliding' risk tolerance, for adding to my position once I'm within a trade.

Types of money management strategies include Fixed Ratio, Fixed Contracts, Fixed Sum, % of Capital, Optimal f, Secure f, Kelly f and hybrids thereof. Some are considered more risky than others (Kellys). You can create your own. I urge all traders to look to money management principles to create a money management strategy that makes sense, that is sound, and leads to future growth.

Friday, November 16, 2007

Money Management: Performance Analysis

In the beginning of this series on my blog, I mentioned that Money management consisted of:

Risk Analysis
Reward Analysis
Trade Management
Drawdown
Accuracy Rate
Performance Analysis

So what about Performance Analysis?

I believe human beings are very visual creatures. We need things in front of our eyes, (or our minds eye, for the visually impaired). And sometimes, we need to consolidate everything in front of us, in one neat package, so it's easier for our mind to see the big picture. Basically, what I mean here, is consolidation of all of the above facts - that I have been reviewing for the last few days. I've been running my own active Money Mangement thread, on all of my public trades that I run in the VIP section of my forums.

What should be included in such a consolidated performance analysis? Let me show you how it reads. Now mind you . . . this is only public trades (because I don't like the idea of claiming credit for trades that can't be verified):

Total Trades: 7
Largest Inter-trade Drawdown: $33.60 per unit (Per Share or Per Option)
Consecutive Losing Trades (Drawdown): 0
Average Drawdown: $18.8102 per unit (Either per share, or per option)
Accuracy Rate: 100%
Average Reward: $53.47 per unit
Risk Reward Ratio: 1:2.097

No matter what you do, I think you need some place where you have those figures in front of you - consolidated - just as I was taught to do, and display them.

Why?

It brings home to you - your entire trading career. Now mind you, the above is only 7 trades because those are the trades that I posted before I took them, publicly, and posted my thoughts during the trade (A good cross section to understand a money management system would consist of about 100 trades)

But I digress. Again. Why have this information in front of you? It teaches you something. It shows you exactly where you are in your trading career. So let's look at my last 7 public trades, and see what it teaches me.

The first thing a newbie might notice is . . . wow . . . 100% accuracy. But as we've already discussed in this thread, that number means very little. Especially since this System Analysis confirms for us that it's only 7 trades. I guarantee you that after 100 trades, that accuracy rate won't read 100%. But since we consolidated all of the numbers into one format? Then it becomes easier for even the newbie to see that. It's easy to see that's it's only been 7 trades, so the 100% number shouldn't be thought of too highly..

What else do those numbers tell us? Well, since they are my trades, they tell me I have to work on my risk / reward ratio. See . . . by consolidating your trading numbers, and having them in front of you? It helps point out areas that you need to work on. While 1 risk to 2.097 reward is acceptable? I personally think it needs work. The average winner number needs to be higher. So that's an area that I believe I need to work on. Because as my number of public trades increase, so will my losers. And as the accuracy rate decreases, I already know that the risk / reward ratio has to be higher to compensate. No trader should become so egotistical, that he can't look at his numbers, and see the areas that he wants to improve on.

I'm pleased with my Drawdown. But that also highlights the need that I have - to improve on my average winner #, which in turn will improve my risk / reward ratio. Since my risk has been so incredibly low per unit (Per share, or per option), then there's no reason that I should not be riding out my winners a little longer, or finding ways to maximize my trades.

So having those numbers in front of me? With a humble spirit, and setting my ego aside? Helps me, and any trader who does this, to understand the areas he needs to improve on . . . so that we can become even more profitable.

Performance Analysis consolidates your trading history, and can very well demonstrate to you where you are doing well, and where you need to improve. As they say, 'the proof is in the pudding'. And Performance Analysis will help show you exactly what the pudding consists of.

Thursday, November 15, 2007

Money Management: Accuracy Rate

Accuracy describes just that. How accurate are you with your market calls? 30% accurate? 50% accurate? 80% accurate?

I don't think I have ever seen a more overhyped, yet necessary part of money management stressed. 'Systems' and knowing ones accuracy rates are vital for proper money management. And let's face it, we'd all like to be right 90% of the time, as to market calls.

Yet small time traders and speculators act as if Accuracy rate is the end all be-all of trading. As if a person had an 85% accuracy rate, that would guarantee him to be profitable when trading and investing.

Nothing could be further from the truth.

It's an idea which is wrong. False. Untrue. And downright dangerous to believe. The reason people focus on accuracy, is because they get everything in reverse, when it comes to their trading and investing. It comes about, is because people look to the system that sells signal first, and money management principles second. If they look to money management at all. Want proof? Do a Google Search for "Market Picks" or "Winning Signals". Then try to find one, just ONE of them that teaches about money management.

The system for giving you signals comes second to your money management strategy, not the other way around!

In fact, an investor and/or trader can be right only 50% of the time, and still be profitable if his money management strategy is set correctly. An investor? Can generally stand an even lower accuracy rate, and still be highly profitable. This is because it generally takes less capital, less leverage to invest in the stock market, than it does to trade stocks, or trade futures and commodities.

Regardless, want proof? Simple test.

You have a trader who is right 50% of the time. Let's say every trade he engages in, he risks 1 dollar, to try to make 4. He actually averages a ratio, in practice of 1 risk to 3.5 dollars. What does the math tell us? That he is a profitable trader.

SYSTEM A:
TRADE 1: Loss - $1
TRADE 2: Profit - $3.2
TRADE 3: Loss - $1
TRADE 4: Profit - $3.2
TRADE 5: Loss - $1
TRADE 6: Loss - $1
TRADE 7: Profit - $3.2
TRADE 8: Loss - $1
TRADE 9: Profit - $3.2
TRADE 10: Profit - $3.2

5 Losses. 5 Wins. Total Lost: $5.00. Total Wins: $16.00.

Now lets take the 80% accurate trader, who doesn't pay attention to money management principles or have a money management strategy.

SYSTEM B:
TRADE 1: Profit - $1
TRADE 2: Profit - $3.2
TRADE 3: Profit - $1
TRADE 4: Profit - $3.2
TRADE 5: Loss - $10
TRADE 6: Profit- $1
TRADE 7: Profit - $3.2
TRADE 8: Loss - $7
TRADE 9: Profit - $1
TRADE 10: Profit - $1

2 Losses. 8 Wins. Total Lost: $17.00. Total Wins: $14.60

System A was 50% accurate. System B was 80% accurate. But which system made money?

Now do we see why risk / reward ratios, both projected and actual are so important? Why accuracy isn't as important as money management? Why it's important to have an adequately funded trading account, and only risk 3%?

Now that I'm done debunking the "Accuracy" overhype? Let me stress how important Accuracy is to your money management strategy overall Smile

It's important to view your Money management strategy as a math equation. You need all of the variables to work together, in order for you to be a success, right? Accuracy is one of those equations, and it is important to know both what your accuracy rate is, and how it fits in with the rest of your money management strategy. Let's face it, an 80% signal system would be good, as long as it doesn't call for large losses. Unfortunately, by the very nature of some systems and how they work? That's exactly what happens. When they lose, they lose big. Regardless, I won't digress into that speech again.

One must keep track, and know ones accuracy rate, in order to know how to work the rest of your money management strategy. It's one of the variables. Mind you, it's only ONE of the variables, but a variable nonetheless.

Wednesday, November 14, 2007

Money Management: Drawdown

Unless you are God, no one has any idea what will happen in the markets tomorrow. We cannot predict accurately. The best thing we try to do, is what any business person does. Try to look and see what the current market is telling us, and what might be on the horizon in the future. Then identify low-risk, hi-reward possibilities.

And sometimes. Sometimes we get it wrong.

Our reaction to that can be very interesting. Often, we rail against it. Our ego is bruised. We are convinced that we knew the direction the market was going to take. When in fact, nothing could be further from the truth. We don't know. We never did. Again, what is our business? Try to look and see what the current market is telling us, and what might be on the horizon in the future. Then identify low-risk, high reward possibilities. That's it.

Now, if we have applied the above topics to our trading? Risk Analysis? Reward Analysis? Proper Trade / Investment management? Then our 'bruised' ego will be much less. We won't need that trade to win, because it only represents 3% of our total account. That's all. No biggie. It's only the undercapitalized investor / trader that needs a particular trade to be a winner. Thus, when it's only 3% - we can see the bigger picture. The bigger picture, is the systems performance, not the individual trade.

Having a trade move against you? Or having a series of losing trades? That's drawdown, and it is a fact of life. Drawdown is a reduction in account equity from a trade or series of trades. As I said, it's a fact of trading. Because none of us are god. We may not like the fact that we can't predict market direction correctly 100% of the time, that our trade plan may have been off, etc. But there it is. We're going to have the market turn against us at times while we are within the trade. And we're going to have the market stop us out of trades at times. Fact of life.

What do we do?

DRAWDOWN TRACKING: It is vital that you track your drawdown. There are two types of drawdown we need to track. Inter-trade Drawdown - which means, when we are inside the trade, how much does the market move against us? And there is Multi-trade Drawdown. How many losing trades do we have in a row? What's the maximum?

Why keep track of this information?

First of all . . . because we sometimes err. We make mistakes as to how much our 'total risk' is. When we keep track of both of these types of drawdown. We may have been fooling ourselves with our risk analysis, and when we keep track of all our drawdown, it tells us how accurate our analysis of our risk actually is. Or if we are risking more than 3%.

Secondly, it has to do with something else every trader must engage in. Something I'll mention later . . . performance analysis. In short - how well are we doing overall? Or perhaps our drawdown is so low, that we mathematically figure that we might be able to increase our risk to 3.5% per trade. Or perhaps our drawdown is such that we need to decrease our risk to 2.8% per trade. Keeping track of

INTER-TRADE DRAWDOWN: Let's say we enter a trade. We're going to short Sugar at 10.15. Ok. Let's say we're capitalized enough, to where we can enter an actual futures position, not an option. Ok. So we're short, and in the market at 10.15 October. Great.

Sugar moves to 10. Fantastic. We're up 15, or $168.00. Great.

Then the market moves back to 10.15. No biggie. Then it moves up to 10.20. 10.25. 10.40. 10.50.

That . . . is inter-trade drawdown. We're inside the trade, but it's moving against us. In this case, our drawdown would be 35 points, or $392.00. We better have around $13,500.00 in our account, to handle this sort of drawdown. If so, great. If not, then a) we should have been stopped out earlier due to risk analysis, so that wherever our account is at - we should be stopped out or b) we're trading beyond our means, and are starting failure in the face. We're risking more, to make a little. Not good risk / reward ratio.

But let's say we're still in that trade. We're adequately funded, and we can withstand that sort of drawdown. Then what happens? Ah, Sugar starts to head lower. And lower. And lower. Now we're at 9.75, and quite happy. We're $1,000.00 up. Cool beans. Perhaps (if we are adequately funded) we have even added to our position, and are up more. Great! We have an opportunity to add even further to our position with trade management below 9.75! Great! More profit.

But that doesn't change that we had inter-trade drawdown, and it is vital to understanding our systems performance, that we keep track of that drawdown. It's vital to our future risk analysis, that we keep trade of that inter-trade drawdown.

MULTI-TRADE DRAWDOWN: Let's go back to the above example. Let's say our account is only $10,000.00. We can't stand drawdown (risk) of $392.00. Let's say we're stopped out with a $250.00 loss to our account.

That's a fact of life, and it happens. This is what traders must understand. It is proper to lose from time to time. This doesn't mean you are a bad trader. It means our timing may have been off, or the market just did whatever the market was going to do. That's all. We can possibly short sugar still. A poster on a financial forum once made an interesting statement. He said:

It can be hard at times, but you have to let those winners ride. It has been stated here that you can be profitable with only 30% wins. That is VERY true, but not if you don't let the winners ride much farther than the losers. 30% at a 1:1 risk to reward is NOT a winning system. I've been tempted at times to just close out a winning trade because it was up and I was unsure if it would continue on towards my profit target... but in all honesty, when are you ever completely sure it is going to continue towards profit? If you don't let those winners ride on, and always cut them short, you could very well fall into that scenario of 1:1 at 30%.

human natures is such that we do not like losing

[this is] very true . . . and this makes it more of a reason why a high percentage of people that trade eventually fail. Human emotions can be very distracting and by having such emotions, they cut out their profits too early and start to mess up their odds in the long run..

Keep to your risk analysis. What makes money, is not any individual trade. It's the whole thing together. Maybe you enter a short on Sugar #11 in a couple of days, when another timing tool tells you to enter it again. Then you're short from, say, 10.25, and the market heads down to 9.75. Great! Little drawdown, and you've got your profits. You can't let your ego get bruised to where you just ignore good signals, when the market is telling you to enter it once again. Too many traders become disgusted with themselves, and would walk away from Sugar altogether, only to see that in a few days, the market headed in the direction they thought it would. Instead of entering the market as they should again - they blame what? The stop / loss. I've seen many, many traders do this. And then what happens? They stop trading with a stop loss. They get margins calls, and before they know it, they're out of the markets. Then I've heard them rail on how there is a "them conspiracy" and the market is "out to get" the small trader. Anything. Anything but realizing the truth. Their ego was what got them in trouble, not the stop / loss order.

I say the above, and wanted to take an emotional tack, when discussing mult-trade drawdown. You're going to have periods with losing trades. One after another. If your money management strategy is set correctly, if you have an adequately funded account, and engage in all of the above concepts? When this happens - it will be easier to handle. But if not? It can destroy a perfectly good system, and cause you to become an emotional basketcase when trading the markets.

Keeping track of mult-trade drawdown, can also expose weaknesses and strengths in the trading system overall. For example, lets say you're trading markets, and everything is going well. Little drawdown. Remember this - market conditions change. They change all the time. Not just what the markets are doing overall, but they go from nice trending markets, to extremely volatile ones. Some systems work great in trending markets, but horrible in volatile ones, and vice versa. Your periods of multi-trade drawdown, will give you indications as to what sort of markets you should be trading.

You must keep track of those losses. For the same reasons that you must keep track of inter-trade drawdown. It helps you plan out your future risk analysis better, and is needed later, when analyzing your overall system performance.

Tuesday, November 13, 2007

Money Management: Trade / Investment Management

Man, if this isn't an area that receives total neglect on the part of even most guru's. It's very, very difficult to find information about it. At most you'll hear this:

"Make sure you have a trading plan, once you are in the trade". Or you might hear "Ride out your profits, cut your losses" or "Always use a stop / loss order"

That's it.

Ok.

What does that mean? I mean let's face it, those are all pretty much common sense factors. "Make sure you have a trading plan" while true? Is about as helpful as "Buy low, sell High"

Well duh.

So yes. You need a trading plan, once you have pulled the trigger, and you are in the investment, or the trade. What should that plan consist of?

TIME: How long are you looking to be in this trade, or this investment. When dealing with the markets, timing is everything when it comes to your entrance right? Well it should be a big part of your exits as well.

I'm a big one for considering seasonality into a market. This gives us not only an entrance clue (notice it's only a clue), but also a clue as to when we might want to start thinking about exiting the trade.

Gann wrote that timing, for the individual investor, is the most important aspect. NOT price. Price is important, but of the two, I agree with him. TIMING is the more important.

What about an investment? Well, perhaps your timing is more concerned with how to add to your position, since I very rarely sell any of my investment stocks or 'take profits'. But you still have to be concerned about time, once you have bought a piece of a company as an investment.

Let's say I bought Ford at 6.55 (Which I did). It rises to $8.90 and I'm making dividends along the way, for each share. Great. Do I buy more Ford at $8.90 on July 20th? Seasonality is telling me that such timing may not be a great idea. That I may want to look for dips in Ford, and buy more of it (thus increasing my dividend income) come November, when the market typically bottoms out from the Autumn doldrums and weakness.

PRICE: What is your profit goal?

Now you must understand that sometimes, you won't make this goal. But it's very important to have a price goal in mind before, and once you are in the trade.

RISK: What are you willing to risk? If you are trading, where is your stop / loss order? How does this risk equate to to your profit goal?

EVOLVING MARKET FACTORS: Your plan must be flexible. And you can't be afraid to reward your winners, if the market calls for it. At the same time, you must realize when a trade has run it's course, and you may not reach your profit goal.

For example. I'm short in Sugar #11 since July 25th. I bought a Sugar #11 950 October Put. My risk is about $125.00 (Actually, a little less, probably around $56.00 since I'm selling the option before expiry). My profit goal is for the market to hit $9.40, which would mean that my option would be almost 4 times my risk. This particular seasonal weakness in Sugar #11 runs until about August 21st.

Now after I initiated the trade, the market hit some support, and couldn't go any lower. So now what? I decided that if the market broke through a certain level of support - to add to my position and buy another put option. That's exactly what happened. The market broke below 9.97, and I bought a 925 October 925 Put for 8 ($87.00). Actually at the moment, that account is looking at two 950 puts, and 1 925 put. The market conditions told me that 9.97 was some key support. I should reward my winners as much as possible, so an entry point was to add to my short position, and buy another put option if the market fell through that support. (Put options are for when you are expecting the market to DECREASE in price. They gain value as the price falls)

Now remember my goal? What happens if the volume starts to decrease around August 17th, the market sinks to 9.50, but not my goal - 9.40? Do I hold out until 9.40? No. I've made a profit. Seasonality is telling me that the market weakness would be ending on the twenty first. Sinking volume on sinking prices The market is technically starting to chop around, and has trouble sinking lower? It just might be time to take my profits as market conditions are telling me that while I was correct as to the markets direction - that direction has run it's course.

* * *

When you use all of the above factors in conjunction with one another and come up with a good trade plan, the result is that you know what you want out of the market, and are not left with questions rattling around in your brain at each tick of the market: Should I take my profit? Should I let it ride? Will I be cutting my profit too soon? What do I do?

Next topic for tommorows blog? The dreaded drawdown! Oh noes!

Monday, November 12, 2007

Money Management: Reward Analysis

You might notice that I am reposting my money management thread from my forums. I understand that those of you who have read this before might have already read this, but the topic is just that important, that I want to go over it again; in this venue (the blog). It's that vital. And it helps other folks out who have not read the forum before.

Now, what of that 'dark side' that I mentioned when it comes to risk analysis? At times, ones will become so concerned with risk control, that they give no thought to the reward. For example, what if a trader was so concerned with limiting risk, that they engaged in buying cheap, severely out of the money options? Is their risk limited? Yes. Let's say that Sugar is trading at $10.00 and we expect it to fall to at least $9.25. Instead of buying a $9.50 put option, what if they were to reason "Well, I can buy a 750 put option, for only $11.00. That way, my risk is limited to $11.00."

The question becomes, how reasonable is this? Will the market move close enough to 7.50 for that option to become worth anything? Honestly? So did the trader limit their risk? Yes. But they didn't sufficiently consider their reward, or analyze for a reasonable reward, for that limited risk. All they end up doing is throwing away money on cheap options, and nickle and diming themselves to death.

Every human on the planet engages in reward analysis. Open-mouthed Sound familiar? Well, it's true. We talked about Chrysler offering Joe a job. There were risks, ah, but what about the reward? The money in the form of a salary and benefits that Chrysler is offering Joe is very nice. So, what does Joe do?

He balances the risks against the reward.

That is key. That is fundamental to good trading. This is something that 99% of small speculators never consider. They never look at a trade, and look at the balance between the risk, and the reward. Which is ironic. Because any good businessman balances those two factors.

You must plan out what a reasonable reward would be. A good rule of thumb, is that any reward should at the very least be twice as much as your risk. Why in the world would you become involved in any business where the risk was greater than the reward? You'd be setting yourself up for failure.

I can't tell you how many traders I've seen consistently risk $3000.00, seeking a $500.00 reward. Mathematically, they are bound to fail. It's a certainty, and is so obvious, it needs very little explanation although mathematically it has been proven again and again, such as in this linked example.

What a trader needs to do, is consider what is termed the risk / reward ratio. 1 risk, to how much of a reward? The ratio should be at least 1:2, and preferably, rest around 1:4.

Now there I do provide caution here. You must plan out a reasonable reward. This means that there should be market conditions, tools, and indicators that provide and seem to signify that the market can reasonably reach your goal. In the above example, we would like Sugar to go to $3.00. However, historic volatility in that market demonstrates that this is not a reasonable conclusion.

So plan out something, that given historic volatility, the market can reasonably reach that will give you a reward 4 times greater, than your total risk.

So what do we have to date? A few rules.

1) Limit your risk. Determine ways to limit your risk. Do not risk more than 3% of your account on any one trade. We'll talk more about how that number can be adjusted later, but for now? That's your baseline. Risk 3% of your total capital on one trade. This leaves you alive to trade another day, in case something horrible happens on your one trade.

2) Also, plan out a reasonable reward given historical volatility that is at least twice as much as what you are risking. Preferably four times.

We will continue with another aspect that needs desperate attention by most traders, and something that relates to our reward. Proper trade management. Because there is another caution. There is nothing saying that the market will make your reward goal. So what are you to do? We'll talk about that in the next blog . . .

Saturday, November 10, 2007

Money Management: Risk Analysis

Every human on the planet, engages in risk analysis every day. Chrysler offered Joe a job. Should he take the job? Will he be outsourced next year? Will his job move to another country? Will he be unemployed? Will the union help lower that risk?

It’s the same in this business. You have to determine your risk. You have to try to devise ways to try to limit that risk.

Let me say that again.

You have to determine your risk.

You have to devise ways to try to limit that risk.

Determining means – you have to sit down, and at least plan out a reasonable worst case scenario. How much money would you lose. How much of your account would that loss represent? How would that impact your ability to trade further?

You have to figure any methods at your disposal to limit the risk. For example, I recommend never, ever putting more than 3% of your total account size, into one trade or investment. Some people will say 2%, but I raised it to 3% due to what I will talk about next. Reward. Open-mouthed Regardless, the number has to be very low. When you are very experienced, you can raise that number to perhaps 5%, if the situation is right. However, again, it must be low. Why?

It helps mitigate your risk. Thus, you become someone engaged in business, rather than gambling on your money in one area. With only 3% of your account towards Ford? If Ford tanked and went out of business tommorrow, that would only represent a 3% loss to account size, which is your business. Your risk is mitigated. You are left to trade another day, and one disaster doesn't sink you.

That means also, that you must do something that most traders fail at. Have an adequately funded account. An underfunded account is one of the FIRST No-no's, when it comes to trading. This is only logical. Let's face it, if you only have $1,200.00? Then 3% of your account is $36.00. And who can initiate a trade with a risk total of $36.00? Commissions would eat that up, and I can't think of a trade vehicle where the risk is TRULY limited to $36.00. Options maybe. But they'd have to be so far out of the money, that your reward would be nill.

So having an adequately funded account, and keeping your risk per trade to 3%, helps your keep the rest of your account available for other trades. You won't miss business opportunities, because you had your money all in one area.

There are other ways to mitigate risk. Options. Options LOCK IN your total loss, at the price you paid for the option. Of course, Options come with their own risk that you have to consider. Part of the value of an option, is the time decay. As well as the volatility of the market. If your strike price is too far away, if the market isn't volatile enough? The market could slowly move in the direction you thought it would . . . but the option theta (time value) ticks away, and volatility remains low. Your option won't rise much in price.

Again, it comes down to determining your total risk. And trying to figure out strategies that mitigate that risk. There are many.

But there is a dark side to risk analysis that I will talk about in my next blog entry . . .

Friday, November 9, 2007

The Most Important Key for any Investor or Trader

What is that? Is it using a stop loss order? Is it risk reward ratios? Is it analyzing your system? Your accuracy rate?

Nope.

Using sound money management principles and strategies, which encompasses much of the above. Money management principles means using stop loss orders, risk reward ratios, or analyzing your system. But it also means much more. Anyone who follows my posts understands that I will rail on and on about this topic more than any other. Because without it, I feel a trader or investor is bound to lose.

Money management means your overall plan. Your overall strategy for dealing with losses, and maximizing gains. It's no good to tell a new trader "Cut your losses short, and ride your winners" unless they understand how to cut their losses short, and ride their winners.

People will hear the words "Money management" and think "Oh, you mean how much to risk?" or "Only risk 2% of your account size" or, "Oh, you mean my stop / loss" order?

The truth is, those are all very small parts of what comprises Money Management. Proper Money management involves analyzing risk. But it should also look for growth. For your money, making you money. Money management is about managing your trades. But managing your individual trade, does not comprise all there is to know about money management.

I would say that Money Management is made up of:

Risk Analysis

Reward Analysis

Trade Management

Drawdown

Accuracy Rate

Performance Analysis

Over the course of the next several days, I will be discussing these topics at length, so a new trader or investor can understand how to implement money management principles.

Thursday, November 8, 2007

November is here, what about the $500 Challenge Accounts?

Ok, I have three rules for the $500 Challenge Accounts.

1) The initial investment is $500.00, to be split amongst the accounts. This has been completed. Sharebuilder has $130.00, and the Xpresstrade account has $370.00.

2) Every month, I can contribute $100.00, that can be split amongst the accounts however I choose. In other words, I can send $30.00 to Sharebuilder, $70.00 to Xpresstrade; or $100.00 to Xpresstrade, and nothing to Sharebuilder, etc. Now that we have arrived in a new month, I'm thinking I'm going to contribute the entire $100.00 to the Xpresstrade Account, bringing that balance to $470.00. I will be transfering $100.00 to that account on 11/9/2007. Which means it probably won't clear until about 11/13/2007, or on the Tuesday after the transfer. Regardless, there is still too little in each account to trade or even invest with, since I'm going after aggressive growth with these accounts. The commissions would eat me alive, and I can't trade the Xpresstrade account for money management reasons. I want to build the Xpresstrade up to at least $700.00 (preferrably more) before I start trading that account. My accuracy rate is about 92%, and my risk / reward ratio is about 1:2.3. So it wouldn't make any sense to trade it before that time.

The Sharebuilder account will earn approximately 4.40% interest on the money that's in there, and there are no fees.

That's the plan for now.

3) I'll be using regular investment and trade vehicles. Bonds. Stocks. ETF's. Futures Options. But not this month, for the reasons I listed above. Open-mouthed


***

This is not an investment or trading recommendation. The losses in trading can be very real, and depending on the investment vehicle, can exceed your initial investment. I am not a licensed trading or investment advisor, or financial planner. But I do have 12 years of experience in trading and investing in these markets. The $500.00 challenge account is run for the education of other traders

Wednesday, November 7, 2007

What are "Futures Options"?

Ok, now that we've gotten through that? What is a "Futures Option"?

If you are familiar with stock options, then this will be much easier to explain. If not, I'll do my best . . .

When you purchase a Futures Option, you are purchasing the right, but not the obligation to buy a specific futures contract, at a predetermined price, within a given period of time.

That's it in a nutshell.

Now let me try to make it a bit easier, and perhaps you will see why I put those two statements in italics, and bold. When you hold a futures contract (not an option)? You have the right, and the obligation to buy and sell a specific futures contract; with all of the risks that implies, and that I discussed yesterday. In other words, your margin deposit is controlling one of the large and valuable contracts that's in the market. You are using a great deal of leverage to do so. Leverage is just what it sounds like. A lever, to move a larger object (unless of course, you have $80,000.00 cash to control one contract in the clear).

So, what's the difference with a futures option? 1) It expires before the Futures contract does. 2) It is an option that is tied to the value of the Futures contract 3) It has a set price. In other words, you put down $300.00? That's all you pay, and that is the maximum amount that you can lose as long as you do not exercise that option. But you are under no obligation to exercise it. You can trade it on it's singular value alone.

The reason options are valuable, is that at any time, provided you have the margin, you can exercise your option. This means, that you would call up your broker, and let them know that you want to exercise the option. When you exercise an option, the option is no longer in your account, and you are now within an established Futures contract position, at a price determined by whatever your Strike Price was that you specified when you bought the option. As I stated yesterday, is something I do not do. The risk to your account increases almost exponentially when you exercise an option, so I do not exercise the options I buy.

If you buy the right option (ah, therein lie the rub), then your option can gain just as much value as the futures contract, with none of the associated lock-limit risks.

How are futures options calculated? It's pretty complex. And no, I'm not kidding. It runs something like this:

C = S * N(d1) - K * (e ^ -rt) * N (d2)

ln (S / K) + (r + (sigma) ^ 2 / 2) * t
d1 = --------------------------------------
sigma * sqrt(t)

d2 = d1 - sigma * sqrt(t)


Where:
C = theoretical call premium
S = current stock price
N = cumulative standard normal distribution
t = time until option expiration
r = risk-free interest rate
K = option strike price
e = the constant 2.7183..
sigma = standard deviation of stock returns (usually written as lower-case 's')
ln() = natural logarithm of the argument
sqrt() = square root of the argument
^ means exponentiation (i.e., 2 ^ 3 = 8)

Don't worry. I deal with none of that when looking for a futures option. Heck, I had to go find the formula off the internet when writing this, because I had no idea what the actual formula was. What it basically says is that the further you are away from the STRIKE PRICE of the commodity, the less valuable the option will become, dependant upon 4 other factors, which include how long is it until the option expires (You pay more for an option, the further away it is, and that value decreases over time), how volatile is the market, interest rates, and other variables.

So in the end? I generally find an option that is the right option for the strategy I have in mind; (which I will discuss as time goes on). If you don't choose the right option? You can nickle and dime your account to death if you don't know how to find the right option that's applicable to your strategy.

That's it in a nutshell. Feel free to ask me any questions at secure.communication@gmail.com, and don't worry. I'll explain more as time goes on.

Monday, November 5, 2007

Ok, so what ARE Futures??!

Futures? Ok, I still haven't answered that question. We got through Commodities, but what are 'Futures'?

First of all, when you deal with Futures on commodities, you are dealing in contracts. Not shares. That's the first difference. There are no 'shares' of anything when dealing with futures. Only contracts.

Ok, a contract to do what?

You are entering a contract that states you will take delivery of a specific commodity, at a certain time. It is said that you are entering a contract that gives you the right to take delivery of a specific commodity at a certain time. A commodity, say, like Sugar. Or Live Cattle. Or Wheat. Whatever it is that you are trading in. But there are no 'shares' of Sugar #11. There are no 'shares' of Live Cattle. You enter into a contract of Live Cattle, or of Sugar.

In other words, the contract comes 'due' at a specific time. This is the second major difference from stocks. A company's stock can't 'expire'. The company can go out of business. The company can buyback shares. But it can't 'expire'. A Futures contract expires. You put down a small amount of money (your Margin requirement) that states that you are undergoing the obligation to buy or sell a commodity at a specific price to be delivered to you at a specific time. This is why the Futures / Commodity markets are purely speculative vehicles. You cannot 'invest' in sugar. You're speculating for price difference in the Future. Thus, the term, futures contract.

Of course, you have no interest in taking delivery of a commodity. A commodity contract of, say, Sugar #11, means that you'd be placing a margin amount down, to control a Sugar #11 Contract for delivery of 112,000 pounds of Sugar. Are you actually interested in having 112,000 pounds of Sugar delivered to you? Of course not. You want to profit from the trade difference in the price of Sugar, that's all. So you enter and exit your position, usually, within the time span of a few weeks, and exit that position. Wala. Thus we enter the realm of speculation. Thus, it's time to discuss the risks. Which are very, very real.

Generally, one tick on Sugar #11, translates into $11.20 worth of profit. Think about that for one second. One tick = $11.20. You move 10 ticks? You're looking at $112.00. That's pretty fast movement and return. This is because the size of the contract is so large, and therefore valuable. The current margin requirement for one contract is sugar, is $910.00. When you initiate a position, $910 of your account is set aside, so as to control one contract in the market, at the price you buy in at. So let's say you buy the March Contract of Sugar #11, when the market is trading at $9.91. It goes to $10.50. That's how many ticks? 59 right? (10.50 - 9.91). So 59 * 11.20 = $660.00 that you just made, minus commissions. Congratulations. You have discovered the positive power of leverage. Leverage is taking a small amount of money (That $910 of your initial margin), and controlling an extremely valuable commodity like Sugar. If the market goes your way? Great. You're making money. But this sort of margin leverage is a two edged sword. What happens if the market moves against you?

You just used a small amount of money, to control a large asset. If the market moves against you too much, you need more money to control your position, as the market just ate your initial margin. You must maintain at least $850.00 in your account, free and clear. This is called the 'maintenance margin'. What happens if the market moves against you to the point that you are below the $850.00? You will be asked to place another $910.00 in your account. Immediately. This is called a 'Margin Call'.

Now let me let you in on a little secret with Futures on commodities.

You can be locked out of exiting your position.

When a particular market moves so fast, and reach a certain price, it is said to be 'lock limit'. This means that the market is not accepting any more buy or sell orders. This is usually because some piece of news has hit the market, and the market reacts quickly.

So let's say you are in, oh Soybean Meal last July. And you bought. Whoops, Soybean Meal has a down day. A really down day. It hit lock limit last summer (Meaning it moved 200 ticks away from the opening price, or $2000 since 1 tick = $10). You cannot exit your position. You are stuck. And if you do not have enough money in your account to meet your maintenance margin, you will be asked for a Margin Call. You must place this in your account, because the market has moved so fast, that it's locked. Your position cannot be liquidated.

The extremely famous Futures trader Larry Williams tells the story of being stuck in a lock limit situation for days on end. I believe in the end, he lost over $60,000.00. In one trade.

Now, you know why it is that I do not deal with Futures Contracts. Ever. I have 200 million dollars in my Futures Brokerage account, I might think about it. I deal in Futures Options. Big. Big difference. Futures Options do carry their own risk which I will get into a little later. But you can completely avoid those sort of lock-limit situations with a Futures Options. I will discuss this more tomorrow. I suggest anyone following this blog do more research into Futures and Commodities. Learn the very real risks.

Again, tomorrow, I will discuss the advantages of Futures Options.

***

This is not an investment or trading recommendation. The losses in trading can be very real, and depending on the investment vehicle, can exceed your initial investment. I am not a licensed trading or investment advisor, or financial planner. But I do have 12 years of experience in trading and investing in these markets. The $500.00 challenge account is run for the education of other traders.

Sunday, November 4, 2007

What are Futures?

Futures? What are 'Futures'?

This is going to take a while to explain, so I'm going to do so over the course of the next few days.

Futures contracts (not shares, contracts) generally deal with, and / or are called "Commodity Futures" or "Commodities". But futures, and commodities are a bit different. What are commodities? That's what I will discuss today.

Quite simply, commodities are things we use every day. Items that are consumed, en masse' and needed by our civilization. Food items such as Wheat. Sugar. Corn. Without them, we can't live. We can live without Ford. We can't live without food. They are items that make the world go around like Copper. Gold. Silver. Natural Gas. Unleaded Gasoline. The Commodity Futures that I trade Futures Options in are:

Sugar #11, Cocoa, Coffee, Cotton, Orange Juice, Copper, Gold, Silver, Feeder Cattle, Cattle, Hogs, Pork Bellies, Corn, Wheat, Soybeans, Soybean Oil, Soybean Meal, Oil, Unleaded Gasoline, and Natural Gas.

Those are commodities. From time to time, I deal with Futures Options on the major Indices; or stock markets. Such as Futures for the S&P 500, etc. But those are a bit different that just raw commodities. But I digress. Smile

These are all basic commodities that we all use. How is the price determined? Ah, this is something that you generally won't hear about when Politicians want to promise you lower food prices.

How is any price determined between a buyer and a seller? You haggle right? That's free market at work. Without the freedom to haggle for price? Then you're no longer in a free-market, and I won't even begin to go into the horrors that this can produce. One form of haggling is the bid-ask spread. This is basically a form and descendant of the auction (Asking for a price, and bidding on it), only it's a form of haggling for price. The purchaser will announce the highest price he is willing to pay. This is the bid. The Seller will announce the lowest price they are willing to accept. This is the "ask". In our modern day, various exchanges have developed where buyers and sellers (Farmers, Commercial Interests such as Kellog, etc.) meet to try to agree on a the price to a future contract of a given commodity via the bid-ask. So Hershey needs to buy so many tons of Cocoa for production of their candy? They do so at a Commodities Exchange. If you've ever seen Ferris Bueller's Day Off? Ferris, Sloan, and Cameron visit and sit in the spectator booths at one of Chicago's commodity exchanges. If you've ever seen the movie "Trading Spaces", then you've seen a movie that's about Commodities.

The above, is a very brief overlook as to the commodities that are traded on the Commodity Markets. Here is a wikipedia article that discusses Commodities a bit more, and one describing the Commodity Markets.

Ok. Now. How do you make money doing this? What are Futures? And why is it considered so risky? Why do I insist on using Futures Options for some commodity futures? I will discuss that tomorrow . . .

***

This is not an investment or trading recommendation. The losses in trading can be very real, and depending on the investment vehicle, can exceed your initial investment. I am not a licensed trading or investment advisor, or financial planner. But I do have 12 years of experience in trading and investing in these markets. The $500.00 challenge account is run for the education of other traders.

Saturday, November 3, 2007

What is it that I do exactly?

Ok. What is it that I do?

1) I invest in companies via stocks.

2) I trade the stocks of companies.

3) I trade commodity futures and futures options.

Those are three totally separate things. That's important to understand. First, it's important to understand that trading, and investing are two different things. What do I mean?

Trading: There is the old expression: Buy low. Sell high. You do this, and you're trading. I buy 400 shares of Frontline Ltd (FRO) at $41.00 I sell the 400 shares of Frontline Ltd (FRO) at $46.00 I walk away with approximately $2000.00, less the $7 to $15 in commissions. I just traded that company. Trading is basically considered more speculative. A great way to make money, as long as you know what you're doing. If you're trading in the Futures arena, it is absolutely vital to understand that you're are trading and engaging in a zero-sum game. I will discuss this more later.

Investing: I buy Frontline Ltd stock (FRO). I now own a common share with voting rights in FRO. I am looking to make money by owning stock in that company. I don't sell it. I'm trading nothing. I'm interested in making money from owning FRO. That is key. Investing is a long-term way to make money. You make money by owning the company in two ways. By means of dividends, by means of the stocks valuation. Investing in the stock market is not a zero-sum game, as is Futures. The stock market can create wealth.

Sometimes people use the term 'investing' and 'trading' interchangeably. While there are similarities, it's important to note the differences. Some may say I'm being rather pedantic and playing with semantics. But I think if you have those two terms clearly in mind with such definitions, it will aid you. You will understand each purchase you make. It automatically forces you to assess and plan each purchase before you make it. You will be thinking of it as either an investment? Or as a trade. This will aid you as you develop your strategy for that purchase.

Dividends, valuations and yields. Always, always, always check to make sure a stock pays you dividends if you're going to invest in it. I'm what you term a 'dividend investor' so dividends are very important to my investment portfolio. I think in my entire career, I've only invested in one company that did not pay me dividends (Google). Trading? Dividends aren't really important when trading. I trade companies all the time, that don't pay any dividends. No biggie though, because in trading, you're trying to make money by price difference. But when you invest in a company, you are looking for dividends, yields and stock price valuation; or the rise in the stocks price. In other words, you can make money by the worth of the stock rising. Every shareholder wants this to happen. But if it doesn't, it's not a total loss.

So what is a dividend?

Well, let's take Frontline Ltd. as an example. They're in the business of shipping tankers. Why? To make money right? Well, when they make that money, they can do one of two things with the profits. The profits can either be re-invested in the business (called retained earnings), or they can be paid to the shareholders of Frontline Ltd as a dividend. This encourages others to buy the stock, which in the end, adds to the Value of owning Frontline stock. Many companies retain a portion of their earnings and pay the remainder to their shareholders. Companies differ as to when you'll get the dividend. If they pay one. Some just keep it all to retained earnings. Companies usually pay dividends on a fixed schedule, commonly annually, bi-annually or quarterly. But in all honesty, they can declare a dividend at any time. The dividend is usually cash, but I've been paid in stocks of other companies at times as well.

Frontline Ltd (FRO) has a history of paying very high dividends. Generally, they run about $6.00 per share annually. This means that for every share of FRO you own? You are paid $6.00 over the course of a year. There's a lot to consider before investing in a company due to dividends. What if they paid their shareholders $12.00 per share, but they've only done that once in 5 years? Look for good strong companies, with a strong balance sheet, and that pays regular dividends. There's more to it than that, but I figure we'll just go at this slowly.

Here's a great article at Wikipedia that will teach you everything you need to know about dividends.

Ok, now what about trading Futures Options? Heck, what are Futures? Well, that's another topic I will discuss over the next few days . . .

* * *

This is not an investment or trading recommendation. The losses in trading can be very real, and depending on the investment vehicle, can exceed your initial investment. I am not a licensed trading or investment advisor, or financial planner. But I do have 12 years of experience in trading and investing in these markets. The $500.00 challenge account is run for the education of other traders.

Friday, November 2, 2007

$500 Challenge Accounts: Implementation

Ok, I have both sub-accounts created.

I'm sending $370.00 to the Xpresstrade account, and the remaining $130.00 to the Sharebuilder account. This is due to the strategy that I've come up with given the circumstances that I've allowed for myself in this little scenario. My one rule states that I can add, and split amongst the accounts up to $100.00 a month. This is key. These accounts have to be larger than they are before I actually begin trading in them. By my math (using money management principles) I'm figuring the Xpresstrade account has to be $750.00 before I start trading options in it, and the Sharebuilder account should be at least $150.00 before I even think of making a purchase. The benefit on the Sharebuilder account is that the money within it earns approximately 4.40% - as it is considered a money market account. So I don't actually have to have bought a stock in this account, before I start making my money work for me.

It'll take a couple of weeks for the pending transfers to occur for the Sharebuilder account. I've already transfered the money from my primary Xpresstrade account to the sub-account. The Sharebuilder account should be ready to go by the first week or so of November. This gives us some time to 'talk'. :) While we wait for that to be done,. I will discuss for the next few weeks, various principles that someone must be familiar with as the begin investing and trading. Tomorrow I will discuss the specific ventures I engage in, as I make money in the markets; and the differences between them. After that, I'll discuss money management principles (Risk / Reward ratios, Accuracy rates, Drawdown, etc.) as well as strategies for picking stocks and trades.

* * *

This is not a recommendation of how to spend $500.00. The losses in trading can be very real, and depending on the investment vehicle, can exceed your initial investment. I am not a licensed trading advisor, or financial planner. But I do have 12 years of experience in trading and investing in these markets. The above experiment will be run for my own education, and education of other traders.

Get rich overnight? I don't think so . . . but what about slowly?

I had the brother-in-law over the other night for dinner. And what I call that conversation arose. We started off talking about Railroad Tycoon (the video game). The "stocks" that you can play with in that game led to a discussion about infomercials and get rich quick schemes. Which of course led to what I do for a living. What is that conversation? Discussing what we all see promised on various infomercials.

The promise of making a million dollars from investing and trading within a matter of weeks. Because it's all so easy.

Which . . . of course, is a crock. This is what I do for a living, and I'm telling you . . . it's a crock. To make those sort of returns in that length of time, you're not investing. You're not trading. You're gambling. I get tons of that crap in the mail everyday (start investing for your living, and your junk mail increases almost exponentially). Those claims are so easy to pick apart, it's almost stupid. And trading for a living isn't easy. It's work. Hard work that requires a ton of emotional discipline. Research these days is infinitely easier than it used to be (I used to chart by hand), but it's still a lot of work.

However, the more forums I travel to, the more I find people who want to learn about the markets. They have a keen desire to learn. They understand that it will be work, but they have no idea where to begin. They understand that most of what you see isn't worth hot air it's comprised of. They want to better their lives, but quite frankly, they are in a position where they don't have a lot of money to start out. I see more and more posts of "I only have $800.00, how do I get started?" My god, the Zecco forums were replete with those sort of posts.

So, the question came up. Can it be done? Can you take $500 to a million dollars like you see in those infomercials? What's the real deal? Realistically, throwing all that hype garbage out the window? Can it be done? I always respond the same way.

Absolutely. But there is a catch. The catch?

How soon you want it? Time. I mean, lets face it, any dummy could do it, if given 80 years. Stick it in the highest yielding interest account and forget about it. Right?

But can it be done? Realistically? I finally said yes, but it would have to follow a very strict plan. Because if anyone knows anything about my trading and investing? It's that I rail on and on and on about money management. And part of money management? Is being adequately funded. For a stock trader, you need at least $30,000.00 to start off nicely. You have to have room to maneuver in this business. And with only $500.00 – you don’t have a lot of wiggle room. But then again, not to blow my own horn? But I have a great deal of knowledge when it comes to investing. I manage risk very well. And to be frank, I know what I'm doing. So I was thinking about it. And thinking about it. And I finally thought? Why not find out?

So I decided, I'm going to run a real experiment. Take $500.00 of my real money, and trade it in separate, but very real accounts, with real trades and investments to see if it can be done, and see how quickly it can be done. And I'm going to do it publicly. I am going to open up sub-accounts, and trade $500.00. I'm a stock investor and trader, as well as someone who trades Futures Options, so that's the route I'll be going.

I've already opened the sub-accounts necessary at Sharebuilder and at Xpresstrade, and they are in the process of being funded. The Xpresstrade account is just a regular sub-account, and the Sharebuilder account is a regular "Individual Account" Once that is done here in the next week, I'll post screenshots of the sub-accounts. These are the rules that I'm going to abide by:

1) The initial investment is $500.00, to be split amongst the accounts.

2) Every month, I can contribute $100.00, that can be split amongst the accounts however I choose. In other words, I can send $30.00 to Sharebuilder, $70.00 to Xpresstrade; or $100.00 to Xpresstrade, and nothing to Sharebuilder, etc.

3) I'll be using regular investment and trade vehicles. Bonds. Stocks. ETF's. Futures Options.

* * *

This is not a recommendation of how to spend $500.00. The losses in trading can be very real, and depending on the investment vehicle, can exceed your initial investment. I am not a licensed trading advisor, or financial planner. But I do have 12 years of experience in trading and investing in these markets. The above experiment will be run for my own education, and education of other traders.

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