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Trading Book Reviews

Book Review: Broken Markets

[easyazon-link asin=”0132875241″][/easyazon-link]In the retail foreign exchange market there is a long history of complaints about brokers taking advantage of customers to their own benefit. Having now read [easyazon-link asin=”0132875241″]Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio by Sal Arnuk and Joseph Saluzzi[/easyazon-link], I can’t help but think things in the equity market are so much worse. At least in the forex market the types of front-running and conflict of interest activities the book talks about tends to draw the attention and ire of the regulators. In the US stock market, though, this stuff and worse is going on at the hands of high frequency trading (HFT) systems, and it’s largely thanks to regulatory changes that have been made over the last number of years. Not only that, but nothing has really been done to prevent another Flash Crash from happening. At least that’s the takeaway I get from reading this book. It’s an eye-opener.

We’re not just talking about front-running, which was a complaint often aimed at the old specialist system. We’re talking about what information is being provided to which market participants and not to others. We’re talking about the way orders are being routed and how brokers are being paid to send orders to specific exchanges and/or dark pools. It’s no wonder so many individual investors think it’s a rigged game!

Now, as much as there’s a lot of really interesting (and potentially horrifying) information and ideas in the book, it is a text with a clear agenda. The authors are advocates for change – in some cases a reversion back to prior market structures. They make good arguments (and there are copious footnotes), to be sure, but as someone who doesn’t have a deep knowledge of the mechanics and inner workings of today’s equity market, I would personally need to hear from the other side of the debate before forming my own position on specific proposals. That said, the case I have heard made in the media in support of HFT in terms of added liquidity, etc. thus far is not sufficient to overcome the objections presented by the authors of Broken Markets.

As much as this book is a good argument for a change to the system and the need to rein in HFT, however, it gets marks off for how it was written and structured. There is a lot of repetition of ideas and arguments. It has the feel of a book comprised of a collection of articles rather than being something purposefully written. The inclusion of a couple of guest chapters furthers that impression. While I haven’t (yet) read the white papers written by the authors (they are included as an appendix), I get the distinct impression most of the book comes right out of them. As a result, I can’t help but wonder if it wouldn’t be better to just read them and not bother with the book. The white papers can be found on the web, and the authors blog regularly on the HFT subject.

So the bottom line is that [easyazon-link asin=”0132875241″]Broken Markets[/easyazon-link] has a lot of important information and ideas, but isn’t the greatest book because of how that stuff is presented, so I give it a middling rating overall.

Make sure to check out all my trading book reviews.

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Trading Book Reviews

Book Review: Buy Don’t Hold

[easyazon-link asin=”0137045328″][/easyazon-link] [easyazon-link asin=”0137045328″]Buy – Don’t Hold[/easyazon-link] by Leslie Masonson is called a investing book, but I’m tempted to put it in the trading category. It depends on how you prefer to define the difference between the two. The book’s subtitle is “Investing with ETFs using relative strength to increase returns with less risk”.  Using relative strength makes me think trading, but there are definitely elements of the approach outlined in the book which speaks toward what I would probably think of as investing. In any case, as I noted in [easyazon-link asin=”047179063X”]The Essentials of Trading[/easyazon-link], I look at trading and investing as being functionally the same thing, with perhaps a philosophical difference in approach. I’ll leave it to the reader to make their own judgement.

This book is largely a practical text focused on application. The author outlines a very specific strategy for deciding whether the stock market is to be considered in an uptrend, downtrend, ranging, or turning. His “dashboard” comprises a collection of indicators which are very much technical analysis oriented. They include market breadth indicators, sentiment readings, and some basic price studies. The scoring of the indicators provides the user a market reading from which to develop a strategy. From there, Masonson moves on to picking the best trading/investment vehicle based on relative strength readings. In other words, it’s very much a top-down approach.

On the plus side, the author is very good about explaining the various methods he employs in his strategy. He suggests specific tools (most free, some paid, but not necessarily required) and walks the reader through applying things. On the negative side, much of the first third of the book is dedicated to proving how bad an idea buy-and-hold investing is - definitely overkill there – and I thought in general the writing could have been better. Also, while Masonson does demonstrate the value of the dashboard indicators he uses, he doesn’t actually show a good historical look at how the overall strategy would have done. Still, it’s a book which can certainly provide the fodder for research and development for those interested in longer-term stock market trading/investing and/or asset allocation between and among markets.

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Guest Posts Trading Tips

Using Unusual Options Activity to Predict Large Stock Moves

Options have become an increasingly larger focus among stock market traders of late. Recently a question came in from a reader asking “How true is it that this can be used as a leading indicator of underlying stock price movement? Where can this information be found?” My colleague Joe Kunkle focuses a lot on options trading, so I asked him to provide his thoughts.

Along with the use of technical, fundamental, event driven, and other types of analysis, one of the best indicators of future stock price movements is to follow the “smart money”. One of the easiest ways this can be done is by focusing attention on unusual activity in the options market. Many contend that the options market is where the smartest traders are because of the ability to use leverage and the ability to take huge profits with minimal investments.

I will try and explain this, assuming a basic knowledge of the options market and the coinciding vocabulary.

Spotting Unusual Option Activity
Without getting too in-depth, the way to spot unusual activity is through the comparison of call/put volume versus average daily trading volume. There are many web-sites that provide this information for free, and I will list them later. However, simply looking at volume is not all that it takes. I tend to compare the volume in a particular contract versus the prior open interest. If the volume exceeds the open interest you know that new activity (as opposed to closing open positions) is flowing into the contract, and traders are taking their bets. You can also see if the volume was new by looking the next day to see the change in open interest.

A second way to come across unusual options trading is through a backward induction process. Basically, if you see a stock trading heavy relative volume or moving an unusual percentage amount, check the options in the front two months to see if anything catches your eye, and go from there.

Another important aspect is looking for large lots (or blocks) of contracts that are purchased and the time of purchase, and www.LiveVol.com is a very useful tool for this, albeit a 15 minute delay. Large blocks often symbolize that large institutions are trading, and not just every day retail investors.

Is it Option Buying or Option Selling?
Now, once you find the stock trading unusual options volume, and have identified the contract where the “action” is, the next step in the process is to see if the activity is opening buys or sells, and this can be tricky especially with options trading tight spreads. The way this can be done is to look at the Bid and the Ask on the contracts and watch to see where the last trade (paying close attention to trade size) price is, to see if traders are aggressive is selling the option (hitting the bid) or buying the option (willing to pay the offer).

After that step you should have a good idea of what traders are betting on, as for movement in the underlying stock. I personally pay attention to the front 2 months of trading, but some people find success looking further out as well.

News, Events, Data
There is usually a reason for the unusual options action, so pay attention to news releases and upcoming events such as earnings, FDA meetings, investor conferences, etc. I like to combine some technical and fundamental analysis to try and explain the options positioning to see if it looks to be a good bet.

Implied volatility, which can be added to your basic stock charts, will also show when investors are expecting large price movements, and you can use the price that the at-the-money straddle is pricing at to determine the anticipated move in the underlying shares.

Additional Considerations
This method of trading is not sure-fire, but has provided me with some blockbuster trades. In the last year I have been able to predict the demise of multiple financial stocks: State Street (STT), HSCB (HBC), Wachovia (WB), Prudential (PRU), Hartford (HIG), Citi (C), Lehman (LEH) just to name a few. Takeovers like Omrix (OMRI), UST (UST), Corn Products (CPO), Terra (TRA) and many more, the fall-out of the Rohm and Haas (ROH) deal, and various large movements from earnings and guidance announcements have all been spotted ahead of time from the options trading.

One final note: Be Careful and look at the full Options Montage to see if the trading volume is part of a spread trade, a complex strategy, a rollover, etc. This part takes some practice, but identifying call and put spreads becomes easier through time, by looking for eerily similar volumes in various strikes. Also be wary of the intraday stock chart checking for large block trades that could be part of an options strategy, as a hedge (such as a collar trade). Lastly, pay attention to ex-dates on dividends because sometimes heavy option flow comes in for dividend stripping, a strategy for later discussion.

Helpful Option Tracking Tools
Now that I have given you some of the secrets to this method of investing I will provide you with some tools to get started. Before that, please note that I provide analysis of the options market, and highlight anywhere from 10 to 20 trading opportunities daily, along with color regarding not only what is trading and who is trading it, but also why it is trading. I will soon be launching my own site (blog) at www.OptionsHawk.com where I will provide this analysis daily, and the site is currently under construction.

Finding Unusual Activity:

Looking at Historical Options Activity and Average Trading Volumes: