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Trading Book Reviews

Book Review: Trading on Corporate Earnings News

[easyazon-link asin=”0137084927″][/easyazon-link]If you’re a stock market trader I think you’ll want to pick up a copy of [easyazon-link asin=”0137084927″]Trading on Corporate Earnings News[/easyazon-link] by John Shon and Ping Zhou. It’s a book that’s focused on short-term options trading, but which could have a fair bit of value to non-options traders and general market watchers as a whole. The authors are a pair of PhDs (Shon is an academic, Zhou a portfolio manager) who really get into the numbers about what stocks do around earnings announcements. It’s interesting and potentially quite useful stuff if you track stocks at all.

Don’t worry about the PhD thing, though. This isn’t an academic paper. The language is very easy to read and there isn’t a bunch of Greek in the text. What they have done is incorporate a considerable amount of academic research (7 pages of references) about earnings forecasts, price performance, and related subjects into a pretty well done discussion which features loads of visuals.

The book starts off by taking an in-depth look at earning surprises, including empirical evidence of how they are distributed and how their patterns have tended to change over time. It then moves on to look at how stock prices react to earnings surprises. I outlined some of their results in Some Numbers on Stock Market Earnings Reactions. The rest of the book focuses on options trading strategies.

By the way, there’s nothing too complicated about the option strategies, so even if you’re not an experienced options trader you shouldn’t have much problem following along with the discussion. There are lots and lots of examples provided and explained. I would have liked to have seen some empirical data on the performance of the strategies outlined, though.

Short-term options trading is not my personal thing, and I was well aware of the different types of options strategies that could be employed for the type of trading the authors discuss in this book. Still, I found it a very worthwhile read for the information presented on earnings estimates and how the markets react to earnings releases. It’s information I could very likely put to use in other ways in my market analysis and trading. From both perspectives I think it’s a good read.

Make sure to check out all my trading book reviews.

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Trading Book Reviews

Book Review: Profiting With Condor Options

[easyazon-link asin=”0137085516″][/easyazon-link]The latest trading book I’ve finished going through is [easyazon-link asin=”0137085516″]Profiting With Condor Options[/easyazon-link] by Michael Benklifa. The author’s bio indicates he “manages millions of dollars worth of condor trades every month for private investors”. I opted to give this one a read because condors have become a common strategy talking point, at least among the websites and blogs I pay attention to on a daily basis. I’ve never traded condors myself, so I figured maybe this would be a good introduction to this options trading approach. I’m conflicted as to whether I want to recommend this book, though.

My first problem with this book is that I couldn’t actually find a definition of what a condor is in the text. I was about half-way through the text when this occurred to me and I flipped back through the earlier pages thinking I must have missed it, but to no avail. There are examples of condors, of course, and from that you can deduce what a condor option spread is, but I never saw it properly defined, which is something you’d think should be a feature of a book like this – one which takes a fair number of pages to talk about option basics.

The other problem I have with the book is that it’s rambling. The author covers a lot of ground, but does so in a rather meandering way. The text is kind of disorganized. I don’t mean the overall structure of the material in terms of content progression. That’s generally fine. I’m referring more to the actual writing, which could have done with some editing to produce a tighter and more focused end project. Instead it’s something that can be challenging to follow at times.

Now, I will say that author does provide a very specific set of rules for trading condors. This is mainly for SPX index options because of their liquidity and tight spreads, but he also talks about individual stock options late in the book when he spends a bit of time addressing day trading. This is probably the part of the book that will be of benefit to most readers, whether they actually use the outlined strategy or not.

I guess the bottom line is that I’m not inclined to recommend this as a strictly educational book for someone totally unfamiliar with the subject. For those looking to get ideas how they could apply condors to their trading, however, there’s probably some value to be had.

Make sure to check out all my trading book reviews.

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Trading Book Reviews

Book Review: Trading Realities by Jeff Augen

[easyazon-link asin=”0137070098″][/easyazon-link]I recently finished reading [easyazon-link asin=”0137070098″]Trading Realities[/easyazon-link] by Jeff Augen. The book was made available to be for free (via Amazon) and I opted to give it a look because it sounded like it was written for new traders. Obviously, the area of new trader education is one I have a lot of interest in. That being the case, I thought it made a lot of sense to check this book out to see if it was worth recommending.

Unfortunately, this isn’t one I’m putting on my recommended list.

I’m not entirely sure what the point of this book was. I think it was to present option trading as a better path for trading the stock market than actually trading the stocks themselves, but I can’t be positive. The author does do a pretty good job of laying out some option strategies that could be used along with or in place of holding stocks, and I definitely agree that for many people they present a better path (I for one have been trading options rather than stocks for quite a few years). That’s just one chapter out of seven, though.

Unclear focus aside, I have a few major issues with the book.

First, there are things he says in the book which are flat out incorrect. One of them is very early on and very obvious for anyone familiar with the currency market. He suggests that during the major dollar weakness a few years ago the Yen reached a value of $1.15. The fact of the matter is that the Yen has never been worth more than about $0.0125 – that one and a quarter cents. This isn’t a horrible error, and doesn’t alter the context of what he’s saying at that point in the text, but it does trigger a credibility warning flags.

A much bigger error, especially coming from someone claiming expertise in options, comes when he talks about price change distributions – an important element in volatility measurement and option pricing. He makes the statement “These values fit a bell-shaped curve where the peak represents a small number of unusually large price changes.” This is totally incorrect. The peak of a bell curve represents a very high frequency of small price changes. I thought maybe he’d just misspoke, but in the same paragraph the author goes on to talk about how the large price spike in Amazon was the peak of the bell curve of that stock’s price change distribution. Anyone who’s ever studied basic statistics would know that to be completely backwards. This definitely challenges his credibility.

Oh, and he talks about price changes in terms of them fitting a standard normal distribution, which has been well documented as being incorrect. Real price change distributions in the market have fatter “tails”, which mean higher probabilities of large price moves than a normal distribution would suggest.

My second issue with the book was the extreme cynicism that dominated most of the first half of the text. The author basically goes off on a rant about things like the impact of high frequency trading, how investors who think they can do a better job picking stocks are fooling themselves, and how the government is lying to us through the statistics it publishes. There are talking points in there, to be sure, but the one example of erroneous stats he show is hardly proof of anything.

Another issue I have is the amount of ex post facto market analysis the author does in the text. At points it’s little more than a history lesson. Sure, there’s always value in going back and reviewing things, but isolated examples of how one should have interpreted developments doesn’t really give the reader a lot they can use moving forward – especially since, according to the author, the individual cannot hope to beat the institutions anyway.

But wait! In the latter half of the book the author lays out directionally based options strategies which imply the trader/investor is looking for the market to move a certain way and can get it right. He also talks late in the book about how modern technology allows individuals to identify inefficiencies in the market, even though he spent pages earlier talking about how the market is efficient and how individuals cannot hope to compete on the technology side with the institutions. In other words, there’s a fair bit of contradiction.

The author has other books on option trading which might be better choices. Needless to say, I’d skip this one.

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Reader Questions Answered Trader Resources

Is The Essentials Of Trading applicable to trading options?

An emailer by the name of Daniel asked:

My question: Is “Essentials Of Trading” applicable to trading options? I was looking at trading options

The answer is yes - in two ways.

The first way my book is applicable to trading options is in the fact that it focuses on the foundational elements of trading in general. At its core, trading options is no different than trading any other market. You need to understand the mechanics of trading, price movement, and tracking your P&L. You need to have a strong trading plan which includes the what, when, where, how, and why of your trading. You need to have a trading system of some sort to determine when to get in and out of positions. You need to have good money management. You need to understand where the psychological pitfalls could trip you up. All of that stuff is discussed in The Essentials of Trading.

The second way my book is applicable to trading options is much more specific. It’s in one of the appendices where I lay out the methodology I’ve used for years trading options on the stock market. I didn’t put it in there to recommend it as a system for everyone. In fact, I’d venture to say most folks wouldn’t be inclined toward using it, but it does present an example of a trading plan and system which employs options that’s well constructed.

If, by the way, you are looking for an introductory book on options trading you should give a look to Mark Wolfinger’s The Rookie’s Guide to Options: The Beginner’s Handbook of Trading Equity Options.

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Reader Questions Answered

Avoiding a Covered Call Being Called

A former classmate of mine from my undergraduate days (he and I were officers for the Finance Club once upon a time) sent me a question about option trading.

I want to get your thoughts on something – A covered call option that I wrote is now at the money with expiration in Jan. I planned to sell it in the new year so this is fine. Logically, it shouldn’t be exercised early but I’m not sure it will hold in practice? So, if the option is exercised early will I have a chance to settle for cash? or buy an offsetting option or the shares? It’s a big gain and selling the shares now means a big tax bill in 2010, that I’d prefer to hold off another year.

Now, I’m sure our derivatives professor will be disappointed that he doesn’t remember all the stuff he learned, but that was nearly 20 years ago, so I think some slack can be cut at this point. 🙂

Just for quick clarification for those not in the know, a covered call strategy is one in which a person holding stock (or futures, etc.) writes/sells a call option against their position. It’s a type of yield enhancement strategy in that selling the option provides a bit of income. Of course there are limitations and caveats. I won’t go too far into them here, though.

The concern of my classmate is about the stock being called from him prior to year-end. The option strike is clearly above his purchase price, meaning were he forced to sell it to the holder of the option he would have a gain to be booked, and thus a tax liability. He’d rather avoid that happening until into 2010.

Now options are very rarely excercised early because it generally doesn’t make sense to do so. The only time early exercise pays off is if there is no time value left on the option, implying the option is trading at or below intrinsic value. That basically never happens.

Of course you cannot be 100% sure an option won’t be exercised, which is my classmate’s concern. The problem, however, is that you can’t cancel out exercise risk all together without buying back that option. He could reduce the prospects for an unwanted exercise by rolling to a further out option and/or to a further out of the money strike, but any alternate strategy would still require buying back the original option in order for the exercise risk to be reduced.

But this does bring up an important point. As traders we often don’t give a lot of thought to the tax consquences of what we do, focusing instead mainly on attempting to generate profits (can’t tax what you don’t make). Sometimes, though, it makes sense to take a look at the tax implications of things.

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Trading Tips

Fighting the Ignorance of Traders Who Claim They Know

It’s ranting time!

There’s a certain blogger out there who’s only purpose for posting (seemingly) is to sell his trading guide, or whatever he calls it. I’m not even sure why I bother to look at his posts. It must be to occassionally get me pissed me off at his hubris and ignorance enough to turn his foolish blathering into an educational post here.

The latest entry (I’m not going to do him the favor of linking to it and helping his page rank) is full of nonsense like this bit here:

There are certain types of trading instruments that I feel should not be peddled. One is the futures market. I’ve never traded the futures but this is a highly leveraged form of trading and it’s just stupid because 99% of all traders who delve into this arena will fail.

There is no market in which 99% fail, so right there he’s killed his credibility with anyone who knows anything – if he hadn’t already done so by saying he’s never traded futures. Yes, the failure rate is high. But it’s also high for his preferred market, which is individual stocks (and it a whole lot of other activities one could get started in).

Read this and remember it well:

Leverage is not the reason people fail in trading. It just punishes more severely those who fail to manage risk.

After relating the story of a trader who ran a small amount up to a large one and right back down, this blogger even makes my point:

It was lack of risk management and money management that made him $4 million very quickly and also the lack of risk management and money management that caused the demise of his account.

That’s the brightest point he made in his whole post bashing all but his favored market.

After he got done with futures he trashed penny stocks and options (for some reason he starts calling people involved in these “mouth breathers”), claiming he particularly hates the latter because buying them is a big scam. Here’s why:

In order to win, you have to get EVERYTHING right – the timing, the magnitude and the direction. The time decay is always eating at your money every single day. Similar to penny stocks, you cannot put too much of your money into one trade or you risk immediate ruin. Putting 1-2% into each options trade means you will need 50-100 great trades (of 100% gain each trade) to double your initial principle. That’s almost an impossible task!

I’m not going to deny that if you want to make directional plays in options that timing is a critical factor. I would contend, though, that magnitude and direction are something which any straight out stock trader has to get right as well. And it’s absolutely true that you cannot put too much money in any one option, just like you can’t put too much in any one stock. We just had the risk management discussion.

As for needing tons of winners to double your portfolio, apparently someone doesn’t really grasp the upside potential for options. It’s nothing for one to double. If you catch the right moves you could be looking at 5- or 10-baggers, and up. Oh, and not everyone is necessarily out to double their money each year.

So what does this braggart trade?

The best way still is trading mid to large cap stocks. They are alot safer than those trading instruments mentioned above. And you can still make huge gains, like I did last year being mostly on the long side in a terrible bear market.

Anyone who’s followed my writings for any time now will no doubt anticipate what I’m about to say.

Safety is not about what you trade. It’s about how you trade.

and…

There is no best market – only the best market for you.

I don’t know this guy’s methodology, and don’t really care. If it works for him, that’s fine. It might work for others as well. I’m going to guess that some options folks would have ideas for ways they could use take that approach and apply it successfully in that market. I know that for the way I trade stocks, options work very well for providing great risk management and expanding opportunities. Again, that may or may not work for others. I do not, however, make any suggestion that my way of doing things is the only or best way. There are a lot of perfectly workable trading methods, and money can be made in any market, though some are clearly better for some traders than for others for any number of reasons.

I hate it when these types of people claim that their market is the only one that makes sense to trade. It makes me want to slap someone upside the head. I don’t care a whit how good their performance is.

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Reader Questions Answered

Minimum Amount Required for Option Trading

How much capital is required to trade is a question which crosses just about every trader’s mind somewhere along the way. It certainly comes up in questions on trading forum sites frequently. I actually got a fairly specific version of the minimum funding questions yesterday by and emailer.

How much is needed to start trading options? What things should I be considering before going ahead?

There are a few general things which come in to play here:

  • How many positions will you have open at a time?
  • What is the price level of the underlying market?
  • Are you trading in, out, or at the money options?
  • Are you doing outright long/short positions, or spreads?

Obviously, the fewer positions you have open the less capital you need. Likewise, if you’re trading options on lower priced underlying markets the price of the options will tend to be lower. For example, an option on a $100 stock is going to be markedly more expensive than one on a $10 stock.

Similarly, there’s a difference in cost, and thus capital needs, depending on whethere you are trading options that are in-the-money (ITM), out-of-the money (OTM), or at-the-money (ATM). ITM options will be the most expensive and OTMs will be the cheapest, and the further away from ATM you get the greater the price differentials.

Finally, if you are doing outright long or short positions your capital needs will probably be greater than if you are spread trading. This isn’t a guaranteed thing, though, as in some cases spread trades can require just as much capital as going straight long or short. It depends on the strategy in question.

Consider the strategy as well
Beyond those basics, there is the need to look as your method of trading and what it means to things like exposure and potential drawdowns. More frequent trading probably, but not necessarily, means a higher capital requirement. That likely depends mostly on how many overlapping positions you’d have, but also takes into consideration transaction costs. They can really chew up an overly small account.

What kind of losses you may take on individual trades makes a difference as well. If you are figuring that you will lose all or most of the money you put into a trade (or potentially more if you’re shorting) then you’ll need more capital than if you normally would only take fractional losses on the options when trades go against you.

You also need to consider your risk of ruin, in a manner of speaking. Basically, that’s a look at the potential drawdowns you could suffer. You have to make sure you’ll never lose enough to keep you from being able to trade any more. That means having enough staring capital to make sure any drawdown that may come about will not cause too much trouble.

Bottom Line
If you’re just getting started in options, stick to one position at a time and one contract in size, and focus on lower priced underlying stocks you could probably begin with $1000 and be assured of at least a few trades to get your feet wet. Once you’re beyond that stage and are set to really make a go at trading options with a decent chance of success you’ll probably want to be working with something