The Best of Louise Bedford’s Articles

Congratulations on purchasing ‘Trading Insights’.

These articles have been compiled from years of writing for Shares
magazine, Personal Investor, Your Trading Edge and a variety of
other publications.

There are droplets of trading wisdom that you won’t find in any of her
books, all presented with humour and a style that will make the
concepts easy to remember.

The best way to navigate around the articles is to use the list of
hyperlinks shown in the Index to go directly to your article of choice
(and the ‘Back to Index’ link at the bottom of each article to return to
the Index).

For more information, about trading, refer to

www.tradingsecrets.com.au and www.tradinggame.com.au

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Index

-Articles on Options and Downtrend Strategies-

1) Getting Started With Options

2) Downtrend Doesn’t Have to Mean Doom
3) Short Selling Strategies
4) Cheap and Nasty
5) The Option Pricing Puzzle
6) 8 Option Traps
7) Volatility Trading
8) Trading Volatile Markets
9) The Naked Truth

-Articles on Trading Psychology-

1) The Art of War

2) Temples of Doom
3) In Your Dreams
4) Know Yourself – the Key to Super Profits
5) Affirmations
6) Avoid Primal Urges

-Articles on Technical Analysis-

1) Relative Strength Comparison

2) Failed Signals

-General Articles-

1) 7 Deadly Sins
2) Pyramiding – House of Cards
3) Position Sizing
4) The Derivative Kicker
5) Handling a Windfall Profit

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-Articles on Options and Downtrend Strategies-

1) Getting Started With Options

Novices tend to overestimate the returns that they can derive from
the sharemarket, yet underestimate the amount of effort that
becoming a successful trader will require. Often influenced by a slick
sales pitch, many naïve ‘hopefuls’ begin trading options prematurely,
to their detriment. Let’s have a look at some of the ways that you can
safely begin trading options.

The Covered Call

The covered call is a simple way that you can generate a solid
cashflow if you currently own shares in the Top 15. This is when you
own the underlying stock and you write calls over it. If you are
exercised (ie you are told to sell your shares at the strike price) and
you have written a call with a strike price (eg $20.00) greater than
your purchase price, you will realise a capital gain on the share, in
addition to the premium (eg 38 cents) that you received for writing
the call. This is the best way to begin trading in the options market.
Only write options against shares that you are willing to sell, or you
will need to take defensive actions to remove yourself from risk
before being exercised.

Bought options depreciate in value. Once you have sold another

trader an option (ie written an option), if all other things remain
equal, the option will expire worthless. You will have the money in
your bank account and the buyer of the option will be holding a
worthless asset at expiry. In fact, up to 85% of people lose money
when buying options.

Let’s have a look at an example. Imagine you own 5000 BHP shares,
and you decide that you would be happy to sell your shares if BHP
goes up to $20.00. You could write a $20.00 call due for expiry at the
end of April and receive a premium of 38 cents. 5000 shares x 38
cents = $1900. If the share price stayed below $20.00 by the end of
April, $1900 would be yours to keep and you would get to hold onto
your shares. However, if the share price was greater than $20.00 by
the end of April, you would in all likelihood be required to sell your
shares for $20.00 per share, but you would still get to keep the
$1900 that you had earned in options premium.

This strategy is suggested for shares that are trending gently

upwards, moving sideways or trending gently downwards. A share
with high levels of volatility is not suited to this concept. At all times
be aware that the premium that you receive by writing calls will not
outweigh the capital loss you will make by holding onto a down-

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trending share. Set your stop losses and stick to them, even if you
have open written call positions over that particular share.

The other concern is that you may miss out on the additional capital
gain that you could receive if the share trended upwards suddenly.
Written calls are rarely exercised prior to expiry (in contrast to
written puts). If your share becomes very bullish, it may be best to
close out your call position. Alternatively, a sound re-entry strategy
to repurchase your uptrending shares may be required. For this
strategy, always choose options that are liquid (ie have large open
interest, or many other buyers and sellers). If you do not deal with
liquid options, it may be difficult to close out your position if the share
trends against your initial view. By consistently writing calls over
shares that you own, you will receive a cashflow similar to receiving a
dividend cheque in the mail every month.

Put Option Writing

A put option writer is of the opinion that a share will be trading in a

sideways band, or bullish in their view. They are under obligation to
buy the shares from a put option taker at the strike price should they
be exercised. You could implement this strategy if you were happy to
buy the share at a certain value below the current market price.

As an example of this strategy, imagine that we wrote an ANZ put

option at $14.00, and the current price was $15.00. We would be of
the view that ANZ would not go below $14.00 by expiry. If ANZ
stayed above $14.00, we would keep the premium that the taker had
paid (eg 20 cents). One contract provides exposure to 1000 shares,
so if we wrote 5 contracts, we would receive $1000 in premium,
providing exposure to $70,000 of ANZ.

There are defensive actions available if the trade does not trend in
the expected direction, however, as an option writer, technically our
loss is unlimited. It is for this reason that monitoring is an essential
component of trading options, particularly for written put strategies.
Never write a put if you have concerns that the share will downtrend,
or if you have reason to believe that we are due for a market
correction. If you do not have a clear view regarding the direction of
the share, do not write or buy options. Do not write more puts than
you can cover if the market suddenly trends downward sharply.

Make sure you have a clear exit strategy in mind before you enter
into any position in the sharemarket. If you have difficulty trading
shares successfully, it would be foolhardy to move into a leveraged
area such as options, warrants, or the futures market. For
experienced traders however, options can multiply the available

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rewards.

Many traders mistakenly believe that a Utopian “Risk-Free” trade

exists - and they spend their lives searching for this elusive goal.
Options do not represent a shortcut to untold profits. As with any
leveraged instrument, options will escalate your speed of failure if
you do not fully understand the principles of analysis, strategy and
discipline.

Back to Index

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2) Downtrend Doesn’t Have to Mean Doom

There is no such thing as a ‘born trader’. Every principle of trading is

learned. It is easy to feel daunted by the jargon involved in the
sharemarket, but with effort you can learn how to trade like a
professional. Professionals make money regardless of the market
direction. Most people know how to make money in a bull market, but
few know how to profit from a bear market. Let’s have a look at some
of the methods that you can use.

Act on Your Stops

Aldous Huxley stated, "facts do not cease to exist because they are
ignored". If you recognise that a bear market is in place, the first step
is to review your existing portfolio. Take a close look at where you
have set your stop losses, and make sure that these levels are
consistent with your trading plan. If your stop is hit, exit immediately.
Do not ‘hope’ that your shares will recover. Traders tend to hold onto
shares that are trending down, yet sell shares that are trending up
prematurely. This trait will ensure that you will stay amongst the
mediocre masses, and never fight your way to the top of the class.

Writing Call Options

There are two types of call options – a covered call and a naked call.
A covered call is where you own the underlying stock. If you are
exercised (ie you are told to sell your shares) and you have written a
call with an option strike price greater than your share purchase
price, you will realise a capital gain on the share. This is in addition to
the premium (eg 40 cents a share) that you received for writing the
call. This is the safest way to begin in the options market. Be aware
that you must only write options against shares that you are willing
to sell, or you will need to take defensive actions to remove yourself
from risk before being exercised. By consistently writing calls over
shares that you own, you will receive a cashflow similar to receiving a
dividend cheque in the mail every month.

If you do not own shares, you can write a naked call. Writing a call
assumes that you have a sideways or downtrending view on the
future share price action prior to the expiry date of the option. As
long as the share price stays below the strike price of the option, then
you will get to keep the full premium that the option taker paid you.
If the share price goes above the option strike price, you are likely to
be exercised, and told to deliver shares to sell to the option taker.
Unless you own these shares, you will be required to buy them at
market value, and then deliver them to the option taker. This
strategy is best reserved for professional traders, or traders that fully
understand the risks involved.

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Bought options depreciate in value, right up until a defined expiry
date. This is called time decay. Once you have sold another trader an
option, if all other things remain equal, the option will expire
worthless. You will have the money in your bank account and the
buyer of the option will be holding a worthless asset. In fact, up to
80% of people lose money when buying options.

Buying Put Options

Writing options involves collecting a small fixed premium, yet

incurring a theoretically unlimited loss. Buying options has a lower
probability of success, yet due to the leveraged nature of this
strategy, the rewards from the 20% of trades that do work, may
outweigh the losses from the 80% of losing trades.
In the options market, as the share price drops, the price of put
options increase, often very dramatically. If you buy a short dated
option, then time decay will erode your profit. For this reason, it is
preferable to buy an option that expires in at least 4 months or more,
and exit before the final month.

Short Selling

Usually when we buy a share, we are hoping to buy it at $5.00 for

example, and sell it at $10.00 at a later date. Short-selling performs
this same process, but in reverse. In effect, you borrow shares that
you do not own, sell them with the expectation that the share price
will drop, then buy them back at a later date. Your profit or loss is the
difference between your sell price, and your buy price – so if the
share price drops, you make a profit. If the price increases, you will
incur a loss. It is actually quite a simple concept, yet less than 1% of
transactions in Australia are executed utilising this method. There are
approximately 300 shares that can be short-sold on the Australian
market.

In the majority of cases, a leverage of 5:1 applies as brokerage firms

usually require you to lodge 20% of the value of the initial share price
in a cash management account. Be aware that you will be margin
called, and required to place more money into this account if the
share price trends upwards, (against your initial view). Remember
that these strategies must be used with shares that have sufficient
liquidity, or you will have trouble extracting yourself from the position
if the market suddenly turns bullish. This is absolutely essential, as
there is nothing worse than being trapped in a trade due to of lack of
volume.

The sharemarket will continue to redistribute wealth to the people

that are determined to educate themselves. Much of our success is

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ultimately determined by the strategies that we implement, as well as
our discipline and mindset. Your financial future is in your hands.

Back to Index

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3) Short Selling Strategies

Short selling is similar to buying a share, only the buying/selling

order is reversed. Instead of buying a stock and then selling it, you
sell the stock first and then buy it back at a later time. In effect, you
borrow shares that you do not own (your full-service broker will
organise this for you), sell them with the expectation that the share
price will drop, then buy them back at a later date. Your profit or loss
is the difference between your sell price and your buy price – so if the
share price drops, you make a profit. If the price increases, you will
incur a loss. It is actually quite a simple concept.

A significant benefit with short selling is that unlike the options and
warrants market, there is no time decay issue. (Bought options and
warrants decrease in value as they approach their expiration date).

The US Market

Many of the texts available on short selling originate from the US

market. There are a few differences between the Australian market
and the US market. The good news is that in many ways, these
differences serve to improve our efficiency as traders, rather than
detract. Although you cannot short-sell online in Australia at this
stage, you at least do not have to wait for an uptick in price to short
a share. The uptick rule means that in the US, you have to place an
order one tick above the last sale. US traders are more likely to have
the trade trend against their initial view, prior to it co-operating and
ultimately dropping in price. It is likely that in the near future, an
online shorting facility will be introduced here, but for now, you must
use a full-service broker in order to short the market.

Contrary to the views of some journalists, you cannot ‘drive’ the

share price downward by short selling. You are not legally allowed to
short sell at a price below the previously recorded last sale price. This
is one of the main execution differences between short selling and the
usual method of merely buying a share. It is also one of the likely
reasons why there has been a delay in establishing short selling as an
online facility. Complications such as this tend to delay programming.
From my understanding, there is no legal reason as to why an online
facility could not be introduced.

Broker Considerations

Some old-fashioned brokers may lead you to believe that you are
required to pay a daily fee to cover their costs, but this practice is
largely being phased out of the industry. Other brokers purport to
only allow short sold positions to be active for a limited time period,
for example 3 days, before they will close your position. This is not an

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ideal situation, and I would question this rule with your broker. It is
becoming more common practice for brokers to enforce deadlines of
3 or 6 months. Unless you can be convinced otherwise, it is likely that
time limits are negotiable. Alternatively, you could close out your
initial position and then reopen it. Unfortunately, you will incur
additional brokerage fees, but if your system suggests that you re-
enter your position, you should follow it.

When you place your order with your broker, make sure that you
stipulate that you want to short sell. By just asking your broker to
‘sell’, it could appear that you are requesting a sale of an existing
share position.

Not all Australian shares can be short sold. A complete list can be
obtained from your broker or from an online broker. There are
approximately 200 shares that can be short sold on the Australian
market, so the field is wide open for you to make money from a
downtrending share. This list varies only to a minor degree on a
month-to-month basis. You cannot short sell any shares involved in a
take-over bid and if you are in a current position with a share
involved in a take-over, you will probably be instructed to close out.

Especially smaller brokerage firms may have difficulty borrowing the

scrip required for you to open a short position, and they are more
likely to enforce a maximum amount of time for the position to be
active. Dealing with one of the larger brokers for this type of
transaction will help you to avoid a multitude of problems that
smaller brokers are likely to experience. A large brokerage firm
should be able to borrow any scrip on their short sell list to enable
you to perform your transaction and there are fewer limitations on
the minimum position sizing and time limits. Some firms require a
minimum position of $10,000 for you to execute a short sold position,
although this varies according to company policy and your own
personal relationship with your broker.

In the majority of cases, a leverage of 5:1 applies as brokerage firms

usually require you to lodge 20% of the value of the initial share price
in a cash management account. Although when you are starting, it is
astute to consider that you have short-sold the entire value of the
share, so that you will not be ‘margin called’. Being margin called
means that you will be required to place more money into this
account if the share price trends upwards (against your initial view)
to maintain the original leverage ratio. Convince yourself that you do
not have this advantage of leverage and that you are responsible for
the entire value of your position (ie the total number of shares that
you have sold, multiplied by their share price). By doing this, it is
unlikely that you will run into difficulties with margin calls. It is
important to know how to trade successfully before you apply any

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form of leverage, as leverage will multiply your results, whether they
be positive or negative.

Remember that a short selling strategy must be used with shares

that have sufficient liquidity, or you will have trouble extricating
yourself from the position if the market suddenly turns bullish. You
will need to arrive at your own rule for liquidity, but as a guide, you
should not open a position in a share where you are trading more
than 1/5 of the average daily volume over the last 3 months. There is
nothing worse than being trapped in a trade due to of lack of volume.

Leveraged Equities

Leveraged Equities have a short sale product called ShortShare. This

is available through most brokers who short sell. Using this method,
there is a slightly reduced list of shares available to short, however
the costs and time limitations (if your short sell broker enforces
them) are reduced. Your broker will charge you their fee, as per
usual, and Leveraged Equities will also charge a small one-off
establishment fee. You have up to 12 months in the position without
further fees. There is a minimum position size of $50,000 which
requires between 15 - 25% of this amount to be lodged in margin. If
you are learning how to short sell, I would suggest that a minimum
position size of $50,000 is far too large, regardless of the level of
capital that you have set aside for trading.

The main advantage of this type of product is that there is no

problem with Leveraged Equities borrowing the scrip (ie shares)
required to perform a short sell transaction. They always have the
stock available because they are holding it as collateral for others
who are long in that stock (ie have ‘bought’ positions). Personally, I
am not certain that this is enough of an advantage to use this
product.

Sometimes the best way to learn about short selling is to try it and
see how you go – ideally with a small position size when you begin.
This will teach you the lessons that the sharemarket is seeking to
reveal to you with amazing clarity. “The distance is nothing; it is only
the first step that is difficult’ – Marie De Vichy-Chamrond (1697 –
1780).

Entry Strategies

To some extent, to enter a short position in the market, all you need
to do is to reverse the entry signals that you would usually use for a
long position. This certainly simplifies your search routines. Here are
some of the signals that you could look for:

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 • A share trading below its 30-week moving average that has
just dropped through support on a bearish black candle.
• A gap downwards during an existing downtrend.
A top reversal pattern of a temporary uptrend, during an
existing, overall downtrend.
• Divergence in a momentum indicator to show a sign of
weakness, prior to entering a short position on a black
candlestick that has punctured an uptrend line.
• A share that bearishly trades below a candlestick bottom
reversal pattern, without responding to its potential to
reverse the trend, could also trigger an entry.
• Consider the sector that the share belongs to. A share that
has been underperforming its sector, in a sector that has
been underperforming the All-Ordinaries Index is preferable.

There are many other patterns that assist in a profitable entry into a
short-sold position. The list is only limited by your familiarity with
technical analysis.

Volume

There is an important difference between my assessment of a high

probability uptrend and a high probability entry into a short sold
position. For an uptrend to commence, I place a significant emphasis
on the importance of heavy relative volume levels. Contrary to this
view, if other set up signals are present but volume is not increasing
during downticks in share price, I am still likely to short sell the
share. It becomes a higher probability trade if increased volume
levels are evident as the share drops in price, but it is not an
essential pre-requisite.

The emotion of fear is much more pervasive than the emotion of

greed or hope. A ripple of fear will spread very quickly throughout a
market. It only takes one small stone to begin an avalanche. It only
takes one seller at a price below the current market value to create a
selling frenzy.

Exit Strategies

Consider the term of your view regarding the strength of the

downtrend, prior to determining an effective exit strategy. Traders
with a medium term view can attribute a wider stop to their positions
and be prepared to weather the discomfort of several periods of
counter-trend reversal. Shorter-term traders may find that their short
sold positions are closed out within just a few days. Stops can be set
utilising any of the same methods used to exit a long position, only in
reverse. Examples of stops may include:

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 • A break upwards past a resistance level.
• A top reversal pattern of a temporary uptrend within an
existing downtrend, that fails.
• 2 or 3 ATR above the point of entry
• A technical indicator that has provided a bullish signal

Position Sizing

Position sizing for a short sale can follow the same principles that you
apply to your long positions. You will also need to decide whether you
are comfortable pyramiding into your position if it continues trending
downwards. Some traders take full advantage of their leveraged
situation to pyramid very aggressively to short sold positions.

The Implications of Dividends

A good knowledge regarding the implications of dividends while short

selling is essential. Make sure you check the dividend status of the
company that you are trying to short sell, prior to entering into a
position. Occasionally a brokerage firm will absorb the dividend
payment, especially if they are insisting upon a daily fee to hold the
position open. Most firms will make you pay the dividend out of your
account, as well as any franking credit benefit that may be derived to
cover the tax implication. This can be an unexpected shock for the
newcomer to the shorting market. As a suggestion, when you are
learning to short sell, don’t short anything where the underlying
share is due to pay a dividend, or you may end up being responsible
for the amount of this dividend, plus any associated franking credits.

One strategy that you could consider is short selling a share that is in
an existing downtrend, after it has gone ex-dividend. This will help
you to avoid any of the consequences of being ultimately responsible
for the dividend, while capitalising on the additional momentum that
an ex-dividend gap may provide in favour of the existing downtrend.

For shares in an existing downtrend, a gap downwards may act as a

trigger to open a short position. A gap that drops through a
previously well-established level of support is a particularly bearish
signal. Pay particular attention to the trend of the share prior to the
presence of a gap, and trade in line with the direction of the trend.
The lead up to the gap, and whether it is confirmed by subsequent
trading activity must be taken into account if you are to trade
effectively using this method. With knowledge about how to short the
market - you need never fear a bear market again.

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Review

1. Define short selling.

2. Describe a signal that would be likely to trigger your entry into a

short-sold position.

3. How do you plan to exit your short-sale position?

4. How does an ex-dividend situation effect the share price action? If

there was a fully franked dividend of 26 cents declared on a share,
what would be the likely share price drop when it went ex-dividend?

Answers

1. Short selling is similar to buying a share, only the buying/selling

order is reversed. Instead of buying a stock and then selling it, you
sell the stock first and then buy it back at a later time. Your profit or
loss is the difference between your sell price, and your buy price – so
if the share price drops, you make a profit. If the price increases,
you will incur a loss.

2. This is a personal decision, but any bearish chart pattern, preferably

within an existing downtrend could trigger your entry into a short-
sold position.

3. Exits can be made on the same basis as the signal required to exit a
long position, only in reverse. For example, you could use a volatility
stop loss, a pattern recognition stop, or a bullish technical indicator.

4. An ex-dividend situation will often create a bearish gap in a chart. If

a fully franked dividend of 26 cents is declared, the share price is
likely to drop approximately 39 cents ie 26 cents + (0.5 x 26c)

Back to Index

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4) Cheap and Nasty

It is an inbuilt instinct for people to hope. Cheap options, just like

Tattslotto, feed into this delusion that you could be an overnight
millionaire with no skill required. The slight probability of winning is
overcome by the small amount of money required for a Lotto ticket,
and this seems irresistible and worth the gamble.

In the options market, you will not get rich because of some lucky
break. It will take hard work and discipline before those elusive
profits find their way into your bank account.

Novice buyers of options are particularly attracted to "cheap" options,

which ironically have little probability of appreciating. This helps
explain why a vast majority of option buyers end up net losers in the
market.

In terms of risk/reward and probability, buyers of low-priced options

make a trade with a low probability of success, where the rewards are
high and the risk is minimal.

Why are they cheap?

Traders often buy options that have nominal time to expiry, which
means that their bought asset is depreciating like a time bomb. Most
options expire worthless and are only ever traded once. People don't
like to be "wrong". They would rather sweep their bad trade under
the carpet, along with any remaining value that they could claim by
closing out their position, than confess that the trade didn't work.
There is no room for this type of ego in trading.

Often, naive traders underestimate the strength of a move required

to affect the price of the option. These unfortunate souls believe that,
even though BHP may have increased by only 10 cents in a month, it
could potentially jump $10 within three days (when their option
expires). Magically, BHP should recognise the brilliance of the trader
with the deal in play and co-operate!

The concept of delta and gamma becomes extremely important in

this situation - but, rather than learn what these terms mean and
how to use them, overly optimistic traders would rather just place
their orders and take their chances.

Delta measures the sensitivity of an option price to changes in the

share price. Gamma measures the curvature of delta, so it can act as
a precursor indicator when to exit a position. For advanced option
plays, these two "greeks" or "option sensitivities" can greatly assist

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your chances of extracting a substantial profit.

When you next see that amazing bargain option at two cents, ask
yourself why it is that price. Maybe there is a reason that you haven't
explored. Perhaps you are about to buy an option that is actually
worth that small amount, not an option that has been mistakenly
under-priced by market dynamics.

Brokers

Brokers receiving commission based on the number of contracts you

buy - rather than your overall exposure - may urge you to buy cheap
options with a short time before expiry because they make more
money. This way, they convert your trading capital to brokerage with
lightning precision. Don't rely on your broker to guide you in this
arena. Stand on your own two feet and take responsibility for your
future by educating yourself about options, and identifying trades
with a higher probability of success.

There is much less risk on the part of the broker when dealing in
bought positions in comparison to written positions. Written positions
contain contingent liability. This requires careful monitoring by both
the client and the broker to eventuate in a profitable trade.

Alternatively, your trading account can be loaded up with bought

positions without the need for close monitoring. With bought options,
the worst thing that can happen is that you will lose everything you
placed into the trade -you can't lose your house. This is much simpler
for brokers to monitor, and has the side benefit of their not ending up
behind bars for inaccurate suggestions that led to their client's
financial collapse.

Buying at or in the money options with two to four months to expiry

will often seem like a more expensive trade, but it is much more
likely to eventuate in a profitable trade.

Written positions

When I first started writing naked options on NAB, I reached a

startling conclusion. I was presented with two choices. I could choose
to write five close-to-the-money option contracts, where I would
seemingly take on more risk as the share price could easily break
through my strike price, or I could write 28 option contracts that
were miles out of the money, yet receive the same amount of money
overall. For a brief moment, I thought I was completely brilliant!

Can you see the problem with writing more contracts but receiving
the same amount of money in total? If you can't see the problem with

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this, stop writing options immediately! I have one word that you must
learn about before you progress: EXPOSURE.

By writing many more cheap option contracts, it seems as if your

trade has a higher probability of success. However, what happens if a
huge announcement is made, or if the share price goes ballistic? Your
exposure is completely blown out of the water! Rather than being
liable for 5000 NAB, I would have become responsible for 28,000 NAB
if the trade had backfired. Yikes!

When we begin our trading career, we are strong, brave and

bulletproof. The market had better not cross us. Unfortunately, the
trading world doesn't work this way, and often the market will
provide a proverbial kick to our soft underbelly to ensure that we
don't repeat our past errors of being too cocky.

Back to Index

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5) The Option Pricing Puzzle

Many factors have an impact on the price of an option or a warrant. It

is crucial to understand these to determine whether these
instruments represent "fair value" to trade. These factors also affect
the cost and timing of the defensive actions that you may take if the
trade turns against you.

Rather than provide you with a revolting array of mathematical

formulae, we will show you some general principles that affect the
premium value of options and warrants.

Pricing models are available to help calculate the theoretical premium

value of these instruments at specific strike prices. Some are
available online, and require you to enter in a few basic details such
as the strike price, share price and interest rates. A difficulty with
these models is if the derived price is not backed by market support,
we have gone to a lot of effort to calculate a figure that is largely
useless. We prefer to let the market dictate the "fair value" based on
the following concepts:

Degrees of risk

As a rule, the greater the risk, the greater the potential reward. This
definitely holds true when referring to the sharemarket. The closer
the strike price of the option or warrant to the share price, the more
the inherent risk, and the greater the premium price. If you do not
understand the ramifications of in-, at- and out-of-the-money strike
prices, you need to do more research.

A call option/warrant is in-the-money when the share price is more

than the strike price. A put option/warrant is in-the-money when the
share price is less than the strike price. Option/warrant buyers will
pay greater premiums if the option is in-the-money, but this equates
to less risk. If you are intending to write options, this means that you
will receive a greater premium if you write in-the-money or at-the-
money options, but you are exposed to much more risk.

At-the-money options/warrants show the strike at about the same

price as the share value.

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 Options strategies

Conservative Aggressive
out-of-the-money at- and in-the-money
WRITE
calls and puts calls and puts
in-the-money at- and out-of-the-money
BUY
calls and puts calls and puts

Out-of-the money instruments show the reverse of the conditions

required for in-the-money positions. If you are an option writer, out-
of-the-money options represent a more conservative trade with less
reward, but also less risk. Buyers with an aggressive nature will buy
out-of-the-money instruments for a low price and high rewards, but
with less probability of success. Apprentice buyers of
options/warrants are particularly attracted to "cheap" out-of-the-
money options, which have very little probability of appreciating.

Buying strategies have a lower probability of success than writing

strategies, yet due to the leveraged nature of bought positions, the
rewards from the 20 per cent of trades that are profitable may
outweigh the losses from the 80 per cent of losing trades. A quick
reality check, however - only experienced option traders can achieve
these results. Despite popular opinion, it is still a tricky proposition to
profitably buy options and warrants. Complete at least one year of
trading shares successfully before you even attempt to trade these
instruments.

If you want to follow a conservative strategy, buy in-the-money

options/warrants and write out-of-the-money options (see table).

Delta

Delta measures the sensitivity of option price to changes in share

price. For example, if a call option delta is 0.7, for every one dollar in
share price increase, the option premium will increase by 70 cents.
(Put option deltas are expressed as negative figures.) Therefore, if we
buy an option that is worth 70 cents, we will approximately double
our money when the underlying share increases in price by one
dollar. The delta approaches one as the instrument becomes deeper
in-the-money.

Share volatility

The more volatile the share, the higher the premium price. A simple
way to see the effect of volatility is to have a close look at a share
chart. The days that have higher volatility or candlestick length are
the days that attract a higher premium. Choppy shares with greater

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distances from the peak to the trough of the share price action are
more volatile and will attract higher premiums. For shares with a
lower volatility level, the option/warrant premiums will also be lower.
Although this description is simplistic, it can provide you with a basis
of understanding why some shares attract vastly different premiums
than others.

In volatile conditions, options and warrants become more expensive.

This information feeds into a calculation called historical volatility. If
the market expects future volatility to increase, this affects a statistic
called implied volatility. The effect of implied volatility was apparent
after the events of September 11. Not even the market makers could
accurately predict the future, so option and warrant prices went
ballistic. This was because the implied volatility spiked in a dramatic
way. Uncertainty about future market conditions tends to drive the
prices of options and warrants upward.

Volatility strategies can be implemented more effectively in the

options market than the warrants market, as warrants tend to be
written at high implied volatility levels. Warrant trades involve a
directional bias, rather than a volatility bias. This actually makes it
more difficult to make money using bought warrants as a vehicle in
comparison to a correctly aligned volatility bought option trade.
If your understanding of this concept is a bit foggy at this stage, you
will need to educate yourself so that you can trade fairly priced
instruments based on volatility, not just expected future direction.

Time decay

The longer an option has until maturity, the greater the time value
reflected in the price of the premium. For example, a July
option/warrant will incur a higher premium than a June
option/warrant. Options lose value at an ever-increasing rate as they
move towards the expiry date (when all
else remains equal, such as the price of Option Time Decay
the share, volatility and so on).

The graph at right refers to the entire

life of an option. As is evident, the
Price

closer the option is to expiry, the more

steeply the curve slopes. The time
decay curve is flat at the beginning of
an option's acceleration downwards as
it nears the expiry date of the option. Time
As a buyer of an option/warrant, it is
prudent to buy an option with at least two to three months' expiry.
For writers of options, this time decay curve provides a greater
degree of encouragement to write shorter-term options so that the

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buyer will have bought a rapidly depreciating asset, rather than a less
dramatically depreciating asset.

Other influences

There are many other influences to option pricing. Although it is

interesting to consider these influences, when you are starting to
trade options it is not essential to analyse them all. It is not even
necessary to understand every definition in order to trade options
effectively. I find that if I get too sidetracked with details, I miss
many trading opportunities.

Other factors affecting option prices are:

Theta - the sensitivity of option price to the passing of time

Gamma - the sensitivity of delta to changes in share price

Vega - the sensitivity of option price to a change in share price

volatility

Iota - the sensitivity of option price to interest rate changes

Clever young players sometimes try to jump into the deep water of
trading with leverage, without sufficient knowledge about how to
trade more conservative instruments successfully. With enough
bravado, even the most stupid of us can convince ourselves that we
can outwit the market. Good luck to you if you hold this attitude. We
wish you the best of luck when the debt collectors start knocking on
your door.

Trading options and warrants is designed to add spice (and additional

returns) to the lives of experienced traders. Your trading habits and
results will be the best guide to whether you should start trading
options and warrants. Successful trading relies on developing your
skills over time, so don't feel pressure to dive headlong into using
leverage if your ability does not match your ego.

Back to Index

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6) 8 Option Traps

Consistent sharemarket winners have a series of strategies for rising

markets, but they also know how to benefit from a sideways or
downtrending share. If you can make money regardless of the
direction of the market, you have guaranteed yourself an income that
will last as long as you keep trading. This skill ensures that you will
be able to effectively trade any market around the world, as long as
you know the rules of the stock exchange. Your longevity and
security will be assured.

Many naive traders begin trading with leverage prematurely, often to

their detriment. Trading a leveraged instrument will multiply your
results. But, if you are not already trading proficiently, leverage will
only speed your demise. However, if you are already a skilled trader,
then using derivatives and leverage may be worth investigating.
Learn about options, warrants, futures and short-selling so you will
be better placed to make money in all market conditions.

A quick review

Options and warrants are very similar tools. There are traders who
write call or put options, and traders who buy call or put options.
Warrant traders can only buy to initiate the trade. Buying options and
warrants has a lower probability of success than writing options, yet
due to the leveraged nature of this strategy, the rewards from the 20
per cent of trades that do work, may outweigh the losses from the 80
per cent of losing trades. You will need to make your own assessment
regarding which strategy you should engage.

Other forms of leverage include short-selling and futures. Short-

selling is similar to buying and selling the physical share, but the
order of the transaction is reversed. Short-sellers look to sell to
initiate the transaction and aim to buy back the share at a lower
price, locking in a profit. Futures traders deal in standardised
contracts that do not experience time decay, and can benefit from
upwards as well as downwards movements.

The table below describes the market moves required by traders of

different strategies in order to profit.

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 Strategy Market Trending Up Market Trending Down

Buy Shares

Short Sell

Buy Call Options

and Warrants
Buy Put Options
and Warrants

Write Call Options

Write Put Options

Trade Futures

Let's have a look at the mistakes that many traders make when using
leverage and derivatives.

1. Not analysing the share price direction

Would you like to make money in the sharemarket beyond your

wildest dreams? Trade in the direction of the overall trend and
you'll be amazed at the results. This sounds obvious, but in reality
you'll probably spend the rest of your trading life trying to achieve
this goal.

There are two main rules in the sharemarket - if it is trending up,

buy it. If it is trending down, sell it. When you add derivatives into
the picture, this ends up being a little more complicated.
If the instrument is trending upwards over the time period that
you are interested in trading, you can buy a call option/warrant,
write a put option, or buy the physical share. If the instrument is
trending downwards, you can buy a put option/warrant, write a
call option, or short-sell the share. Futures contracts can be used
with any of these trends.

All of these leveraged strategies involve trading with the trend. Be

rule-oriented but maintain a degree of flexibility and adapt to
changing market conditions.

The nature of the derivatives market means that you will need to
get used to "thinking on your feet". Share traders may make a
decision each week, but with derivatives, depending on your

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 trading style, you may need to make several decisions every day.
This adds to the complexity of this style of trading. If you are not
up to the task, there is no harm in refining your skills in shares
and then returning to leveraged instruments when you are ready.
The first time you come into contact with any particular trading
scenario, it is likely to make your adrenalin pump at a furious
rate. The key to controlling your emotions is to think about every
conceivable scenario in advance and to plan your actions in
meticulous detail.

2. Underestimating the role of volatility

There are two broad categories of analysts who trade derivatives.

There are traders who use volatility to determine the types of
trades that they are likely to enter, and there are traders who
focus on direction. A successful strategy is to combine these two
methods and trade using a hybrid approach. To ignore either
direction or volatility will not enhance your profits.

Choppy shares with greater distances from the peak to the trough
of the share price action are more volatile and will attract higher
derivative premiums. For shares with a lower volatility level, the
option/warrant premiums will also be lower. Although this
description is simplistic, it can provide you with a basis of
understanding why some shares attract vastly different derivative
premiums than others.
Volatility strategies can be implemented more effectively in the
options market than the warrants market because warrants tend
to be written at high implied volatility levels. Warrant trades
involve a directional bias, rather than a volatility bias. This
actually makes it more difficult to make money using bought
warrants as a vehicle in comparison to a correctly aligned
volatility bought option trade.

If your understanding of this concept is a bit foggy, you will need

to educate yourself so you can trade fairly priced instruments
based on volatility, not just expected future direction.

3. Only analysing direction when trading derivatives

Trading with leverage can be complicated. So many traders

assume the derivative will behave in the same way as the share.
If this is your belief, then your wake-up call may be in the shape
of massive losses. Trading derivatives relies on a greater level of
skill than that possessed by the average share trader.
Most traders only look at "direction", but options require a
consideration of several additional components that share traders
do not require knowledge about, such as:

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 • Dividend knowledge.
• Knowing the correct type of derivative to trade.
• Understanding the implications of time decay.
• Effectively analysing implied and historic volatility.
• Being aware of the importance of liquidity.

Many traders buy out-of-the-money options/warrants and write

in-the-money options. They allow their bought option/warrant
positions to expire worthless and have no idea about how to set
an appropriate stop-loss. They write long-dated options and buy
short-dated options/warrants, and have little understanding about
how to control their risk levels. This is the opposite approach to
that of the professional derivatives trader.

If you are not familiar with these terms, give yourself some time
to learn about the importance of these concepts.

There is no harm in paper trading to establish your foundation of

knowledge, before you jump headlong into some of the more
complicated methods of trading. It makes sense to bide your time
and invest in your own education.

4. Searching for the totally 'risk-free' trade

Many traders mistakenly believe that a utopian "risk-free" trade

exists - and they spend their lives searching for this elusive goal.
No risk means no reward. Derivatives do not represent a short-cut
to untold profits. As with any leveraged instrument, options and
warrants will only escalate your speed of failure if you do not fully
understand the inherent principles of trading successfully.

5. Dealing in illiquid instruments

If a trade turns against us in a liquid position, we can usually find

a market to buy back our option so that we can "close out" our
position. This is not the case if we deal in illiquid derivatives. We
may want to escape from the trade, but there may be no market
available for us to exit our position. This is a terrifying situation.
Save yourself from unnecessary stress by refusing to deal in
illiquid instruments.
6. Using strategies that are too complex

Because derivatives represent a more sophisticated trade, many

people believe that this will lead to a greater chance of success.
Don't delude yourself into thinking that just because something is
complex, it will make you money. Often the simplest ideas and
strategies are the most effective.

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7. Letting your losses run

If you do not know how to set a stop-loss, then for goodness

sake, stop trading immediately. An initial stop-loss is designed to
preserve your trading capital. A breakeven stop will help lock in a
no-loss trade. A trailing stop-loss will assist in preserving your
profits. Learn how to set a stop and then follow it. If you can keep
investing in the markets for long enough, you are bound to learn
the secrets about how to succeed. There is no such thing as a
"born trader". Every principle of trading can be learned.

Develop a ruthless quality when it comes to taking a loss. To

quote author and chairperson of the US Strategic Learning
Institute Chin-Ning Chu: "The killer instinct is not solely reserved
for the vicious and cunning; it can benefit the virtuous and
righteous as well".

If you lack discipline in being able to take a loss, you may have
difficulty trading in the derivatives market. Trading with leverage
is not for everybody. Recognise your own strengths and
weaknesses and be prepared to maximise your strengths. If you
struggle with the application of discipline, perhaps stay with tools
that are not quite as leveraged, such as shares. There is no
shame in this.

8. Inadequate money management

Having conducted many courses on trading, I can usually assess

how much experience participants have in the market based on
the questions they ask.

As a trader matures, the questions they ask tend to involve

psychology. Ultimately, traders evolve to conquer the final
frontier... money management.

I dare you to go boldly where few traders have gone before.

Separate yourself from mediocrity. Consider position sizing, stop-
loss procedures and capital allocation based on risk. Here are
some basic guidelines to ensure that you don't get blown up while
frolicking in the financial jungle.

Commit a maximum of 20 per cent of your total equity to higher

risk sectors of the market as well as derivative trades. As an
example, with a trading float of $100,000, $20,000 can be
devoted to speculative shares and derivatives. This will allow you
to maintain a maximum of four to five lower risk positions and up
to three to four speculative shares. This will still provide exposure

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 to potential high returns, without the potential to devastate you
financially if the market does not co-operate with your view.

Before you enter a trade, determine where you will exit if the
market turns against you. If you only permit a loss of a maximum
of 2 per cent per position of your capital base, even a string of
losses won't destroy your equity.

Your number one goal in the market must be preservation of

capital. When traders have learned how to consistently make
more money than they lose, they enter the realm of the
professional trader.

Successful traders are among the most highly paid professionals in

the world, yet many beginners in the market expect to earn the
income of a brain surgeon without undue planning and effort.
Profitable trading does not rely on luck. It demands the highest levels
of skill and discipline.

Your trading habits and results will be the best guide to whether you
should start trading options/warrants, short-selling or trading futures.

Summary of the Eight Trading Traps

1. Not analysing the share price direction

2. Underestimating the role of volatility
3. Only analysing direction when trading derivatives
4. Searching for the totally 'risk-free' trade
5. Dealing in illiquid instruments
6. Using strategies that are too complex
7. Letting your losses run
8. Inadequate money management

Back to Index

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7) Volatility Trading

Amateur traders are a predictable bunch. Most seem obsessed with

finding the magic indicator/software/set-up that will help them
become a monumental success. In sharp contrast, professional
traders form a view and back that view, using a variety of strategies
most suited to the markets at that time.

Let's imagine that you have formed a view on News Corp (NCP)
shares. You think that, by the end of October (two months from the
time of writing), it will rise by 10 per cent from $10.50. We can use
this view to add specifics to some potentially profitable strategies.

NEWS CORPORATION (NCP)

2002

(Please note that this is a hypothetical example; good traders don't

give tips and they don't listen to tips.)

After you have completed your analysis, you will need to work out the
appropriate strategy to use in order to profit from your findings. You
will need to decide which vehicle is best to make money from your
observations - for example, shares or derivatives.

These are some of the strategies you could choose:

Buy the share

Most technical analysts tend to follow a trend. For trend-followers,

there are a few simple rules. The first rule is that if a share is
trending up, buy it. The second rule is that if it's going down, sell it.
There are some traders who continually try to trade against the
prevailing trend. People who trade against the trend will ultimately

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run out of money and self-destruct.

Using the above chart, if you purchased NCP at $10.50, for example,
and sold it three months later at $11.55 (10 per cent higher), you
would make 10 per cent return on your initial investment, minus
brokerage costs and such. This equates to an annualised return of 40
per cent, which is substantial. When we apply some leveraged
strategies, it is possible to enhance this return even further.

Buy a call option/warrant

Buying options is often similar to a Tattslotto ticket mentality. Novice

buyers of options are particularly attracted to cheap options, which
have little probability of appreciating. Although the chance of winning
Tattslotto is minuscule, millions still gamble on it. The slight
probability that you will win is outweighed by the small amount of
money needed for a ticket. This reasoning helps explain why the vast
majority of option buyers end up net losers in the market. Buyers of
low-priced options enter a trade with a low probability of success
where the rewards are potentially high.

If the call option buyer's view is correct, however, and the share
increases in value, they can either sell the option at a profit, or if they
choose, exercise their rights. They have the right to purchase the
writer's shares at the strike price (which will represent a lower-than-
current market value). Most players in the options market do not
exercise their rights. They sell their options if their position has co-
operated to experience a capital gain. The bulk of options are only
ever traded once and then left to expire worthless.

Strategies
Strategy Pros Cons

Easy to execute
Buy Shares Lack of coverage
Easy to understand

Buy a Call Terrific for strong moves

Confusing to novices
Option/Warrant Excellent income potential

High probability of Limited income but

Write a Put Option
successful trade unlimited liability

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If you are looking to buy an option there are a few simple rules to
follow:

• Buy an option with a significant time until expiry. This will

help minimise the negative effects of time decay.
• Always exit your bought position before the final stages of
expiry. An option close to expiry will incur exponential time
decay, sweeping away your capital at an alarming rate.
• Buy an option that is in the money, which by definition will
not be the cheapest option available. Betting that NCP will
go up by $10 within two weeks is not a high-probability
trade.
• Buy an option that gives the share a bit of room to move,
just in case it does not co-operate immediately. If you do
not fully understand the implications of in, at and out-of-
the-money options, do not buy them.
• Do not buy options if you do not understand the impact of
delta and volatility on option prices.
• Bought option positions work well as a short-term trade. If
this perception matches your view, but this time horizon
does not suit your trading style, do not buy options.
• Only buy (or write) options that have sufficient levels of
liquidity.

Using our hypothetical example of NCP rising 10 per cent in three

months, you could choose to buy a $10 November call option for
$1.29. This is slightly in the money, and provides you with reasonable
relative open interest and a suitable delta of 0.61 (at the time of
writing). The implied volatility is relatively low, which suggests that
the option is undervalued and would be suitable for an option-buying
strategy. So, by buying a November $10 call option, you would
expect, based on this delta, that the option would be worth $1.93 by
expiry - an option price increase of 64 cents. In reality, you would
probably close out your position by the end of October to avoid the
last month of dramatic time decay. This represents a 49.6 per cent
return on investment in three months, or an annualised return of
198.4 per cent.

Although it is unlikely that you will achieve these terrific returns

consistently, the occasional extremely profitable trade can be
essential to a professional trader's survival.

Another strategy that you could consider either separately, or in

addition to buying a call, is to write a put option.

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Write a put option

A put option writer either thinks that a share will be trading in a

sideways band, or is bullish. They are under obligation to buy the
shares from a put option taker at the strike price, should they be
exercised. You could implement this strategy if you were happy to
buy the share at a certain value below the current market price. You
could also write a put if you were of the view that NCP would not
penetrate a certain price within a certain period. Most written
positions are taken out with three to six weeks before expiry, so you
could use this strategy at least twice within our three-month view.

Trading Terms
Implied volatility - This is the value that you would derive after plugging all of the
variables into an option pricing model (underlying price, days to expiration, interest
rates, and the difference between the option's strike price and the price of the
underlying security).
Historic volatility - This describes volatility observed in a stock over a given period of
time. It is the standard deviation of share price changes over a particular time period
which will match the time until expiry of your option.
Delta - Measures the sensitivity of the option price to changes in share price.

Option pricing factors - Effective option trading requires a consideration of several

additional components that share traders do not require knowledge about. Factors that
can influence the price of an option include direction, type of option, time decay,
volatility and strike price.

As an example of this strategy, imagine that you wrote an NCP put

option at $9.00, and the current price was $10.50. You would be of
the view that NCP would not go below $9.00 by expiry (within five
weeks). If NCP stayed above $9.00, you would keep the premium
that the taker had paid. In this case, using the option pricing current
for this period, you would be paid 40 cents from the option buyer.
Assuming you repeated this trade in the subsequent month and
earned a similar premium, you would earn 80 cents in total per share
per contract that you wrote.

Do not write more puts than you can cover if the market suddenly
trends downward sharply. For example, in the NCP example
described, if your contingent liability is $100,000 (that is, 11
contracts), it would be prudent to have enough cash or shares at
hand available to cover this level of exposure.

So in keeping with your view that you expected a 10 per cent rise in
NCP in the short term, you could choose to buy the share, buy an
appropriate call option, and/or write a put option. Each strategy has
unique advantages and drawbacks that you need to evaluate before
entering a position. There are also many defensive strategies that

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you could implement if the share did not co-operate with your initial
view.

As well as knowing appropriate strategies, it is also essential to

understand which strategies would not be effective, given a bullish
view. These include writing a call option, buying a put option, or short
selling the share. Each of these strategies would be trading counter to
your view of the potential trend, and they are unlikely to be effective
if the market moves in this bullish direction.

Even though these strategy examples provide some ideas about how
to make money by backing your view, the trading world is not so
clear-cut. Unfortunately we are not given crystal balls as soon as we
decide to become share traders.

Successful technical traders have a defined set of rules to enter a

share, and to exit from the market promptly at the first sign of a
downtrend, or to preserve their capital after the share or derivative
has retraced in value. They maximise their profit potential through
dedication to the principles of money and risk management.

Back to Index

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8) Trading Volatile Markets

I have a challenge for you. Call up any three share charts at random.
Take a few minutes and write down your observations. I can almost
guarantee that you will spot an over-riding similarity. (Yes, I’ve been
practicing my skills with amateur clairvoyance).

I can bet you that each of the three random charts, have one major
thing in common. In the current market (late 2002), almost without
exception, share charts seem to be displaying vast levels of volatility.
Peak to trough drawdowns are entering the ‘extreme danger’ area.

Many traders have found that they have been getting stopped out of
their long positions, as well as their short positions prematurely,
despite the share continuing in the expected direction after they have
exited. Previously easy to read charts which showed ripples of calm
directional activity have erupted into tidal waves of undisciplined
violent share price action.

If you’ve been getting stopped out regardless of the direction you’ve

been attempting to trade – you’re probably ready to jump off the
proverbial cliff, especially if you have any grain of emotional
attachment to your bank balance. Take heart. Help is on its way.
Here is how to survive and thrive in the current trading environment.

1. Set Stops Carefully

The golden rule of trading is: ‘Keep your losses small and let your
profits run’. Stop losses provide a sign that it is time to exit your
position, as the trade is no longer co-operating with your initial
view. Every successful trader has pre-meditated the point of exit,
prior to entering the trade.

You may remember that there are several methods available to

set a stop loss. Volatility and pattern-based systems tend to work
well for short-selling, or trading shares. Hard dollar stops are
terrific for option/warrants and futures positions.

Pattern based stops are a very popular way to set a stop loss.
When the share is no longer trending upwards, exit your position.
An appropriate exit can be made if the share’s price closes below
a trendline or below a support/resistance line.

Volatility is a measure of movement, not a measure of direction.

Shares can be heading in an overall direction upwards, or
downwards, but this general direction is characterised by dramatic
peak to trough drawdowns. This is typically characteristic of the
current market that we are experiencing.

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 Volatility based stops imply that you should to exit your position
when the volatility of the instrument increases dramatically, or
beyond a pre-defined level. To assist in this goal, an indicator
called Average True Range (ATR) can be utilised. For an exact
definition of the ATR indicator, refer to the glossary in the FAQ’s
at www.tradingsecrets.com.au.

A simple definition of ATR is the move in cents that a share could

reasonably be expected to make during a particular period. On a
daily chart, it shows how much the share price is likely to go up or
down in a day. It typically shows a figure compiled from the last
15 – 20 days price activity. You may choose to exit if the share
goes up (for short positions), or down (for long positions) by
greater than a multiple of 3 or 4 times ATR. For example, if the
ATR is 10 cents, and the share goes up by 30 cents, you could
exit your short position. A drop in share price of 30 cents, would
suggest that you should exit your long position.

During volatile periods, set a wider stop loss. Otherwise you will
exit your position only to see the share continue in the expected
direction, without your involvement.

A hard-dollar stop can be effectively utilised for bought

options/warrants, or futures. For example, when you’ve lost a
maximum of 2% of your allocated trading equity in any particular
trade, exit that position immediately. You may decide to exit when
your position has a drawdown of $1000, for example.
Alternatively, for a trailing stop, you could exit when the option
has pulled back your equity $500 from the maximum profit peak
that you had attained in that position at any time. This is an
effective method of controlling your losses, and letting your profits
run. A wide initial stop, but a tighter trailing stop tends to be the
best strategy in the present market conditions.

2. Learn How To Trade Long and Short

I moderate a trading forum for traders where members can ask

trading questions and receive answers (located at
www.tradinggame.com.au ). Recently I was asked a question
regarding searches. A particular trader was wondering whether he
should loosen up his search parameters as he could not find any
shares to buy that fitted his criterion. Previously, he had identified
numerous opportunities. However, in the current market he was
struggling to find two or three potential positions per month.
Obviously he was frustrated.

Can you see the problem with applying more liberal searches

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 during periods of volatility? By changing our trading system to
supposedly more accurately reflect market conditions, sometimes
we just end up kidding ourselves about the calibre of opportunity
available.

If your trading system is telling you to buy shares – you

should buy them. If your system is suggesting that it would be
more effective for you to sit on the sidelines and not trade due to
insufficient opportunities in the market, ignore this advice at your
own peril.

Alternatively, learn how to recognise a downtrend. Reverse the

parameters of your usual searches. Use an option or short sold
position to capitalise on your observations.

3. Use Margin Wisely

I recently had lunch with a trader who could be characterised as a

bit of a ‘cowboy’, but had managed to generate a good trading
plan and consistent profits without the benefit of margin. From
the first few minutes of the conversation, I knew that he had a
problem. He excitedly explained to me about a new online system
that he had discovered that allowed him to trade long and short,
using minimal margin to open substantial positions. The
conversation went something like this:

“They only want to take 20% margin from my account to open

any position. Oh my gosh – do you realise what this means… I can
leverage myself up to the hilt! I can open up as many positions as
I want. My $100,000 will allow me to trade up to $500,000 worth
of shares! I’m going to be rich!!”

Now, at risk of bursting his bubble, I decided to curb his

enthusiasm, (lest he couldn’t afford to pay for his own coffee –
the next time we wanted to meet).

Too many traders decide to position size based on the margin that
they are requested to deposit, instead of the total exposure of
their position. If you do not immediately recognise the drawbacks
of this rationale, you owe it to yourself to work through this
example.

Let’s say that your system suggests that you can short sell
$15,000 of a particular share, but your broker only requests a
20% margin. The logical thing to do would be to reserve $15,000
in your equity account, and give your broker $3000 in margin to
open your position. (Brokers require a margin in order to open
short sold positions and written option positions). Imagine that

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 you had identified a $4 share that you wanted to short sell. This
means that you could short sell 3750 shares at $4, which equates
to a total position size of $15,000 (even though the broker is only
going to take $3000 in margin).

If the share did not co-operate, then at least you would have the
remaining $12,000 of liability available at a moment’s notice to
answer any potential margin calls. This is a conservative
approach. It works. It means that you won’t end up losing your
house if the market ricochets upwards against your position with
meteoric speed.

On the other hand, you could consider the $15,000 that you have
available for this trade to be the margin. Rather than only selling
$15,000 of the share, now you could short sell a position size of
$75,000! Yikes!! Instead of short selling 3750 shares at $4, you
would now short sell 18750 shares! Think of the implications of
this move. It is five times the exposure of your original
calculation. It leaves no room for error, and opens you up to the
threat of a very nasty margin call that you are unlikely to be able
to cover.

The current market chews up and spits out non-conservative

traders with ruthless efficiency. Position size based on the position
itself, not the margin required to open your position. Only use
leverage when you have developed your skills as a trader. If you
insist on doing otherwise, your career as a trader will be short-
lived, but spectacular.

4. Limit Contingent Liability Positions

Writing naked options involves collecting a small fixed premium,

yet incurring a theoretically unlimited loss. This is the meaning of
contingent liability. Written naked option can surprise novices with
their effectiveness to deplete trading equity.

Many traders are attracted to this concept because the chances of

success of this strategy are high. Approximately 80% of options
are only traded once and never exercised. On the surface, this
sounds like a great chance to make money. When you look at the
risks involved however, which contain contingent liability, this
strategy should be left to sophisticated traders.
With any position that has the ability to wipe out your bank
account within one foul swoop, apply caution, limit the number of
this type of position, as well as limit position sizes.

To trade ‘spreads’ in options, it is essential to understand both

sides of the transaction – both buying and writing options. By

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 spending some time learning about these types of strategies, you
can work out creative ways to minimise your risk and maximise
your profit.

Trading during volatile times can multiply your rewards. Take

advantage of this trading environment, but remember to use
caution and common sense.

Back to Index

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9) The Naked Truth

Novice traders often take on incredible levels of risk without realising

the consequences of their actions. This can lead to a short career in
the sharemarket. Professional traders tend to quantify the risk
involved in any strategy, weigh up the rewards and make an
informed decision as whether to engage the market.

One of the most common questions asked is whether a trader should

write naked options. Naked options involve a high probability of
receiving a limited reward in return for an unlimited level of risk.
They imply that you are selling to initiate an option position where
you do not own the underlying entity. In the right circumstances,
writing naked options can be the ideal strategy. However, if you get it
wrong, the consequences can be dire. There are several factors to
consider. Let's review ways you can limit your risk.

Pricing factors

Many factors have a large impact on the price of an option. It is

critical to come to an understanding of these factors to determine
whether these instruments represent fair value to trade. These
factors also have an impact on the cost and timing of the trading
tactics you may consider implementing if the trade turns against you.

Some of the main factors determining the price of an option are:

• The level of risk - the greater the risk, the greater the
potential reward. The closer the strike price of the option is
to the share price, the more the inherent risk, and the
greater the price of the premium.
• The level of volatility - in general terms, the more volatile
the share, the higher the premium price. Choppy shares
with greater distances from the peak to the trough of the
share price action will attract higher premiums. For shares
with a lower volatility level, the option/warrant premiums
will also be lower.
• This information feeds into a calculation called historical
volatility. If the market expects future volatility to increase,
this affects a statistic called implied volatility.
• The time to expiry - the longer an option has until maturity,
the greater the time value reflected in the price of the
premium.
• Other factors such as delta, gamma and interest rate
fluctuations also have an impact.

If the naked option trade I am considering does not provide an ideal

combination of all of these factors, I walk away from using this as a

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strategy for that particular instrument. There is no point in entering
into an option trade that contains unlimited risk unless the set-up is
ideal. The risk must justify the rewards.

The perfect combination that would encourage me to write a naked

option rather than employ an alternative strategy would be where the
option had a limited time to expiry in a highly liquid share and option
series. Ideally, the volatility set-up would suggest that the option is
over-priced and likely to decrease in value. Comparing the implied
and historical volatility levels will assist you in this quest. Before
plunging into writing a naked option, also consider the expected
strength of the move.

If a strong move downward is expected, writing a call does not often

represent significant profit potential. It will result in a small fixed
profit, regardless of the strength of the ensuing move in the expected
direction. Another choice would be to buy a put option or short sell.

If a strong move upwards is expected, then writing an unprotected

put position will not capitalise on this. Alternatives would include
buying the share or buying a call option or warrant.

Alternatives

There are several other methods you can implement that do not
involve writing naked options.

Covered calls

One way to learn about the options market is to write "covered" call
options over shares you own. When you write options, you receive a
small, fixed amount of money because you are selling to initiate the
transaction.

The risk with written covered call options is that if the share increases
dramatically in price, beyond the strike price of your written option
(the level at which you wrote the option), it is likely your shares will
be "called away". When you write a call option, you are under
obligation to sell your shares to the option buyer, which is usually
enacted if the share price exceeds the strike price.

If you are exercised and the strike price is above the initial price you
paid for the share, you will experience capital gain of the share as
well as keeping the premium from selling the option. By writing these
covered calls, you are making your portfolio work hard. Writing a call
will bring in some regular income in particular circumstances.

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Many traders have found that by implementing this strategy, their
returns have safely increased, and that the additional cashflow has
been a welcome contrast to awaiting dividend payments. If you want
your blue-chip portfolio to return an extra 5 to 15 per cent per year,
this may be the strategy for you.

Credit spreads

The concept behind some of the most effective credit spreads is that
you limit your downside risk by "covering" your written position in
some way with a bought option position. Written straddles and
strangles also fall under the banner of credit spreads, but we will
save the discussion of these concepts for another time.

An excellent text to enhance your knowledge of these types of

strategies is Chris Tate's ‘Option Trader Home Study Course’,
available through www.tradinggame.com.au

A call bear spread involves writing a lower strike price call and
buying a higher strike price call with the same expiry date. This is
usually written out of the money, above the share price action. It is
profitable if the share stays at the same level or drops in price.

Some people think of the bought position as being a form of

insurance against a catastrophic loss. Any potential loss is
quantifiable and known in advance, so provides a degree of
consolation to the trader.

The payoff diagram in Fig 1.1 shows the construction of this option
spread. A call is sold at A and a call is bought at B.

Fig 1.1 – Call Bear Spread

The reward is limited to the credit received, so it is probably not the

ideal strategy if you expect an explosive move to the downside. For
explosive moves you could short sell, or buy a put option. This
strategy will not benefit from a change in volatility either, because
you have both a written and a bought option position.

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If the share price moves up, this will damage the position, so you can
use an effective stop loss in order to recoup some of your investment.
This is often a more effective alternative than letting both positions
expire.

A put bull spread is where you sell a put option, and then buy a put
option with the same expiry date, at a lower strike price. This is
usually written out of the money, below the share price action. Share
price action that moves sideways or upwards will lead to profit in this
situation. This strategy yields a credit and limits your downside risk
by capping your potential loss.
The payoff diagram in Fig 1.2 shows the construction of this option
spread. A put is sold at A and a put is bought at B.

Fig 1.2 – Put Bull Spread

Both this strategy and the call bear spread benefit from a rapid loss
in time value. Traders who implement these strategies will benefit
from a gradual progression in price, rather than dramatic or volatile
directional price movement.

Call bear spreads and put bull spreads are of advantage to new
option players because they give them a capacity to write options but
with a risk management component built in. Along with covered calls,
they represent a great learning ground so that you can learn the
basics without exposure to unlimited downside potential.

Index options

When trading some instruments, such as index options, sometimes it

seems almost impossible to avoid the possibility of writing naked
positions. In order to limit your risk in this situation, remember to
employ an effective stop-loss procedure, and to use a spread to
mitigate potential disaster.

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Some of the spreads that you could implement involve a call bear
spread or a put bull spread as shown in the pay-off diagrams.

It would be foolhardy to write puts under an index without some form

of protection such as a put bull spread. Any severe drop in the index
would involve an unlimited potential for disaster. Several traders
totally eradicated their last five years' worth of profit by ignoring this
risk before the September 11, 2001 index corrections around the
world. By building a put bull spread, they could have limited their
downside risk, yet still backed their view.
As James Rogers states in Market Wizards by Jack Schwager: "Be
very selective. Never trade for trading's sake. Have the patience to sit
on your money until the high probability trade sets up exactly right."

This attitude will ensure your longevity in the markets and give you a
chance to develop profitable strategies.

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-Articles on Trading Psychology-

1) The Art of War

Sun Tzu was a military genius who wrote a classic treatise entitled
The Art of War. The principles in this ancient text are relevant
whether you are planning a military coup, aiming for success in the
boardroom, or desire to excel as a trader. The fact that his ideas
were expressed approximately 2500 years ago ensures that these
concepts have stood the test of time. Let’s have a look at some of his
key concepts and apply these to assist our trading results.

1. “Possessing the ability to calculate the difficulties and danger is a

basic requirement for a good general"

Your number one goal in the market must be preservation of capital.

If you have not evaluated the risks involved, you should not take the
trade. Effective money management skills allow you to quantify the
worst-case scenario before engaging the market.

2. “To be prepared beforehand for any contingency is the greatest of

virtues. The degree of success depends upon the extent of
planning for the anticipated victory"

• Meticulous planning – Before engaging in battle, you have

already won the war.

• Careless planning – Before engaging in battle, you may

have already lost the war.

• No planning – Your defeat is certain.”

Traders who work to a written trading plan stack the odds in their
favour. The market is a more efficient, bigger and scarier opponent
than you have ever faced in your life. You cannot defeat it unless you
‘out-think’ and ‘out-plan’ it.

3. “You need to strengthen yourself and prepare yourself mentally to

be the target of attack.” "Know the enemy and know yourself and
in a hundred battles, you will never be in peril"

The more knowledge that you can muster about the market, the
more likely you will be to succeed. Trading favours the strong of
mind.

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4. “Those who carefully calculate their strategies will be led to
victory. Those who carelessly calculate their strategies will be led
to defeat”

One of the key trading strategies is to let your profits run, and cut
your losses. Unfortunately, the majority of traders have this rule
around the wrong way. They become risk-seeking when faced with a
loss, yet risk-averse when a trade is profitable. Sometimes the old
wives tale of “you'll never go broke taking a profit” or “leave some
thing on the table for the next person” comes into play, and they exit
the trade pre-emptively. It is difficult for traders to obey the rules of
trading because their own psychology often defeats them.

5. “Within the universe, there are no eternal conquerors”

You are only as good as your last trade, so the killing you made in
the tech boom is no longer relevant. Even the bravest among us have
learned that “Out of orderliness comes chaos. Out of courage comes
cowardice. Out of strength comes weakness.” You cannot afford to let
your guard down, or you will suffer the consequences.

6. “When the victory is not certain, adopt defensive tactics. When

the odds for victory are overwhelming, adopt offensive tactics”

One of the key premises practiced by effective traders is to ‘trade

with the trend’. If we are experiencing a bear market, this requires
different tactics in comparison to bull market strategies. Make sure
that your trading is consistent with the overall market environment.

These principles have been utilized throughout the ages to build

effective strategies and enduring victory. If you use them properly,
they will bring you success in the trading arena. Profitable trading
does not rely on luck. It demands the highest levels skill and
discipline, and lucratively rewards the people who develop these
qualities.

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2) Temples of Doom

There are three things that we need to achieve happiness in life;

someone to love, something to believe in, and someone to blame
when things go wrong. Enter the share market guru…

Cashing in on these major needs, this dashing species has all of the
hallmarks of success. A rags to riches story that is difficult to verify,
the ability to arouse emotion previously only realised in religious
cults, and a sound message: “If I can do it, you can do it”. This
combination of popular psychology and extreme promises
hypnotically encourages us to pay copious amounts of money for
seminars - in pursuit of share market happiness. Yet, since the bull
market decided to grow claws, these gurus have taken on some nasty
characteristics. Just like sharks, confined to a fishpond, they are
gnashing their teeth and showing signs of aggression. To encourage
seminar attendance, they are making outrageous advertising claims.

How to Spot a Guru

The flowing swami robe has now been replaced with an Armani suit.
Here is a list of indications that your share market trainer may have
their heart in the wrong place. Be wary if they tell you:

“You’ll make returns of greater than 70% per year”.

A quick reality check… Ed Seykota is one of the greatest traders in

the world. Ed could practically buy the small island of Australia with
his vast bank balance, but he only makes returns of 60% per year.
(No – this is not a typing error). Unrealistic benchmarks will sell a
seminar, but they will set you up for catastrophic losses. What makes
you think that you can outperform Ed?

“I’ve been trading for the last 3 years”.

Don’t confuse brains with a bull market. The worst traders can make
astounding profits if the market conditions are right. Find someone
that has weathered a few share market crises and knows how to
make money out of a downtrend. Three years is a blink of an eye in
the context of the share market.

“I make profits 80% of the time”.

This is a ridiculous yardstick. Most good traders will talk more about
their losses and the lessons they have learned, in comparison to their
profits. This is not just a case of admirable humility. The share
market has a way of punishing those with inflated egos.

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“Here is a no-risk strategy.”

The search for the no-risk trade has achieved Holy Grail status in the
share market. Novices believe that it exists. Professionals know that
it doesn’t. If there is no risk, then there is no reward… simple as that.

“Entry is the key.”

Money management includes position sizing, pyramiding, stop losses

and trade management. These aren’t sexy topics, and won’t sell a
seminar – but they do separate the professionals from the mediocre
masses.

Natural selection dictates that for a particular characteristic to evolve,

it must be ‘attractive’ to those we seek to impress. We have no one
to blame but ourselves. The gurus have emerged because we have
encouraged them to do so. In our desperate and pathetic pursuit of a
higher authority, we willed them into existence. Unfortunately, the
guru of yesterday is the despised charlatan of today.

There is no short cut to trading success. You will need to stop relying
on fairytales and begin trusting your own written trading plan. The
best traders have read widely, sparingly attended high quality
seminars, and been discerning when it comes to listening to other
traders. Don’t blame the guru for your trading results – they only had
power over you because you allowed them to.

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3) In Your Dreams

Once upon a time there was an intelligent guy with movie-star good
looks. He traded the stockmarket for a year and then, at the age of
42, left his job as a NASA astronaut to be a full-time trader. In his
first six months, he made twice his usual salary and laughed merrily.
Then he took a two-year holiday on his fabulous shiny yacht in the
Mediterranean, with a harem of beautiful, scantily clad girls half his
age. Trading was so much easier than he had ever expected...

Quick reality check - this is a fairytale. It will not happen to you.

There is a popular myth that trading is more like a trip to the fun
park than a job. I hate to burst your bubble, but trading is a precise
and somewhat boring activity, where decisions are made long in
advance of any contact with the market. The world's best traders
realise this, and they plan with meticulous care. This approach may
not appeal to those who believe that trading should be frantically
yelling "buy" or "sell" to your broker on a mobile phone while
admiring the upholstery on your new Porsche.

Trading has a way of forcing you to bare your soul. It will make you
come face-to-face with your inadequacies. The stockmarket tends to
highlight all of your flaws while minimising all of your strengths.
Sounds like visiting your mother-in-law, doesn't it? Only the
persistent and emotionally strong will ultimately achieve trading
prowess.

You'll also need a significant tolerance for following a routine

mechanical system. Only traders who define their plan and re-
evaluate it consistently can hope to make consistent returns.
Before you quit your job or business to be a full-time trader, you
should consider how you would handle the isolation. There may be
times when you will want to dial 000, purely to hear the sound of
another human's voice.

Some people also have trouble organising their time, especially if

they are used to being kept on a tight leash by an employer. To get
incredible trading results, you must commit an incredible amount of
work.

To create a business-like profit, you cannot treat trading like a hobby.

The best investment that you can ever make is in yourself. If you
look at successful people from all walks of life, you'll see that this
philosophy acts as their common denominator. Trading follows this
principle to the letter.

There are benefits to full-time trading. If you are successful and

consistent with your approach, you can catch up on the sleep that

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you missed over the past decade and reacquaint yourself with those
small beings that share your household, commonly known as your
children.

On about the third day of full-time trading, you may even come to
the realisation that day clothes are completely unnecessary. Pyjamas
are a much more comfortable trading attire and because the market
doesn't open until 10 in the morning, you can sleep in without fear of
being late for work.

Trading is more like a marathon than a sprint. If you're out for the
glamour of the quick dollar, your hard-earned capital will quickly be
redistributed into the hands of the professional traders.

Back to Index

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4) Know Yourself – the Key to Super Profits

Just imagine that you have the opportunity to have lunch with the
most successful trader in the world at a lavish restaurant. As you
prepare to meet this living legend of the sharemarket, there are
many thoughts running through your mind. You know all about the
history of this incredibly skilled individual and you are in awe of his
outstanding list of accomplishments. Such a unique opportunity! You
will no doubt be the envy of your trading friends. What is the first
question you would ask?

Take a minute to think about it… don’t rush in… this could perhaps be
the most defining moment of your trading career to date. Generally
when presented this scenario, there are three broad types of
questions that traders tend to ask. The type of question that they ask
tends to define their experience and expertise in the market. Novices
to the sharemarket usually ask questions revolving around indicators
and entry signals. They seem totally focussed on determining the
ideal set-up which will give them confidence to pull the trigger and
engage the market.

Their questions may include:

• What moving average do you use?

• What is the effect of dividend yield on future share price
action?
• What is the calculation of the Stochastic indicator?

These types of queries tend to dominate 90% of the question time of

any seminar that I have run. Some never progress beyond this level,
even though they may have been trading for years.

Once a trader has moved beyond their fixation with entry, indicators
and set-ups, it will dawn on them that money and risk management
is a very important concept. How to handle risk, position sizing and
setting stop losses then become a focus.

Questions may include:

• How do you set your stop losses?

• Do you handle highly volatile shares differently from the Top
20?
• What percentage of your capital do you allocate to each
market that you are trading?

Traders asking these types of questions are well on the way to

developing a level of professionalism that very few traders achieve.
At last these traders have come to the realisation that entry is a

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minor determinant of a trader’s profitability. The novice refuses to
acknowledge this fact and insists on pursuing an area that is almost
irrelevant to experienced traders.

Evidence such as this suggests that entry decisions and indicator

selection have little to do with your ultimate success in the
sharemarket.

There is a small but sophisticated group of traders who have moved

beyond these two broad categories of questions. These veterans have
usually had many years of experience in the market, and come from
the school of hard knocks. They have come to realise that an
individual’s mind-set, and their psychological make-up will be the
ultimate determinant of a trader’s success.

Questions asked by this group include:

• How do you maintain a sense of detachment from the

market?
• How do you handle a windfall profit?
• After you have made a loss, what do you do?

Most professional traders would be able to teach you to trade their

system in about 2 hours. Why then do so few go on to achieve
profitable results, even after being taught by some of the best minds
of the trading world? It is because the majority of people are not
instinctively set up to trade. There are very few naturals in the
trading world. Successful traders have had to learn how to trade and
how to handle the inevitable losses that will ensue.

Ed Seykota’s achievements rank him as one of the best traders of all

time. In times of trading pressure, I find it useful to remember some
of Seykota’s wise thoughts; “There old traders and there are bold
traders, but there are very few old, bold traders”. When asked for
some of the main contributors towards his success, he states that “I
handle losing streaks by trimming down my activity. Trying to trade
during a losing streak is emotionally devastating. Trying to play
“catch up” is lethal. Win or lose, everybody gets what they want out
of the market. Some people seem to like to lose, so they win by
losing money”.

There are two main traits that Seykota looks for to identify the
winning trader personality:

1. He/she loves to trade; and

2. He/she loves to win

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Those who want to win and lack skill can find someone with skill to
help them, but they must have the desire in the first place.
By working on your system for engaging the market, you are only
taking the first two steps towards developing skill. 95% of traders
never seek to improve their overall mindset, and as a result
inadvertently deprive themselves of extraordinary profits. These
profits are achievable only to the 5% of traders who are prepared to
get out of their comfort zone and work on their own innate
deficiencies and acknowledge their personal strengths. The first step
is to develop your self-awareness. Your level of financial success will
rarely exceed your level of self-development.

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5) Affirmations

Have you ever wondered what sets professionals, in any walk of life,
apart from the mediocre masses? A key factor is self-belief. But if you
weren't lucky enough to be born with a high belief in your own
abilities, there are still ways that you can cultivate this enviable
quality. Affirmations can help you towards your goals.

An affirmation is a short, positive, powerful statement that you repeat

on a consistent basis. Many of our actions are guided by our self-talk
and our subconscious. The conversations we have in our minds can
either encourage or discourage success habits in the sharemarket.
Affirmations can block out those nagging voices that sometimes
prophesy failure, and substitute positive thoughts in their place.

According to many professional psychologists, affirmations can

reprogram our subconscious patterns and lead to a higher level of
success in any field. From my experience, I believe sharetraders can
receive these benefits as well.

Here are some guidelines for setting affirmations. Those brave

traders who have written some affirmations down may wish to alter
just a few words to have them gain more impact.

Step-by-step guide

1. Have a specific goal in mind.

2. Write it down once a day, 15 times in a row, using this type

of format for at least one week:

"I (insert your name here) will get/do/accomplish ...

(whatever the goal is)."

"I (insert your name here) am an exceptional trader. I

follow my trading plan every time I trade."

You could also emotionalise the statement and speak about

the goal as if it has already happened. The more emotional
you can make it, the more vivid the impact on your
subconscious. For example:

"It feels great to have achieved ... (insert goal here)."

"Every time my stop is hit, I exit calmly and decisively."

3. If you have imposed a time-frame for your goal, make sure

you are being realistic with your desires. For example,

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 winning the next 400 metres Olympic freestyle event is
hardly practical if you can barely dog-paddle.

4. Don't state that you "want" something to happen (your

subconscious already knows this), or that you will "try". You
are already trying. Make the statement concrete and
positive.

5. Write down your affirmations on flashcards and tape them

to your mirror or carry them with you to read while you wait
for appointments. Combine reading the affirmation with an
everyday routine, such as cleaning your teeth. If you find
you're no longer reading the cards after a few weeks,
rewrite them on cards of a different colour. Alternatively,
add some new ones or alter the others slightly to maintain
your interest in the task.

An example

Here is a statement by a fellow trader:

"I must believe in myself and my judgment if I expect to make a

living from trading." He believed it was an affirmation, but a few
alterations are required to make it more effective.

To change this into an effective affirmation, he could state:

"I make an exceptional living from trading and I believe in

myself"

or

"I make such a good living from trading because of my judgment

and self-belief levels"

or

"I choose to trade for a living and I believe in myself."

You have the power to alter your levels of self-belief. Affirmations can
help you achieve the goals that you desire.

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6) Avoid Primal Urges

Our instincts helped get us out of caves and into centrally heated
homes – but can they help us become better traders?

Imagine you are one of our primitive ancestors. The world is a

frightening place. Virtually everything is bigger, faster, hairier and
stronger than you are. The only advantage that you have is your
ability to think… but thinking is of little value in a life or death
struggle.

Risk-Seeking

Suppose that you are out hunting in the primeval forest when
suddenly, a vicious predator leaps out from behind a tree and
attacks. The only behaviour that will offer any survival advantage is
to attack, and become risk-seeking. To run would only invite an
attack from behind, as your predator is superior in speed.
This is the same behaviour that traders exhibit when faced with a
growing loss. The evolutionary behaviour is to attack, to hold onto a
trade, or to average down by buying more. It does not matter that
the trader is faced with losing trade rather than a sabre tooth tiger.
We feel psychological pressure to become risk-seeking. The
sharemarket does not reward this impulse.

Risk-Averse

Let’s return to our primeval scene and imagine that this time you
have come across a bounty. It may be a fruit tree, or a fresh animal
carcass. The instinctive behaviour is to grab as much you possibly
can, stuff your mouth full and then run. There is likely to be
something lurking in the bushes, waiting to attack you.
Profitable traders go against their own instinctive pressures. When a
trade goes against them, they become be risk-averse and instantly
exit. They become risk-seeking when a trade is profitable by
pyramiding and adding more money to their position.

Unprofitable traders follow their instincts and let their losses run, yet
cut their profits short. By giving into their own biology, they deplete
their bank account.

Classification

In ancient times, decisions had to be made rapidly, with limited

cognitive input. Is the movement in the bushes simply the wind, or is
it something more sinister? The only thing that would ensure survival
was a snap judgment. We often feel compelled to transfer this
primitive level of thinking to our trading.

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The popular belief is that trading is a series of instant decisions made
in the hostile environment of the market. Effective traders plan with
meticulous care and consider every aspect of their trade before
committing their capital. They do not make rash statements such as
“BHP is a good share”. (The implication is that good shares do the
right thing and go up). This is a primitive classification made by very
primitive behaviour.

Gossip

Traders love to listen to gossip and rumour. This is also an

evolutionary behaviour. In primitive tribal communities, gossip was
the only form of news communication. Those who understood this
were able to secure a competitive advantage. Sweet talking cavemen
impressed the women, and rose up the political hierarchy of the clan
- so this behaviour was passed on from generation to generation.

The desire to listen to gossip and rumour (or to search for the next
big tip) is hardwired into us. We are programmed to respond to it. As
traders, it is totally meaningless as a form of behaviour and
effectively works against us.

In trading, our own evolution has conspired against us. The

behaviours that in the past ensured our success have, in essence,
guaranteed that the majority of people will never excel. The only way
to overcome this is through self-awareness. Trading is not about
‘feeling right’ - it is about making money.

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-Articles on Technical Analysis-

1) Relative Strength Comparison

There are two broad approaches that consistently locate shares with
a high probability of trending upward. (Simply reverse all of the
signals discussed to identify shares with a high likelihood of trending
downward.) Of critical importance is the concept of relative strength.

The RSC

The relative strength comparison (RSC) takes the progression in price

of one instrument and compares it to another. A share may be
trending upwards, but in comparison to the All Ordinaries Index, it
may not have been performing as well as the other shares
represented. If a share or Sector displays a positive relative strength
in comparison to the All Ordinaries Index, this share would have, in
effect, been outperforming the index.

The ultimate aim is to identify shares that have been outperforming

their sector, in sectors that have been outperforming the All
Ordinaries Index. This is the goal of Top Down analysis. As a
minimum, it is wise to purchase shares that have at least been
performing more strongly than the All Ordinaries Index. These shares
can be identified via Bottom Up analysis.

Top Down Analysis

Top Down Analysis involves relatively comparing each Sector Index

with the All Ordinaries Index. Once these Sectors have been
identified, the next step is to find the stocks in those sectors that are
outperforming their respective Sector Index.

If the sector has been trading positively in comparison to the All

Ordinaries Index for the past 5 weeks, this is a positive bullish sign.
This will lessen the chances of a sector performing well for only a
limited period of time, prior to collapsing back into under-performing
the All Ordinaries.

Have a look at www.tradingsecrets.com.au for the current Hot

Sectors. Here is an example of a chart that shows RSC:

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 CONSUMER STAPLES

RSC – ALL ORDS

Bottom Up Analysis

Bottom Up Analysis involves searching for shares that are

outperforming the All Ordinaries Index, regardless of which market
sector they belong to. Review these shares to seek entry signals
using other technical indicators such as candlesticks, momentum
indicators and volume.

Even though the RSC analysis is a powerful tool, it will only identify
which stocks to focus on, not when to enter. It should always be used
in conjunction with other indicators to determine timing of entry.

Back to Index

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2) Failed Signals

by Louise Bedford & Chris Tate

As traders, our search for trading opportunities usually begins with a

positive expectation. We may look for instances where price action
confirms our perceptions of a move. These can be tools such as using
various oscillators, moving average cross-overs or chart patterns.

But what happens when the signal we were expecting fails to

materialise? In this situation, most traders simply move on and look
for another signal. This is a mistake, as the failure of a signal to
eventuate is a powerful trigger. This reversal away from your
expectation is known as a failed signal.

The failed signal is among the most powerful and reliable signal in
technical analysis. By recognising these failed signals and acting
appropriately, you can profit. This holds true whether you use
instruments such as futures, shares, short-selling, options or
warrants.

Bull and bear traps are breakouts that are followed by a sudden
reversal of sentiment. This sudden reversal of sentiment is often
indicative of major highs or lows.

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Bull traps

ADOBE SYSTEMS

MACD

VOLUME

Consider the Adobe Systems graph. The price had been making a
recovery from a September 2001 low and had entered into what
appears to be a classic congestion, or a "Stage 3 formation",
according to Stan Weinstein's classic text Secrets for Profiting in Bull
and Bear Markets. Stage 3 is characterised by a sideways progression
at the top of a trend prior to a share price decline. Towards the end
of this formation, price gaps upwards, out of this sideways band, and
makes a new four-month high.

Ultimately, the high fails to hold and the price drops back into the
congestion zone, meanders for a few weeks and then collapses.
During the collapse, the share price more than halves.

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In trading this style of formation, we have the following time line:

1. Price enters a congestion zone. The high and low of the price
action defines this zone.

2. Price then tries to break to the high side of the congestion zone
with only a modest increase in volume. This is one of the major
clues that a sustained bullish break is unlikely. A significant
increase in volume would have been a major bullish sign.

3. The failure to sustain a break to the high side is now a set-up

condition. The price has tried to set a new high and failed. This
failure indicates a change in psychology.

4. A trigger to enter a position is given by a break to the downside

and the share price halves. You could enter a written call
position, a bought put position, or a short sale. Price direction
and volatility should guide your decision.

Bull traps are not usually obvious until it becomes apparent that a
move to the upside has failed. However, there are a few warning
signals that can alert the astute trader to their formation. The
breakout has a minimal increase in volume, thereby conveying a lack
of commitment to the move by traders. In addition, the MACD is
demonstrating a bearish divergence.

Bear Traps

Bear traps are exactly the opposite of bull traps. They indicate that a
new low is in place. As such, the methodologies used to interpret and
act upon them are the same. Consider the Coates Hire graph.

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COATES HIRE

VOLUME

The price breaks to a new low under moderate volume, only to

reverse back into the congestion. As this move unfolds we can predict
with a certain degree of confidence that a new low is in place. This
new low and reversal are now a set-up condition, and the trigger is
given by the break to the upside. The use of a failed signal as a set-
up condition requires a degree of psychological flexibility.

Unfortunately, the tendency for most traders is that if an expectation

is not met then they move on to the next stock, unaware of the fact
that the market has provided them with a powerful signal to act.

You can combine your knowledge of other chart patterns to help you
to examine failed signals. Let's look at the failure of triangle patterns,
in particular the ascending and descending triangles.

Triangles

Traditionally, triangles come in three generic styles - symmetrical,

ascending and descending. A symmetrical triangle is characterised by
a convergence of an uptrend and downtrend line. Symmetrical
triangles suggest trader indecision. Traditionally, price stalls and
future direction is questioned. Typically, the contrasting psychology of
bulls and bears fights for ascendancy.

As the trend lines converge, the force of their convictions is almost

equal. Price movements higher are met by selling by the bears. Dips
are seen as an ideal entry point for bulls attempting to catch a
retracement. Eventually, the triangle narrows to an apex.

Volume may also drop during this final phase. From a trader's

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perspective, the symmetrical triangle generally resolves itself in the
direction of the primary trend. As such, they are often characterised
as a continuation pattern. Because symmetrical triangles are simple
continuation patterns, it is difficult for them to fail.

NATIONAL AUSTRALIA BANK

VOLUME

The traditional wisdom of trading a symmetrical triangle is to trade in

the direction of the breakout. The National Australia Bank graph
shows the formation of a symmetrical triangle. An ascending triangle
displays a series of higher lows, with a strong zone of resistance
characterised by highs at the same price point. They usually form
during a strong medium-term uptrend.

In ascending triangles, the prevailing psychology of traders initially

resists pushing prices higher. Bullish sentiment then re-enters the
market and prices move to the old highs where trader conviction fails
once again. This thrust and retreat may occur several times. Each
time, the price makes higher lows and trader psychology becomes
more focused upon moving through the old high.

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COMMONWEALTH BANK

VOLUME

Eventually, price breaks through the old highs. As such, ascending

triangles are strong breakout signals and should be traded as such
(see the ascending triangle formation on the CBA graph). A
descending triangle is the reverse formation to an ascending triangle.
In this formation, the bottom part of the triangle appears flat as bulls
resist any attempt to push prices lower.

RESMED

VOLUME

The dominance of the bears is reflected to add to their positions as

they attempt to in the prevailing downtrend. However, the bulls see

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any halt in price as a justification bargain hunt or bottom fish. The
small retracements are seen as triggers for bears to engage in
retracement trades (see the descending triangle on ResMed graph).

Triangle Failure

The ability to correctly act upon a failure of a triangle will add an

important tool to the arsenal of traders. However, as with all trading
tools, it is the failure to act upon a signal that most hampers the
performance of most traders. The use of these patterns as entry
signals is no different. It is pointless to be able to identify patterns
but then take no action to potentially profit from the unfolding price
action. To overcome this hesitancy it is necessary to generate some
simple rules to prod us into action.

DOW JONES

Triangle Failure

Ascending Triangle

Downtrend Channel

VOLUME

The Dow graph shows a failed ascending triangle unfolding. As you

would expect, this pattern was mirrored in the S&P 500 index and its
smaller cousin, the S&P 100 index. The rules for such patterns are
quite simple. In the example of the Dow, the long-term trend was still
down. This implies that we would discount the breakout to the
upside. Our interpretation would be that initially this breakout would
be a countertrend rally. If the move progressed and the long-term
trend changed, then we would enter the market in the direction of the
new bullish trend.

However, this was not the case with the Dow, as a new uptrend failed
to materialise. The move stalled a few days after the breakout. This is
in line with the predominant bearish direction of the Dow, so it is not
surprising that the attempted break to the upside failed. The failure of
price to break higher confirmed the strength of the existing

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downtrend and provided an ideal entry signal for anyone wishing to
trade in the direction of the trend. The signal to enter comes after the
collapse of the move back below the line of initial resistance. Some
traders may choose to stipulate a number of successive closes below
the line of resistance before entering a position.

The trading of failed signals requires a high degree of flexibility. Too

often, traders will correctly identify an embryonic formation, but walk
away from it as it fails. Failed signals offer powerful entry triggers, so
be flexible in your approach and more profitable opportunities will be
revealed.

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-General Articles-

1) 7 Deadly Sins

I recently heard about a group of Silicon Valley psychologists who

specialised in the treatment of “Rapid Wealth Syndrome”. This
modern day affliction was reaching epidemic proportions in the “20-
something geek” demographic at the start of the year (2001).

However, since investors fell out of love with the word “dot.com”, I
wonder if these psychologists are now treating clients suffering
“Rapid Wealth Depletion Syndrome”?

As traders, there are many lessons that we can learn from the recent
market shenanigans. Here are the 7 deadly sins of the sharemarket:

1. Trading Against The Trend

Self-delusion is a wonderful thing. It can make the trauma of being a

modern adult so much easier to bear, without the need for
medication! However, convincing ourselves that the sharemarket is
trending up when it is not, can be a lethal mistake.

To assist in your quest to become a trader extraordinaire, consider

hiring an 8-year old child. About $2 per hour and the bribe of a
chocolate biscuit should suffice. After they have programmed your
VCR and cleaned up the viruses on your computer, conduct a simple
experiment – show them a chart of a share in your portfolio. Explain
to them that it is picture of how the share has been performing. If
your new mini-employee says that the share is downtrending –
believe them! Find a share that is uptrending to buy, or your capital
will suffer the same fate as the curry that you had for dinner last
night.

2. Greed

“This one’s a sure thing! In a couple of weeks, with the money you’re
going to make, you’ll be able to buy New Zealand!!” says your broker
confidently. If you believe this, and engage the trade without doing
your research, you are the chump, not your broker. Your broker will
still profit from the commission, while you are licking your wounds
and mournfully expecting sympathy.

When traders lose money, they usually blame bad luck, poor advice
etc, rather than their own personal qualities of arrogance, fear and
greed. External attribution of blame is a sign of immaturity. Take
responsibility for your own actions or your trading ability will never

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improve. This is one of the most difficult lessons to learn in your
trading life.

3. Pride

Feel free to beat your hairy chests; men… it helped get us out of
caves and into centrally heated houses. Unfortunately, there is no
public killing of a predator in modern times.

If you have made a windfall profit, what makes you certain that you
were the cause, and not just the hand of lady-luck? Put pen to paper
and work out entry, exit and money management techniques. If you
don’t have a written trading plan, develop one quickly, or get the
heck out of the market. Without defined rules you will lose in the
markets over the long haul. Stay loyal to your system and be aware
that there is no ‘holy grail’ in share trading.

Every system will encounter a string of losses, but as long as you

ultimately make more money than you lose, then you will be
profitable.

4. Envy

As a teenager, with crooked teeth and a few too many kilos, I

remember looking at the popular girls with abject envy. Damn them
… why were they born so pretty, skinny, clever, blonde etc? As my
Grandmother told me: “comparing yourself to others only leads to
heartache”.

Although it seems as if everyone around you is making a killing on

the markets, it is likely that they are only telling you about their good
trades. Traders who tell you that they consistently get in at the
bottom and out at the top of a trend are liars.
Good traders have achieved a sense of detachment from the market
and have divorced themselves from chasing elusive profits.

5. Dividend Lust

“But it pays a good dividend” is the justification that many traders

use for hanging onto a losing trade. This is equivalent to saying that
you are a compulsive gambler because they provide free coffee at the
casino. Even rats will put up with being zapped by an electric current
if they are regularly fed tasty pellets!

Contrary to popular opinion, companies that pay dividends may not

have their shareholders’ interests at heart. If these companies
retained their dividends, and invested in developing their strategic
superiorities over their competitors, their earnings per share would

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increase. Investing in a share buy-back scheme, rather than paying a
dividend would naturally drive the share price upwards. Whenever
demand outstrips supply, a significant return on investment for
shareholders is the result. This is inherently more beneficial to
investors than a dividend, (or a tasty pellet) to keep them interested.

6. Wrath

The market does not know that you exist. Don’t seek revenge if you
have made a loss on a share, or if your dog has just bitten a chunk
out of your best slipper. Fight your battles with an opponent that you
can make eye contact with.

7. Capital Destruction

Dr Alexander Elder, a great trader, explained to me that there is a

popular Russian saying that translates to: “Don’t step on the same
rake twice”. Learn from your past errors.

Decide to exit a trade if it hits a certain point below your purchase

price. The golden rule of share trading is: keep your losses small and
let your profits run. Your first aim must be capital preservation.
Making money is a by-product of following your trading rules.
Money flows naturally from the many to the few. Trading is definitely
not for the faint-hearted, but the potential rewards ensure that there
will always be a continual flow of new punters willing to try their luck.
Luckily for skilled traders, these people still exist. It ensures that the
sharemarket will continue to redistribute wealth. Just make sure that
you are the one that the wealth is being redistributed to!

Back to Index

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2) Pyramiding – House of Cards

When I was a little girl, my sister and I raised the skill of building
card houses to an art form. Each day we would try to out-do our
previous record. Sometimes we would succeed in creating the ‘Taj
Mahal’ of card houses that would practically withstand an earthquake
(in our minds at least). Other times, we could barely make it past 2
levels.

The method that I learned all those years ago is exactly the same as
the technique that I use in trading to add more capital to a winning
position. Let’s review some of the major success factors when
pyramiding into a trade, or building card houses.

Don't go too high

Unless you are aiming to enter the Guinness Book of Records for card
house building, three layers will usually be enough. With trading, if
you pyramid more than three times, usually your position size will
grow to be too large in relation to your trading equity. This does not
represent effective risk management.

Pyramid position sizes

0.25% Second pyramid point

0.5% First pyramid point

1% Initial Entry

Percent risk per position

Don't go too quickly

Wait until your trade is at least profitable before attempting to add

money to it. Set your pyramid points slightly above a level of
previous resistance, and above a round dollar figure. This suggests
that the share must bullishly break through a psychologically
significant price, before you show continued faith in the upward
potential of the stock.

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Make sure each layer is smaller than the previous one

The strongest card houses have a firm foundation. If you are used to
position sizing in trading based on a percentage risk, you could follow
a method that looks like the diagram.

Per cent risk per position

If you are used to adding fixed dollar amounts to your trades, you
could use this diagram to signify units. For example, you may commit
$10,000 to a position. The next position could be $5000, and the final
position $2500.

Never average down

If the card house is looking shaky, don't add more cards. If the trade
is not co-operating, don't throw more money at it.

Averaging down means adding more money to a losing position. It

doesn't work... and I can prove it to you. Let's say that you decided
to buy 500 shares at $15. Imagine that the share price drops, so in
your infinite wisdom, you decide to buy another 500 shares at $12.
As the share price dropped further, you also decided to buy an extra
500 shares at $10. After this, your average price would be $12.33.
Now you own 1500 shares in a stock that is downtrending. Well done
- you must feel very proud!

Instead of buying more of this downtrending share, it would have

made more sense to exit at your initial stop loss of $14 and capped
your loss at $500 ($15 - $14 x 500 shares). To contain your loss to
only $500 after you have averaged down, the share has to trend from
$10 back up to $12. How likely is a share price increase of $2 or 20
per cent when the share is already in a confirmed downtrend? This is
a very unlikely event in the near future. This is why averaging down
doesn't work.

The more times you average down, the greater the commensurate
increase in share price is required in order for your total position to
break even. Only add money to a winning position, or suffer the
consequences.

Unfortunately, most traders do not have a clear idea about how to

pyramid effectively, and they end up devastating their own trading
results, even if they have correctly identified the trend. If you follow
these suggestions, pyramiding, and building card houses, will be so
much more effective for you.

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3) Position Sizing

Position sizing can save you from committing financial suicide in the
sharemarket. Few people realise the importance of this essential skill
because, at first glance, the benefits are not immediately tangible.

Money management and position sizing suggests you know how

many shares to buy and how much of your account to commit to a
given market. Studies have shown that even random entry systems
can be profitable using effective stop-loss procedures and good
money management. When people begin trading, they often believe
that as long as they hitch a ride with a share that is headed for the
moon, they will accumulate untold riches. Few trades co-operate to
this extent.

Ironically, 90 per cent of my trades do not amount to a significant

profit. It feels like I'm treading water, waiting for a trend to unfold.
The majority of my profits are produced by just 10 per cent of my
trades. Trading is often not a consistent income-generating activity.
Many people give up or run out of money before they turn a profit.

It could take you 20 trades in a row of mundane, frustrating, break-

even or loss results to hit the one trade that will bring in an extreme
profit. There is no 'normal distribution' of wins to losses in the market
when you look at a small sample size. Money management and stop-
losses will help keep you in the market long enough to experience a
few terrific winners, even if you hit a cluster of losses.

Sector Risk

If you cannot sleep at night, or if you are continually thinking about

the performance of your shares, your position size is too large for you
to handle. Be aware, however, that if you own more than one stock
per sector, then you are effectively trading the same instrument. For
example, if you have four bank stocks, and own call options on CBA,
you have ineffectively diversified your trading capital. It is as if you
are trading the one position only.

Make it a rule never to trade more than one position per sector. If
you don't, you are opening yourself up to an unacceptable level of
sector risk. Your trading account will eventually suffer when the tides
turn against your favoured index.

There are several models to help answer the question: 'How much of
my capital should I devote to this trade?' Each has pros and cons.
Ultimately, you need to choose one position sizing model, or a hybrid
of the available models, before buying a stock.

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Equal Portions Model

This model is where your capital is divided into equal amounts. For
example, you may have $100,000 equity and decide to split this into
10 different positions of $10,000 each.

There are some inherent difficulties with this concept. It assumes a

consistent risk factor across all trades. This is an illogical assumption.
This method will lead to your demise if you trade derivatives. In all
likelihood, you will be committing too much equity to an illiquid and
complex trade. This is likely to damage your overall trading equity.

The Capital Allocation Model

This model divides your capital between areas of risk. One of the
underlying principles behind the market is the theory that if a stock
has a significant market capitalisation - for example, top 100 or top
300 - then it is likely to behave in a more predictable fashion.
(Market capitalisation is the number of shares that have been issued
in total, multiplied by the share price.) The market capitalisation will
affect whether a share is included in Australia's benchmark All
Ordinaries index.

How To Use This Model

The maximum number of shares that most people can manage at one
time with a larger portfolio, for example $300,000-plus, is about 15
separate positions. People with a smaller portfolio often feel more
comfortable holding six to 10 stocks. This is largely anecdotal
evidence, because according to my knowledge there is no reliable
data regarding the ideal number of shares to hold.

As a guideline, the minimum number of positions in a portfolio should

be at least three stocks, in order to give you a chance to learn how to
trade well. Hopefully out of those three stocks, at least one will be
trending in the right direction, although there is no guarantee.

As a suggestion, it may be best to allocate more money to the top

100 stocks (lower-risk), such as 50 per cent of your capital. You could
allocate a moderate amount to the bottom 200 stocks of the top 300;
for example, 30 per cent (moderate-risk). The least amount of money
(for example 20 per cent) would then be allocated to all other stocks
not appearing in the top 300. All derivative trades are also included in
this category.

This would mean that from an initial starting equity of $100,000, you
could allocate $50,000 to lower-risk shares, $30,000 to moderate-risk

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shares, and $20,000 to higher-risk shares and derivative positions.

For the sake of simplification, let's say that you're happy with holding
10 shares. This could be split into the equivalent of three separate
portfolios defined by the risk inherent within the market capitalisation
level. Your low-risk portfolio of top 100 shares could contain three
stocks, from different sectors, with a position size of $16,666 each.
Your moderate-risk portfolio could contain three stocks with a
position size of $10,000 each. Your high-risk portfolio could contain
four stocks or derivatives with a position size of $5000 each.

Make your capital allocation rules with regard to high-risk areas

explicit. You may decide to commit a maximum of only 15 per cent or
10 per cent of your total equity to higher-risk sectors of the market,
depending on your risk profile. This will still provide exposure to
potential high returns, without bursting the seams of good judgment.

There are refinements to this method, but if you relate to the

concept, then this can be a simple way to position size with a higher
degree of sophistication than the equal portions model.

There is a principle called the 'Kelly principle’, which suggests that

you should not have more than 25 per cent of your trading equity
placed in any single position on the sharemarket. This is in line with
the rationale of minimising the effect of an unforeseeable potential
catastrophic event.

Many traders do not utilise the Kelly principle because it seems to be

in contradiction to the concept 'let your profits run'. However, if your
losing trade is conducted using too much of your overall trading
capital, you could violate this rule easily. If you appropriately size
your positions, then the chance of a one-off shattering loss leading to
devastation is slim indeed.

Capital Allocation
Market Capitalisation

Top 100 Top 101-300 Top 300 +

Trading equity
50 30 20
(%)

Number of
3 3 4
positions

There is a fine line between letting your profits run, and planning just
in case a catastrophe strikes. You want to back the winners, but have

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an efficient threshold that determines when you have placed enough
of your equity into a particular position.

The key is to not allow your overall position size to exceed 25 per
cent of your total trading capital. Take into account the positions that
you hold in different sectors and ensure that their combined size per
sector is also less than 25 per cent. For larger portfolios, you could
consider keeping overall positions to less than 15 per cent or 20 per
cent of the overall trading capital.

Remember to take into account the effect of pyramiding. If you have

decided that you would like to add more money to your winning
positions, you must make sure that you stay loyal to the Kelly
principle.

Back to Index

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4) The Derivative Kicker

If your knowledge of option/warrant trading is up to par, you could

consider using bought options to pyramid your positions, rather than
buying more of the physical share. For example, if your pyramid point
on CBA was hit, yet your overall holding was likely to creep above 20
per cent if you took that pyramid, you could buy call options instead.
This would provide exposure to this instrument in a leveraged
manner, so that it is unlikely that you would risk violation of the Kelly
principle.

This is also an effective method if you are looking to pyramid a short-

sold position. Rather than short-selling more of the physical share,
you could consider buying put options or warrants. I have
implemented this strategy effectively in the past. It has the benefit of
providing you exposure to the trade, without risking violation of your
maximum position size rules. It is also a terrific way to begin learning
about bought options and warrants. Because you are already involved
in the physical share, you are most likely closely watching its
behaviour.

There are several position sizing rules that it pays to follow:

• Take into account sector risk.

• Divide your capital according to market capitalisation.
• Use derivatives to pyramid if you are becoming 'overweight'
in a particular share or sector.
• Monitor your positions carefully to make sure you are
staying loyal to the Kelly principle.

If you follow these rules, you are more likely to limit any downside
potential produced by a disastrous sharemarket event.

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5) Handling a Windfall Profit

You’ve heard the saying ‘Start with the end in mind’. In the
sharemarket, this strategy can be counter-productive. Some traders
in the sharemarket tend to limit themselves unnecessarily by exiting
their positions when they have hit some pre-determined superstitious
level of profit. For example, you may be happy with a 30% profit
from a particular trade, and exit your position once this target has
been reached. What a shame the share wasn’t aware that it should
have stopped at a 30% increase, instead of going up an extra 250%!

It is impossible to predict how long a trend will take to unravel. You

are capping your profits by setting profit targets. Your share may
have had the ability to jump higher, dragging your capital with it, but
you have put a false cap on your potential.

Many traders experience psychological pain when they exit from a

position, only to see the trend continue in the expected direction.
Sitting there stunned and wounded will not help you. The best thing
to do is to re-enter the position, secure in the knowledge that you
had the discipline to exit and preserve your profits had the share
continued spiralling towards bedrock.

To survive all of the nasty small losses in the market, you need to
make the occasional windfall profit. If you cap your profit potential,
you may just end up a net loser in this game. Ride the trend until it
reverses. An effective stop loss strategy will help you recognise when
the trend has reversed, and prompt you to exit from the trade. The
trader’s rule is to cut your losses short and let your profits run.

Mania

From time to time in the markets, you will hook onto the right side of
a trade that goes absolutely ballistic. Good news from overseas, a
new technological breakthrough, or handsome profit results may lead
to an incredibly bullish performance, all on one day.

Sometimes if the uptrend has caught the attention of the relevant

authorities, the share will be issued with a ‘speeding ticket’, and be
placed on suspension. This means that you will not be able to buy or
sell the instrument, pending some significant announcement. There is
no rule of thumb to assist in determining whether the announcement
will be positive or negative.

On returning from suspension, the share may trade well above or

below the last close. For example it may surge 15%. This is a windfall
profit situation.

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In this situation, it may be prudent to exit your position, and re-enter
if you receive a signal that the share is likely to continue in a bullish
direction. Selling into mania allows you to protect your profits, and let
the emotion wash out of the existing shareholders. Some traders
make the decision to sell part of their holdings, to protect their
profits, but continue to ride the bullish trend. Once comparative calm
has been re-established, you will be in a better position to react with
cool detachment.

Remember to take a small percentage of your winnings and buy

something for yourself and your family. Whenever you look at that
asset, or remember that holiday, then you will create a feedback loop
where your subconscious will seek further rewards. This is one of the
reasons why winners in the markets go on to create even bigger wins
in the future, and losers continue to lose money. Winners reward
their own good behaviour patterns.

With trading, you can attribute a windfall profit to a back-tested

system, and therefore, ultimately duplicate your results in the future.
Setting profit targets in advance will only end up eroding your
eventual results.

Plan For the Worst

If you interview any top professional in the world, from a prize boxer
to an Olympic runner, they will tell you that they have considered and
planned for a potential disaster. Traders should follow the same
principle.

Three potential catastrophes should be at the top of a professional

trader's list:

1. Computer crash

Bang, splutter, and smoke or maybe just a flicker, before refusing

to start up again - you have just experienced a trader's worst
fear.

Anyone who has experienced a computer crash knows the

frustration that follows. Traders using online systems are cut off
from the trading world. Those charts and statistics you rely on are
suddenly impossible to access. The stops are placed, and the
active buy orders are inaccessible. Oh, the horror!

At some stage this will happen to you. Here are some steps that
you can take to minimise this impact:

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 • Deal with an online broker that has a back-up telephone
service. This means that you'll be able to find out what your
shares have been up to in your absence.

• Back-up your computer at least once a week, including your

end-of-day data, as well as copying any essential files that
you need to keep organised. You could network your
computers, store information on CD, or rely on a web-based
back-up system. It doesn't matter which system you use -
just use one.

• Keep a manual trading diary. Record your current positions

and stops, either as a printout from your computer, or
handwritten in an A4 binder.

2. In sickness and in health

Is there someone who knows your trading positions and can act
on your behalf if you were suddenly taken to hospital? Can your
online system set automatic stop losses to protect your trading
capital?

Using an ostrich mentality, this is something that often people

avoid thinking about. Have you investigated an "enduring power
of attorney" which enables a loved one to act on your behalf if you
become physically or mentally incapacitated? This lets you appoint
a legally authorised person to look after your financial affairs
should you become incapable of doing so.

Forward planning lifts a burden of responsibility from the

shoulders of your friends and relatives. If you don't appoint an
enduring attorney and lose mental capacity, family or friends will
have to apply to the Court of Protection to appoint a receiver to
handle your affairs.

3. System failure

From time to time, even a previously effective trading system can

create ongoing losses. Have you set yourself a limit regarding
these losses? How do you decide when to stop and take stock of
your system before jeopardising the majority of your trading
equity?

Most traders reach a psychological failure limit, where if they lose

10 times in a row, for example, they feel demoralised. However, if
they were only risking 0.5 per cent of their trading equity per
trade, they have only lost 5 per cent of their bank balance in total
- an acceptable risk.

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 I urge you to stop trading if you have lost 20 per cent or more of
your trading equity because you will need to make a 25 per cent
profit to break even, which can be a tall order. Stop temporarily,
consult a more experienced trader, and review your own
psychology and trading system before diving headlong into
financial oblivion.
If you consider these issues in advance and plan your reactions,
you're more likely to achieve longevity in the sharemarket.

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 For more information on the training courses and
sharemarket services offered by Trading Secrets,
check out www.tradingsecrets.com.au. You can
also order these other titles by Louise Bedford
online at this website.

Video Program

This course is designed to be a complete introduction to the

world of Candlestick Charting. There are exercises to be
completed throughout the program and plenty of actual
trading examples to help cement your knowledge.
Whilst suitable for the novice trader, this course will also take the
more experienced trader to a greater understanding of the markets On DVD
by delving into the psychology behind the price action.

The Secret of
Candlestick Charting
Poster

The Secret of
Pattern Detection
Poster

Valuable quick reference tools for

the main charting patterns using
candlesticks and technical analysis.

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