Financial marketswizardoptionstradingstrategies (1)

Financial MarketsWizard

Options Trading Strategies

Contents

How I Trade Options via Gaps 3How I Trade Options via Breakouts 10How I Trade Options via Opening Range Breakout 13How I Beat Market Maker via Show or Fill Rule 19

ht tps : / / f inancia lmarketswizard com 3

How I Trade Options via Gaps

Gaps trading is one of my favorite trading strategies It is also one of the difficult strategies to trade as trader can get caught in the wrong direction and start losing right away This could be very demoralizing Therefore, understanding gaps, what causes gaps and what to look for in trading gap is very important Dozens of stocks gap up or down every day but not all stocks are trade-able There are only handful of stocks which are good trade candidates on any given day Therefore, knowing which one to trade and which one to avoid is crucial to improving the portfolio balance So lets begin in understanding the gaps and in the next article we will go in detail on how to trade gaps and fade gaps by using Calls and Puts

F i n a n c i a l M a r k e t s Wi z a r d O p t i o n s Tr a d i n g S t r a t e g i e s


1 1 What Are Gaps There are essentially three ways that the price of a stock can open for trading relative to its prior closing price It can open higher, lower, or at the same price

When there is a significant difference between a stock’s prior day closing price and its opening price, it is called a gap If the opening price is higher than the prior closing price, it is called a gap up If the opening price is lower than the prior closing price then it’s a gap down When a stock opens at essentially the same price as the prior close, or the difference is very small, then it is considered to be a flat open

1 2 What Causes Gaps A variety of factors can cause the market or individual stocks to gap Examples include late breaking news on specific stocks, earnings reports, analyst upgrades or downgrades, overnight futures trading, economic news, major world events, or simply an imbalance between supply and demand

Regardless of the specific catalyst, gaps occur due to excess demand on the buy or sell side, which is further exaggerated by low volume trading that takes place outside of regular market hours Since the total number of buyers and sellers is lower during post - and premarket hours, any significant buying pressure pushes stock prices higher than would normally occur during regular market hours The opposite is true when there is more selling pressure

1 3 When Gaps Occur Gaps occur every day of the trading week but mostly on Mondays and Fridays The larger the gap, the better the potential in the trade If stock is gapping up on news such as major analyst upgrade or an upside earnings announcement, then the chances are that stock will continue moving upward But the stocks which gap up for no reason will likely pullback



1 4 Types of GapsThere are mainly four types of gaps Each of these is described below:

1 4 1 Common Gaps

Sometimes referred to as a trading gap or an area gap, the common gap is usually uneventful In fact, they can be caused by a stock going ex-dividend when the trading volume is low These gaps are common (get it?) and usually get filled fairly quickly “Getting filled” means that the price action at a later time (few days to a few weeks) usually retraces at the least to the last day before the gap This is also known as closing the gap or closing the window (in Japanese)

1 4 2 Breakaway Gaps

Breakaway gaps are the exciting ones They occur when the price action is breaking out of their trading range or congestion area To understand gaps, one has to understand the nature of congestion areas in the market A congestion area is just a price range in which the market has traded for some period of time, usually a few weeks or so The area near the top of the congestion area is usually resistance when approached from below Likewise, the area near the bottom of the congestion area is support when approached from above To break out of these areas requires market enthusiasm and, either, many more buyers than sellers for upside breakouts or more sellers than buyers for downside breakouts

Volume should pick up significantly, for not only the increased enthusiasm, but many are holding positions on the wrong side of the breakout and need to cover or sell them It is better if the volume does not pick up until the gap occurs This means that the new change in market direction has a chance of continuing The point of breakout now becomes the new support (if an upside breakout) or resistance (if a downside breakout) Don’t fall into the trap of thinking this type of gap, if associated with good volume, will be filled soon It might take a long time Go with the fact that a new trend in the direction of the stock has taken place, and trade accordingly



1 4 3 Runaway Gaps

Runaway gaps are also called measuring gaps, and are best described as gaps that are caused by increased interest in the stock For runaway gaps to the upside, it usually represents traders who did not get in during the initial move of the up trend and while waiting for a retracement in price, decided it was not going to happen Increased buying interest happens all of a sudden, and the price gaps above the previous day’s close This type of runaway gap represents an almost panic state in traders Also, a good uptrend can have runaway gaps caused by significant news events that cause new interest in the stock

1 4 4 Exhaustion Gaps

Exhaustion gaps are those that happen near the end of a good up - or downtrend They are many times the first signal of the end of that move They are identified by high volume and large price difference between the previous day’s close and the new opening price They can easily be mistaken for runaway gaps if one does not notice the exceptionally high volume

It is almost a state of panic if the gap appears during a long down move and pessimism has set in Selling all positions to liquidate holdings in the market is not uncommon Exhaustion gaps are quickly filled as prices reverse their trend Likewise, if they happen during a bull move, some bullish euphoria overcomes trades, and buyers cannot get enough of that stock The prices gap up with huge volume; then, there is great profit taking and the demand for the stock totally dries up Prices drop, and a significant change in trend occurs Exhaustion gaps are probably the easiest to trade and profit from

1 4 How I Trade Gaps

Ideally when a stock gaps up, we should not buy “Calls” unless it makes a new high after 10:00 AM EST Similarly, if a stock gaps down, we should not buy “Puts” unless it makes a new low after 10:00 AM EST When stock gaps up it makes a high and then reverses to the downside but stays above the open price It trades aggressively between open price and



high price Professionals try to short at high made during the first thirty minutes of the market open They place the stop just little above the high which was made during the first thirty minutes At this stage the battle rages between the bulls and the bears where bears try to push it down and bulls buy on every dip and eventually one of them wins

1 4 1 How I Trade Gap Up - By Buying Calls

I watch the five-minute charts and see how stock is trading Usually it oscillates between open and high I also watch buy and sell pressure to figure it out which side will likely win Sometimes it is evident from the get-go who will win sometimes it is not clear till later stage To enter long the ideal entry is when stock pulls back and comes closer to the open price but do not violate it As soon as the stock comes close to open price and buying pressure starts building up that’s when we could go long with the stop either just below the open or below the support price which is below the open price This is low risk high reward trade and decision has to be made quickly and trade executed at lightening speed If the amount of gap is significantly high then the profit target could be just below the high made so far Another entry for going long is when stock breaks the high made during the first 30 minutes The stop in this case is below the open price of that day or the low made so far If there is a support level below the open then the stop is below this support rather than below open Usually the stock dips below the open to take out the stop and then it moves upward very fast

When I am buying calls then I buy only half lot and keep another lot to buy either at lower price (near open) or buy second lot when it breaks the high made (within 30 minutes) decisively and moves aggressively upward

1 4 2 How I Trade Gap Up - By Buying Puts

When the stock gaps up on news then analyzing this news is very important Before the market opens reading the news on the stocks which are gapping up is crucial to understanding what the stock would eventually do after the stock starts trading during normal market hours



If the stock is gapping up for no good reason, that is no substantial news to justify the gap, then it is likely a good candidate for fading the gap In other words if the gap is overly exaggerated the stock will likely reverse its direction to the downside and if the gap amount is significant then a trader can buy Puts to take advantage of the reversal Another factor which helps in my decision whether to fade the gap or trade in the direction of the gap is where the stock is trading at open with respect to the resistance If the stock gaps up and hit the resistance and unable to conquer the resistance right at the beginning then it has very high chance that it will fail to cross the resistance later during the day and rather it will sell off If this is the case then a trader can buy Puts with stop 50 to 70 cents above the resistance line and lock gains when stock approaches the support The potential between resistance and support should be enough to justify buying Puts as option trading requires certain dollar amount move to justify the spread between bids and ask

1 4 3 How I Trade Gap Down - By Buying Puts

Gap down strategy is the same as gap up but in reverse Stocks gap down due to some major bad news When stock gaps down a trader needs to evaluate the further potential in the trade, buy/sell pressure, any major support nearby which could stop further decline in the stock move For example, if stock gaps down and 200 day moving average is close by then it has high probability that it will stop going down further once it hits 200 day moving average Even if it dips below 200 day moving average it could bounce back above

If the stock has gap down huge and there is no significant support nearby and selling pressure is rising then the chances are that it will continue going down in the direction of the gap During the first 30 minutes of market open - day traders try to fade the gap by going long and placing the stop just below the low made during the 30 minutes Once this low is broken then the selling pressure starts rising and they switch their position from long to short It is at this moment or knowing that stock is further deteriorating that a trader can buy put with a stop above the high made so far However, if the gap is huge this high could be far from the entry point and if stock reverses to the upside then trader



can lose significant portion of its trading amount by the time he stops out Therefore, I look for another resistance point which is way below the open or high and if stock closes above this resistance line then I close my Puts position otherwise the profit target is slightly above the next major support Since gap down trading can be fast and furious and stock could reverse its direction after hitting the support therefore, I do not take risk of greed factor to come into play I place conditional order (described later in this guide book) and let the price move take me out of the trade with profit In this way greed factor is eliminated and I am out of the trade with decent profit Knowing the resistance, support is the key to trading gap down trades

1 4 4 How I Trade Gap Down - By Buying Calls

When stock gaps down and hit support it stops going down further Not only it stops going down but starts moving up aggressively Recognizing this change in trend a trader can buy Calls with stop below the low made during the first 30 minutes The profit target is the first major resistance The move could be fast therefore, I prefer to place conditional order and let the trade close itself with profit The conditional order eliminates the greed factor

ht tps : / / f inancia lmarketswizard com 1 0

How I Trade Options via Breakouts

“Breakouts and breakdowns attract many participants but require precise timing to turn a profit. Insiders know that these hot spots attract dumb money. They initiate whipsaws after each volume surge to shake out weak hands. This ensures that the majority enters positions just as the market reverses.”

—Alan Farley

Breakout occurs when a stock clears a price level that for whatever reason has been a virtual cover on the stocks advance Stock chart readers recognize it as the moment when a stock has thrown off that cover and has the greatest probability of making meaningful gains Some stocks double in price in a matter of few months



Breakout stocks are stocks either rallying to a new high or into a price area with no resistance Breakout stocks typically break through a resistance area and rally quite quickly to a new higher price area

All breakouts are questionable until they follow through A perfect breakout is a clean breakout Most stocks tend to retest their breakout points a number of weeks into their breakouts When they do this they offer some of those investors who are tracking its movements for a second chance to jump in A clean breakout stock does not even come close to its previous resistance line Weeks after a breakout, statistically, a considerable number of stocks do retest its support line They can breach the support line but should not close below the line

For a successful and impressive breakout the stock needs to be trading above its 50 day moving average and 50 day moving average above its 200 day moving average Not all breakouts are from Cup-With-Handle base formations Stocks that successfully retest their resistance level usually rebound forcefully to fresh new highs

One form of breakout is called “Continuation Breakouts”

Continuation type breakouts are typical on up trending momentum stocks moving to new highs The resistance the breakout breaks through is usually a weaker type of resistance For example, stock makes a new 52-week high around $151 and then pulls back 3-5 points Then it starts rising again and breaks price point of $151 with volume This is considered as Continuation Breakout

Higher quality breakouts (fast and big move) usually occur for flat top breakouts with longer top consolidation periods (1 week to 1 month in time frame) Flat top breakouts usually allow for tighter breakout stop limits enabling higher quality profit/loss trades

When stocks breakout after strong rally then it is possible the stock may not go further up as the move has already taken place During the day of the breakout the volume has to be very high

Trader should be cautious on breakouts that occur on earnings or news events (upgrades) These can cause false breakouts Some of the



better breakouts usually occur when there is no news Therefore, traders should be capable of recognizing the failed breakouts and should get out of the trade immediately The initial loss is the best loss in this case as any hesitancy can result in disaster Some price action can indicate that a retest is way underway while in the background that very price action was the beginning of a sell off and eventual price breakdown; with a close below its important support line We also need to be cautious on breakouts after a previous rally While breakouts do occur their profit may be less and stop loss may need to be higher

Trader should master the breakouts with unwavering execution Some of the best breakouts can be found by making a list of breakout candidates prior to the actual breakout and then watch for the abrupt upward stock movement to trigger an entry point I monitor breakout candidates like a hawk and when it starts trading above the important resistance line and volumes starts increasing and meet my minimum criterion that’s when I enter the trade with half lot Once the stock establishes itself as successful breakout then I add another half to my position Sometimes we all have the urge to cheat a little bit and enter prematurely into the breakout, thinking that if a stock is eventually going to breakout then why not buy it at low price This is not disciplined trading rather trading with greed If a breakout is going to happen then the gain will be enormous so it is advisable to wait for confirmation of the breakout

Be cautious on breakouts after a previous rally While breakouts do occur their profit may be less and stop loss may need to be higher


How I Trade Options via Opening Range Breakout

The market opens and your favorite watch list equity is moving upward, so you decide to go long and purchase shares or calls Then are you left wondering why after twenty five minutes of the market open it stalls and stops moving up? For example, one trading day you noticed that PSX opens at $50 50, dipped slightly and made a low of $50 25 and then started aggressively moving upwards You decided to chase the stock and bought when it was trading at $51 40 After you established your position, PSX continued to climb further to $51 65 Then around 9:55 am EST PSX stopped its upward climb and traded in the narrow range of $50 70 and $51 20 for the remainder of the day I used to get stuck in trades like these till I came across the concept of Opening Range Breakout



Statistics indicate that only 1/3 of stocks make their high or low of the day within the first 30-minutes of the market open This means the remaining 2/3 of the equities make new highs or new lows after the first 30 minutes has elapsed So if a trader buys a stock during the first 30 minutes, there is a high probability that the trade will not materially move up for the remainder of the day Therefore if you are determined to make decent money trading stocks you need to understand and apply the invaluable concepts of Opening Range and Opening Range Breakout

Lets first understand the concept of Opening Range The Opening Range is defined in terms of time and price The time element is simply the first X number of minutes in the trading day where the trader defines the time element in accordance to his/her personal trading style Since I am swing trader, I concentrate on a 30 minute Opening Range by progressively examining the 5 minute, 15 minute interval and then finally make my decision on the 30 minute time frame

To better understand the concept of Opening Range let’s consider the PSX example mentioned above In this example PSX made a low of $50 25 and a high of $51 65 Therefore, the 30-minute Opening Range for PSX is simply defined as $50 25-$51 65 Market professionals mostly use a 30-minute Opening Range due to economic reports being released at 10 am EST These reports affect the market sentiment from bullish to bearish or vice versa and thus stocks react positively or negatively The other factor is also related to stocks themselves Stocks may also have news which is driving their moves Once the news is digested and analyzed stocks move in normal fashion

Based on the example above, the Opening Range price range element for PSX is $50 25-$51 65 using a 30 minute timeframe Therefore, when a stock starts moving above the opening range high it is considered as bullish, whereas if the stock is trading below the opening range low it is considered as bearish This is the fundamental starting point for the trader to understand and trade the Opening Range However, there is more to it than just price and time The third variable is the volume, but before we bring volume into the picture we need to understand the concept of breakout, resistance and support



Understanding BreakoutTo clearly understand Opening Range a trader needs to be intimately familiar with the breakout concepts which I have previously described in this eBook

Understanding Resistance and SupportThe high and low made during the Opening Range period can be considered as lines of resistance and support respectively; otherwise the stock would have moved higher or lower depending on the market sentiment during the first 30 minutes To better see these resistance and support levels switch to a 5-minute time frame to illustrate the consolidation pattern at both the high and the low This will visually reinforce the corresponding lines of support and resistance

Now that support and resistance are clearly defined by the high and the low of the 30-minute Opening Range, then once the stock breaks above or below one of these two lines then you can take the decisive action If you cannot clearly see either the support or the resistance of a stock, then it is prudent to move to the next stock which shows definitive areas of support and resistance

Importance of VolumeEarlier we talked about price and time with regards to the Opening Range In this section we will discuss about the importance of volume As we know there are 8000 stocks listed on trading exchange And all of these stocks are making lows and high during the first 30 minutes of trading So how does a trader determine which few stocks to concentrate on when the market opens The answer lies in the volume

Those stocks which are moving with high volume at the market open are the first area of focus On any bullish or bearish day, the number of stocks trading with high volume could reach to 500 or more It is not possible for any human being to manually evaluate this list to identify good potential trading candidates Therefore, it is suggested that you should concentrate on preselected basket of stocks which you have selected based on price, average volume and average true range



If you trade options, then further restrictions will be used to identify option-able stocks which have good history of options, decent spread, high option volume and high open interest Based on these criteria you may come up with a basket of 300 stocks which you can focus on during a trading day Therefore, your Opening Range breakout strategy will be applied only to these 300 stocks

When the market opens I filter my basket of stocks for those trading at high volume For example, stocks which are trading upward at twice their normal volume have higher chance of continuation to upside than the stocks which are moving up only at 50 percent of its normal volume Once I apply the volume filter, I only get handful of stocks to concentrate upon This makes my job easier to identify one or two good candidates to trade that day My Opening Range strategy is then applied to these stocks which are trading at high volume

Let’s say I have basket of 300 stocks based on the criteria I have identified above At market open, I apply the volume filter and it usually returns approximately 40 aggressively upward moving stocks on a bullish day When I apply a 5-minute Opening Range filter to these 40 stocks, then I may find that only 15 stocks are moving beyond the high made during the first 5-minutes of market open Therefore, I concentrate on these 15 stocks starting from the sixth minute of market open

I scroll through these 15 stocks quickly using daily and 60-minutes charts to see bigger picture of how these 15 stocks are trading Looking at these charts I create a short list of 8 - 10 stocks using various criteria such as crossing of 50-day or 200 day moving average from below, determine if it is oversold, or whether the stock is in continuation of previous trend or starting new trend Most importantly, I gauge how much potential this stock has to capture some decent gains if I trade options

In addition to the 5-minute Opening Range window I have set up a 15-minute Opening Range window I now review the 8- 10 stocks which have been screened using the 5-minute Opening Range and longer time interval chart analysis to see which stocks show up in my 15-minute Opening Range window This tells me that other stocks have stopped moving and are going through consolidation or pulling back



Let’s say I now have 5 stocks on my 15-minute Opening Range window allowing me to immediately monitor their subsequent price action At this time, I check the news on these 5 stocks, whether earnings are coming up, how is the action in option side, where is the support and resistance on the day chart, how much potential I have in this trade, which month and strike I will select for my option trade

In addition, I may have other open positions from previous days which I need to monitor and address So during the second 15 minutes of the trading day i e from 9:45 to 10:00 AM I take care of my open positions and wait for the 10:00 am news cycle During this period I am also watching various indices and associated futures to see if these are hitting resistance or support or retrieving from the high/low of the day or the high/low made over night

With my 5 or so candidates on my watch list I am ready to execute my trade on one of these stocks Depending upon where the stock is trading in the landscape of day chart (for details please read “life cycle of a stock”, page 9) I execute my Opening Range breakout strategy One of my strategies is to go long as soon as the stock moves above the high of the 30-minute Opening Range and the market news which was just released at 10:00 AM EST is affecting the overall markets positively

I execute this strategy based on the remaining potential gain and an above average trading volume Note the volume does not have to be 200 percent of the average volume to be considered a viable trade However, I sometimes execute this strategy on my 5-minute Opening Range versus the 30-minute Opening Range when the volume is at 200 and above if the potential is huge and the stock is moving on some solid good news such as major drug approval by the FDA

Another long strategy is using the Opening Range 30 minute resistance line (30- minute high) as support after the initial breakout In this application, the stock is projected to retrace to the high, or just below the high of the 30-minute Opening Range For example, the stock could have consolidated during the last 5 minutes of the 30-minutes opening range (during 25-minutes to 30-minutes of the trading day), and stock has just retraced to this consolidation area and started to move upward



It is at this time I would go long on the stock and the stock should not violate the low of the day If it does, then it means something went wrong with it and sellers have taken control and it is time to cut loose

Since this application of the 30-minute Opening Range is usually executed a little later in the trading day, it allows me to do some additional background checking on the stock I look for things like news events, an earnings event coming up after market close, or merger or takeover news etc that might be causing the stock to move up

One of the reasons for retracement down towards the high of the Opening Range may not be related to the stock itself, but may be a function of the overall market pulling back The stock may still find good support right near the high of the 30- minute Opening Range Decisive action is taken to go long either by shares or call options as soon as the market starts moving up after bouncing off the 30-minute Opening Range high in anticipation that the stock will be buoyed by the rise in the market, just as it retraced during the market pullback

Some stocks after breaking above the 30-minute Opening Range continue to move upward and thus do not provide the right entry opportunity to go long and take advantage of the upward move In this case I look for the stock to pull back or consolidate after an hour or so This consolidation point could be higher than the consolidation area of the 30-minute Opening Range When stock finishes consolidating and it looks like starting to move up then I use this secondary entry point to go long Once again the entry is made based on the idea that the remaining potential in the trade is enough to give me some decent profit


How I Beat Market Maker via Show or Fill Rule

“Show or Fill Rule” or “Limit Order Display Rule” is great help for those traders who buy twenty contracts or less The rule was enacted through Exchange Act rule 11 Ac-1-4 This rule requires the market makers to show or publish any order that improves the current bid or ask prices unless it is filled Any order between the current bid and ask spread will improve the market

Before we go into the details of this rule, we need to understand the basics of option quoting system:

Let’s say you (John) want to buy 3 contracts of February CAT 90 Calls which are trading at Bid $6 00 and Ask $6 75

So what does this mean?



It means the market maker is bidding $6 for the option This is the price he is willing to pay if you want to sell your contract On the other hand he is asking $6 75 per contract to sell to you In this buy and sell process he is making 75 cents per contract In other words we, the option trader, always gets the worst price This is our cost of doing the trading business, besides paying commission to the broker Whereas market maker makes his money by providing liquidity in the market

When we get the quote, the bid price represents the highest bidder, and the ask price represents the lowest offer or seller

The general rule of thumb is that spread should not be more than 5 percent Therefore, if the bid is $6 00 then ask should not be $6 30

So, based on this rule you do not want to pay $6 75 rather willing to pay $6 30 as you think this is the fair value of the option Therefore, you placed the order to buy 3 contracts of February CAT 90 Calls at $6 30 This is your bid You are bidding for the contracts at $6 30

Prior to the “Show or Fill Rule”, the market maker was not obligated to show your bid of $6 30 He would simply leave it as Bid $6 00 and ask $6 75

Under the “Show or Fill Rule”, the market maker has two options: 1 - Either he gives you three contracts at $6 30 or 2 - Shows the Bid as $6 30 and Ask as $6 75

If he decides not to sell you at $6 30 then when he shows the bid and ask the spread will be 45 cents and is reduced from 75 cents

As soon as you place your order, your bid will be shown on the top which is $6 30

Now let’s say another trader (Tom) wants to sell 20 contracts of Feb 90 Calls but he does not want to sell at $6 30 rather at $6 50 As soon as he places his sell order the Bid and Ask will be displayed as follows:

Bid $6 30 - Ask $6 50 The spread is further reduced and now it is at 20 cents



Remember, you are bidding to buy at $6 30 and another trader is asking to sell at $6 50

According to the rule, the bid and ask is valid for at least 20 contracts This means the market maker must fill your order of 20 contracts or less at the current bid and ask price

So, if you are buying three contracts of CAT Feb 90 Calls at $6 30, the market maker is obligated to either sell you at $6 30 or show the bid at $6 30 At this time market maker is thinking that if I do not fill the order at $6 30 and rather show and post the order then by law I am obligated to honor the price of $6 30 for 20 contracts In this process the other seller (Tom) can sell at $6 30 instead of $6 50 or $6 00 In this way Tom will get a better price which is $6 30 instead of $6 00

Therefore, market maker will fill your (John) order of three contracts at $6 30 quickly to get you out of the way In this way he does not have to show your order to the market The other seller (Tom) will not be able to get $6 30 and has to sell at $6 00 if he wants to sell

It is advised that first place the order in between bid and ask and see if you get filled This will make huge difference on your profits in the long run However, if the stock is moving fast in your direction and the potential in the trade is significant then fighting with the market maker is not worth, as the trade may slip away If my order does not get filled within 15 seconds at my bid price I either improve my bid or pay at ask and move on with the trade as I do not want to miss out on the profit

Date post:	14-Apr-2017
Category:	Economy & Finance
Upload:	michael-kleven
View:	76 times
Download:	0 times

Financial marketswizardoptionstradingstrategies (1)

Economy & Finance