Traders Toolbox: Candlestick Formations
Japanese candlesticks, which have been enjoying the spotlight in recent years, are difficult to explain in one broad brush. Candlesticks draw on the same open-high-low-close data as do bars. Here the length of the bar, or “candle,” is determined by the high and low, but the area between the open and close is considered the most important.
This area, the “body” of the candle, is filled with blue (or white for most charting programs) for closes higher than open, and is filled with red (or black from most charting programs) for down days. The wicks above and below constitute the “shadow” of the candle, or high or low.
No pattern is 100% correct, but these formations are often time incorporated into many mechanical systems and can provide as great information source for the naked eye.
*Change to hammer and hanging man made on 12-10-08.
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Doji - When the open and close price is almost the exact same value and the tails are not excessively long. This formation can alert investors of a possible indecision and during oversold or overbought conditions can possibly signal for reversal. The bulls and bears are equally pushing the price.
Long-Legged Doji - You can recognize this formation by one or two long tails (shadows). This formation will sometimes alert that we have reached the top of the market or warn that the trend has lost sense of direction.
Gravestone Doji - This formation occurs when the open and close price is the same or near the low of the bar (period). Although this can be found at the bottom of a trend, this formation can be used to pick out market tops.
Hanging Man - This formation looks like a body with feet dangling… or a hanging man. This occurs when there is profit taking near market open, then a rally with a close at or near the open price. This formation can alert of a reversal and is typically found at the top of an up-trend. The longer the shadow, the greater the change is for a reversal.
Hammer - This formation is a short body with a tail that is twice the body’s length. This occurs when there is a sell off near open, but then a rally supports a close at or near the open. This formation can alert of a reversal and is typically found at the bottom of a downtrend. The longer the shadow, the greater the changes are of reversal.
Spinning Top - This short body has sizable tables both on the top and bottom of the bar. This formation often times represents indecision and a standoff among the bears and bulls. There is little movement between the open and close, but both the bears and the bulls were active that trading day. After a long blue candlestick, a spinning top suggests weakness among the bulls. After a long red candlestick, a spinning top suggests weakness among the bears.
Bearish Engulfing Pattern - This formation is a major reversal pattern after the completion of an uptrend. After a blue candlestick, the next day will open above the previous day’s positive close, throughout the trading day it will blow past the previous days open completely engulfing the previous day’s movement.
Bullish Engulfing Pattern - This formation is a major reversal pattern after the completion of a downtrend. After a red candlestick, the next day will open below the previous day’s negative close, throughout the trading day it will blow past the previous days open completely engulfing the previous day’s movement.
Evening Star - This is a top reversal signal suggesting that prices will go lower. It is formed after an obvious uptrend. The 1st candlestick is a long blue box (usually when the confidence had peaked). This stick is followed by a small blue body, when the trading range for the day has remained small. The third bar (red) plows down at least 50% past the 1st day’s bar signifying that the bears have taken control.
Morning Star - This is a bottom reversal signal suggesting that prices will go higher. It is formed after an obvious downtrend. The 1st candlestick is a long red box followed by a small blue box, when the trading range for the day has remained small. The third bar (blue) shoots up at least 50% over the 1st day’s bar signifying that the bulls have taken control.
Dark Cloud Cover - This is a two bar formation that is found at the end of an upturn or at a congested trading area. The first bar is a blue (positive movement) bar followed by a red bar which reaches over the open of the previous days close and closes at least 50% down the previous days bar.
Piercing Pattern - This is a two bar formation that is found at the end of a declining market. The first bar is a red (declining movement) bar followed by a blue bar which opens (often gaps) below the previous days close and reaches at least 50% of the previous days bar.
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You can learn more about Candlestick formations by visiting INO TV.
Traders Toolbox: Bullish Consensus Meter
Traders Toolbox: Money Management 4 of 4
This is the final portion of the Trader’s Toolbox: Money Management series. This post will recap the 5 main rules discussed. If you missed our previous post please click here for : Part 1, Part 2 or Part 3.
♦ Setting a goal - Decide what your trading objective is (quick profit and steady return) as well as your risk tolerance level
♦Diversification - If possible, allocate your finances between different products to avert the danger of getting wiped out in a single market. Don’t go overboard, though; think in terms of three to five unrelated instruments. Stick to markets you know, rather than risking the unknown for the sake of diversification.
♦Deciding how much money to risk - The total amount you risk at a given time in a particular market group or on a particular trade should be based on a a percentage of your total trading equity. Exceeding your allocation parameters can result in overexposure.
♦Use of stop orders - The name of the game is preservation of capital. Placing conservative stops to cut your losses will ensure you are around to trade another day. Stick to the limits determined by your equity allocation percentages.
Traders Toolbox: Money Management Part 3 of 4
Crucial but often overlooked, money management practices can mean the difference between winning and losing in the market.
-Placing Stop Order- It’s helpful to think of these by their more formal name, stop-loss orders, because that is what they are designed to do – stop the loss of money. Stop orders are offsetting orders placed away from the market to liquidate losing positions before they become unsustainable.
Placing stop orders is more of an art than a science, but adhering to money management rules can optimize their effectiveness. Stops can be placed using a number of different approaches; by determining the exact dollar amount a trader wishes to risk on a single trade; as a percentage of total equity; or by applying technical indicators.
Realistically, methods may overlap, and you’ll have a certain amount of leeway in deciding where to put a
stop, but always be wary of straying too far from the basic asset allocation parameters established earlier. For example, if a trader is long one S&P 500 future at 450.00, a based on his total equity he has a $2,500 to risk on the position, he might place a sell stop at 445.00, which would take him out of the market with a $2,500 loss ($500 per full index point, per contract). Buss after consulting his charts, he discovers strong support at the 444.55, a level he believes if broken will trigger a major break. If this level is not broken, the trader believes, that rally will continue. So he might consider putting a stop at 444.55 to avoid being stopped out prematurely. Although he’s risking an extra $225, he’s staying close to his money allocation percentages and modifying his system to take advantage of additional market information.
Of course, the size of a position will affect the placement of stops. The larger the position, the loser the stop has to be to keep the loss within the established risk level. Also consider market volatility. You run a greater risk of getting stopped out in choppy, “noisy” markets, depending on how far away stops are placed. This can cause unwanted liquidation when the market is actually moving your direction.
Now suppose our hypothetical trader, who started with $50,000, is now looking at a $10,000 gain (which happened to be his goal for this trade) on a long position. What should he do? That depends entirely on his trading goals. He can take the $10,000 profit and, assuming he leaves the money in his trading account, turn to other trading opportunities. If he desires, he can increase the size of his trades proportionally to his increase in trading equity. This would give him the potential to earn greater profits, with the accompanying risk of greater losses.
He also could choose to keep the size of his trades identical to what they were before he made his initial profit, thus minimizing his risk (as he would be committing a smaller percentage of his total equity to his trades) but at the same time bypassing the chance for larger profits. If his winning positions had consisted of more than one contract and he believed the market was still in an uptrend, he could opt to take his profits immediately on some of the trades, while leaving the other positions open to gain even more. He then could limit his risk on these remaining trades by entering a stop order at a level that would keep him within his determined level of risk, as well as protect his profits. He does run the risk of giving back some of his money if he is stopped out, but counters that with the potential for even larger gains if the market continues in his direction.
Good money management practices dictate stop orders be placed at levels that minimize loss; they should never be moved farther away form the original position. You should accept small losses, understanding that preservation of capital will in the long run keep you in the market long enough to profit from the wining trades that make up for the losers.
Trading in the real world almost never seems to go as smoothly as it does on paper, mainly because paper trading typically never figures in such real world factors as commission, fees and slippage. “Slippage” refers to unanticipated loss of equity does to poor fills (especially on stops) that can result from extreme market conditions or human error. Factoring these elements into your overall money management program can help create a more realistic trading scenario, and reduce stress and disappointment when gains do not seem to be as large as they should be.
-One Final Note- Do your money management homework before you start trading. This helps you decide what to trade and how to trade it. On paper, money management sounds so obvious and based on common sense that its significantly overlooked. The challenge is to apply its principles in practice. Without money management, even the most astute market prognosticator may find himself caught in a downward trading spiral, right on the trend, but wrong on the money.
Traders Toolbox: Money Management Part 2 of 4
Crucial but often overlooked, money management practices can mean the difference between winning and losing in the markets.
-Amount Of Money To Risk- It’s difficult to come up with hard and fast money to risk on different markets and trades. For our purpose, though, it’s best to think conservatively. Although some studies suggest initially allocating equity in broad terms of original margin (40% to 50% of total equity committed to the markets at a given time in the form of original margin, 15% to a particular market, 5% to a single trade, etc.), many traders consider these percentages too high, and do not consider the market to be a accurate measure of risk or a sound basis on which to allocate funds, because a trader can always, technically, lose more than the margin amount. These traders find it more beneficial to think in terms of the actual money amount they are willing to lose on any particular trade or trades, determined by their stop level or through some other calculation. 
Although in specific circumstances professional traders may actually risk comparable or even greater percentages of total equity than those listed previously, on average they risk much less-perhaps 12% to 20% of total capital at a time, and 2% - 4% per trade. Depending on the size of your trading account, these levels might seem overly strict, but again, the idea is to conserve money for the long haul.
In developing your trading goal, determine how much you could accept losing on a trade, both financially and psychologically. Based on total capital and the number of markets in which you are active, allocate your equity proportionally between individual trade, market group and total trading activity levels.
These guidelines protect you from dangers of extreme leverage in the futures markets. Though it may seen attractive to have the change to make big money on a small initial investment, the risk of loss is just as great.
-Determining Reward/Risk Ratios- Another common rule in trading is never to put on a position unless your possible profits outweigh your possible losses by a ratio of 3 to 1, or at the very least 2 to 1. So, if a particular trade has the potential of losing $100, the profit potential should be at least $200 to $300. This is not a bad rule, but like so many aspects of trading, it is somewhat intangible. Once you have formed an opinion of a market, determined your entry point and calculated the maximum amounts you could win or lose on a trade, you still are left with the uncertainty of the probability of your trade winning or losing, and unfortunately there is not secret formula for removing this uncertainty.
Some traders don’t consider probabilities valid at all. The most any trader can do is perform his or her best analysis of the market, and, along with experience and intuition, come up with some rough idea of the probability of success for a given trade. This probability can then be weighed against the reward / risk ratio in selecting trades. For example, would it be better to put on a trade where the reward / risk ratio is four to one and the probability of success is 30%, or would it be advisable to put on a trade where the reward / risk ratio is only two to one but the probability of success is 75%? Using this rule, you’ll be ahead of the game by directing resources to the trades with the greatest chance of success.
Traders Toolbox: Money Management - Part 1 of 4
Crucial but often overlooked, money management practices can mean the difference between winning and losing in the markets.
Plenty of books, manuals, and software packages will help you form and opinion of a market, but not many will tell you how to trade once you have decided to get long or short. The goal of money management is to increase the odds of high quality trades. And as we’ll see, leaving the money management variable out of your trading equation can lead to ruin, even if you’re correct about the market direction.
In a broad sense, money management can encompass those elements of trading outside the initial decision to get long or short in a given market or markets – that is, how many positions to put on, when to get out, where to place protective stops. More specifically, it refers to the strategic allocation of capital to limit risk and optimize trading performance in the long run. Allocation of capital can refer to how much money to put into any one market or how much money to risk on any one trade. These decision directly affect how many positions to put on and where to place stop orders.
Given the negative odds inherent in trading (a successful trader can expect to lose money on 60% of his trades), how do you go about maximizing the profit potential of the few winning trades you can expect to have? The answers vary with the disposition and trading style of the individual trader. There exist, however, basic concepts that can be successfully adapted and modified to individual needs, and when the followed in spirit, can boost the promise of long-term trading profits and take some of the stress and uncertainty out of trading.
-Establish A Goal- Having a clear idea of what you want to accomplish by trading, whether it is a short-term profit on a single trade or the desire for a long-term trading career, can go a long way toward building successful trading habits. Regardless of whether or not the goals are set on a per trade, daily or long-term basis, establishing from the outset basic levels of acceptable risk and financial reward will help curtail avoidable risk and extreme losses. Also, determine a specific time frame in which to trade: Will a position have to be liquidated by a certain time for tax purposes or for same other reason?
-Diversification- Just as in the stock market, a portfolio of different instruments can be one of the best hedges against several and unsustainable losses; a loss in one market will hopefully be offset by gains in others. Traders must take caution, though, to truly diversify their portfolios with contracts that are price independent. Spreading your trading among three or four different interest rate contracts that move in a similar fashion is not a good example of diversification, because a loss in one contract is likely to be mirrored by losses in the others. But over-diversification is dangerous, too. A trader can spread his money over too many markets, and not have enough capital in any one of them to weather even small adverse price swings.
A good rule of thumb is to stick with what you are comfortable; do not venture blindly into unknown markets just for the sake of diversification. A balance must be stuck between available resources and a manageable trading scenario. Capital constraints will, of course limit the choices traders can make, forcing those with smaller trading accounts to bypass or minimize diversification.
Traders Toolbox: Learning Options Part 4 of 4
In real estate, they say that the three most important things are location, location, and location. In options, the three most important things are volatility, volatility, and volatility. Often neglected by option rookies, volatility is the cornerstone of an option professional’s trading strategy.
In its simplest form, expressed as the annualized percentage of the standard deviation, volatility measures how far a contract can be expected to swing from a mean price. A contract trading at 50 would have a volatility of 10% if it traded between 45 and 55 over a given period of time.
Historical volatility is just that: the volatility calculated (using closing prices) over a given period – 20 days, 20 weeks, one year, etc. Implied volatility is the volatility using current market prices. For example, using four primary option pricing inputs – futures price, settlement price, time until expiration and volatility – would result in a theoretical price.
By plugging in the current option price in place of the theoretical price and working backward, it would be possible to determine the volatility the current market is implying. (It is not mathematically possible to work backward and solve for implied volatility using an equation like the Black-Scholes model, but an approximation can be derived.)
Options on quick-moving, highly volatility contracts will demand a higher premium because of the increased possibility of such options being in-the-money. For example, an out-of-the-money option on a slow, non-volatile contract will have a lower premium than a comparable option on a volatile contact because there is a greater chance the volatile contract will shirt in price enough to put the currently out-of-the-money option in-the-money.
Astute options traders look at volatility figures to evaluate the potential of a trade, buying or selling options when volatility is exceptionally high or low. If a market is trading at historically low volatility levels, options premiums could be expected to rise as market volatility increases, presenting a buy opportunity. The revers is true for high volatility situations.
Traders Toolbox: Learning Options Part 3 of 4
Two of the more common option strategies are horizontal spreads (identical strike prices, different expiration days) and vertical spreads (different strike prices, same expiration day). Other spread types are combinations or variations of these categories: Diagonal spreads are a mixture of horizontal and vertical spreads; butterfly spreads combine two different vertical spreads.
Selling a March 450 S&P call and buying a June 450 S&P call is an example of a horizontal spread, also known as a time, or calendar spread. The object is to profit from the quicker decay of time value of the nearby short option compared to the more distant long option. The trader is, in effect, selling time value. Most time decay occurs in the last three months, and especially the last month, of the contract. This strategy is generally most profitable with equity options than with future options.
If you sell the March option at 7.75 and buy the June option at 11.75, you establish the calendar spread at a 4.00 debit. (Debit spreads are spreads that the trader pays to establish, while in credit spreads the trader collects premium). The March contract then drops to 1.25, while the June option drops to only 10.50. You could then “lift” (offset) the spread, buying the March back at a 6.50 profit and selling the June for a 1.25 loss, for a total profit of 1.25 (5.25 minus the 4.00 paid to establish the spread).
In a vertical spread, the options share the same expiration date but have different strike prices. An example would be buying a March 445 S&P call at 6.50 and selling a March 455 S&P call at 3.00 with the futures at 450.00, for a 3.50 debit on the spread.
In the market rallies, the deeper in-the-money long option would gain more than the short option would lose. If the futures are unchanged at expiration, the 445 call will be worth 5.00 (its intrinsic value) and the 455 call will expire worthless, for a 1.50 profit on the trade. Once the futures price rises above the higher strike, against on the lower strike are offset by losses on the higher strike, so profit is limited. If the market falls, loss is limited to the amount paid for the spread.
Option spreads are characterized as bear or bull strategies depending on whether they will profit in up or down markets. The previous example is a bull call spread, because it would make more money in a rising market. A bear call spread would consist of selling the lower strike option and buying the higher strike option.
Bull and bear spreads also can be established using put options. For example, a bull put spread would consist of buying a December 445 S&P put and selling a December 445 put. Selling the 445 put and buying the 445 put would be a bear put spread. Generally, you should use calls for bull spreads and puts for bear spreads.
You can alter spreads by modifying the number of options, for instance establishing a vertical bull call spread with two short calls for every long call, also known as a ratio spread. Whether all or some of the options in a spread are in-, at- or out-of-the-money also will affect the risk/reward profile of a spread.
Other strategies focus on the magnitude of price movement rather than direction. Straddles and strangles are two strategies traders use to take advantage of volatility swings. A straddle consists of buying at-the-money puts and calls with the same strike price and expiration day, for example, buying a June 100 bond call and a June 100 bond put. The straddle buyer expects a futures price move large enough (in either direction) that they profit on the in-the-money option will be more than the cost of putting on the spread. If you thought the market would remain virtually unchanged, you could sell the straddle (at a credit) and reap the profits as time eroded its value.
A strangle consists of combining out-of-the-money call and puts. With June bonds at 102, a strangle buyer might purchase a June 104 call and a June 100 put, again expecting a sizable move in either direction. (An advantage to this strategy is it is cheaper than a straddle, but the market also has to move more to make it profitable.) For a trader who expects bond prices to stay between 100 and 104, however, selling this straddle offers an excellent opportunity to “sell volatility.” If the market does stay between these prices, the seller will keep his premium.
Traders should be away that because of higher commissions and increase slippage, a marginally profitable options trade can actually be a loser when all is said and done. Understanding volatility and time decay concepts will help identify strategies with the highest probability of success.
Part 4 Will Be Posted On November 17th, 2008. So come back soon!
Traders Toolbox: Learning Options Part 2 of 4
Many people like options because they believe them to be less risky than futures. Options sometimes offer reduced risk, but usually at the cost of reduced profit potential.
One drawback of options is that a trader must consider market speed (volatility) as well as direction. Traders who buy or sell options outright to profit from up or down moves in the underlying market can find themselves fighting an uphill battle against volatility and time decay. With futures, if you’re right about market direction, you’ll win. With options, you can be right about the market and still lose.
If a market is trading at 200 and you buy a 210 call expecting a rally, you’ll still lose on the trade if the market only rallies to 205 by expiration; your 210 call will be worthless. The same thing would happen even if the market rises as high as 220, but does so one week after expiration. In each case you would be right about market direction but would not profit.
The advantage of options is their flexibility. Because of the variety of strike prices and expiration dates a trader can choose, options naturally lend themselves to spreading strategies (simultaneously buying an selling different options), accommodating varying views of market direction and risk levels. Traders can design option strategies that will profit if the underlying market goes up or down, moves in either direction by a certain degree or remains unchanged.
Options also allow you to profit without predicting market direction because of time decay and fluctuation in volatility that increase and decrease premium. For example, a trader might sell as out-of-the-money call on a relatively volatile futures contract he thinks will fall. Over then next two months, however, the market does not fall, but gradually moves higher, trading in a narrow range (but still below his strike price). The trader was wrong about market direction, but finds the combination of decreased volatility and time decay has eroded the value of his option to the point that he can buy it back at a profit (or perhaps hold it until expiration).
Part 3 Will Be Posted On November 14th, 2008. So come back soon!
Traders Toolbox: Learning Options Part 1 of 4
There are four components to an options price: underlying contract price, intrinsic value ( determined by strike price), time value (time remaining until expiration) and volatility. (A fifth element, interest rates, also can affect option prices, but for our purposes is unimportant.)
Intrinsic value refers to the amount an option is in-the-money. With Eurodollar futures at 95.55, a 95.00 call has an intrinsic value of .55. The more an option is in the money, the greater its intrinsic value. At-the-money and out-of-the-money options have no intrinsic value.
Options are referred to as “wasting” assets because their value decreases over time until it reaches zero at expiration, a process called time decay. Time value refers to the part of an option’s price that reflects the time left until expiration. The more distance an option’s expiration date, the greater the premium because of the uncertainty of projecting prices further into the future.
Considering two equivalent call options. With May corn futures at 232 1/4, July corn futures at 236 1/4 and 10 days left until May corn options expire, a May 230 call might cost 2 3/8 while a July 234 call costs 6 1/2, even though they are equally in-the-money.
Volatility, perhaps the most important and most widely ignored aspect of options, refers tot he range and rate of price movement of the underlying contract. The “choppier” the market, the higher the price that will be paid for this unstability in the form of higher option premiums.
Volatility usually is expressed as a percentage, and is comparable to the standard deviation of a contract. Higher volatility means higher premiums. Lower volatility means lower premiums. A trader familiar with the volatility history of a contract can gauge whether volatility at a given time is relatively high or low, and can profit from fluctuations in volatility that will in turn increase or decrease option premium.
The Black-Scholes price model, first introduced by Fischer Black and Myron Scholes in 1973, is the most popular theoretical options pricing model largely because it was the first relatively straightforward arithmetic method for determining a fair value for options.
Part 2 Will Be Posted On November 10th, 2008. So come back soon!
