You’ll find that most techniques for trading are not rocket science. In fact most of the difference between traders who make money and traders who lose money is about discipline, not about technique. That being said, there are some approaches that I feel can help broaden your toolbox and could be a missing component for some traders. Today I’m going to talk about what I call the “Triple Call Technique.”

I utilize this approach in several situations:

• One is in a market like now, where I lack conviction and I feel that overall the issue I’m looking at might be trading in a line.  In cases where I’d like to go long something, but I’m feeling very risk averse this method can be great.  It works particularly well going long on issues that pay a high dividend.
• Another is when I’m looking to hedge a position.  Typically when I’m hedging I’m trying to pick the issue most likely to benefit if I’m wrong and give myself a small upside on that position.  This can also be useful in markets like today’s where I tend to lack conviction in any fundamental sense.
• Finally I can use this in auto-trading systems where I’m trying to build up a position in something over time.  I have a tendency to employ this with ETFs to gain exposure to a certain position over time.

Ultimately the crux of the system is pretty simple.  Let’s assume I’m going long but it can be used in exactly the same way to go short.  This only works with stocks and ETFs in which you can sell options, so they typically can’t be thinly traded.  Typically I set up some type of automated system that will notify when certain criteria are met.  One great approach is to use Market Club’s Trade Traingle system and get notifed whenever a particular score is hit.  You could also consider using any indicator or combination of indicators, even something as simple as Moving Average crossovers.  Once my signal is hit, I take my position and then immediately sell calls as follows:

• 1/3 I sell a deep in the money call.
• 1/3 I sell a slightly out of the money call.
• 1/3 I leave uncovered.

If I’m hedging or otherwise particularly skeptical of the position, I will sometimes not take the uncovered position at all.  What you’ve essentially done by doing this is get your cost basis down but severely limit your upside.  If the intent of the position is to hedge another position this can be perfect.  Additionally if this is a position where you’re likely to get out if it runs very far anyway, then a limited upside isn’t really a liability, since it should be offsetting the limited risk as set by your stop.  Meanwhile you’re risk is significantly curtailed.   Let’s take an example from today’s prices:

Suppose I want to gain exposure to international sales to offset a bias in my other trading positions.  To do this I set a series of watches on Market Club to let me know when any of a series of stocks hits a score of 90.  If you’d like to get a FREE score for a stock just sign up here.  As of today PM is has a score of 90, which is a strong uptrend so let’s use that as my buy signal.  Phillip Morris International closed today at $48.18.  Now let’s start with my in the money call.  Assuming we’re using Dec calls, here are my possible selection:

With these options available, you might be surprised to learn I would take the $43 strike price option. By taking that on 1/3 of my position, I would make 0.88% in 2 months as long as the price stays above 43. If it plummets and goes to $41 then it has brought my price for that block down to $42.67. This makes my hedge less painful if I’m right.

On the second third of my position I would sell a $50 strike price call for $1.20.  Then I would leave the final third uncovered.  The net result of all this is that my average price is $45.94.  Let’s look at what I gain or lose at various prices:

As you can see, the net effect is that if the stock goes down a lot we lose less than we would have otherwise. If the stock stays about flat you make more than you would have and if the stock goes up you make less than you would have otherwise. Ultimately it dampens your effects in either direction. If I did this over a significant period of time with automatic trading signals and a selection of appropriate stocks, I could build up significant exposure without nearly as much risk.  When trying to build up a position, or in unconvincing market the key components are:

1.) Using an Automatic Trade Indicator
2.) Selling staggered options on portions of your position.

When hedging you should simply take the position to offset your other positions.  You can see the many applications, especially in environments where you are risk averse.

Photo Credit: Corey Leopold

Natural gas is a tricky trade.  While market psychology plays a huge role even in commodity trades, the price is in the throes of some serious fundamental impacts.  The price skyrocketed to reach spectacular highs in 2008 and has plummeted since.  Even as it has declined, it’s been a popular buy by some as evidenced by the fact that the UNG ETF has run out of shares until regulators approve more.

When it comes to natural gas, the ETF can provide an easy way to trade the underlying commodity.  I’m not interested in getting a futures trading account, so the fund works well enough for me.  More importantly however, looking at the trailing 12 months or so in this fund can provide a couple of excellent lessons.  First let’s watch some analysis:

Now if you watched that video the first thing I think you can see is this:  Don’t trade against the monthly trend. You don’t have to trade with the monthly trend, but you definitely don’t want to trade against it.  The other lesson, which is just as important, is: Money management is more important than being right.

If you look at the examples in question, the Trade Triangle system produced 9 trades in that time period, 5 were winners and 4 were losers.  So that’s right around 50% results.  The difference is, the losers were tiny and the winners were huge.  That’s your goal as a trader.  You need to accept right now that you are going to be wrong. Trading is about probabilities and putting them all in your favor.  That’s why I wrote about setting a “stop” point for any trade you enter.  If your losers are small and your winners are big then you will make a fortune.  You don’t even have to be right half the time, if you can make your wins big enough.

As for right now, my interpretation is that the overall trend is still downward, but that the moderate term has turned up.  I would basically say this means “hands off.”  I’d wait for some real signs of an up-side breakout before I went long in this fund.  Of course that’s strictly on a technical basis, for all we know the government may mandate CNG cars soon and UNG will go to 100.  If you want to keep up with UNG, you can get a free trend analysis here, which will give you an idea of whether it’s turned or not.

Free Trend Analysis of UNG ETF

Photo Credit: EnergyTomorrow

The Psychology of the Stop

The psychology of trading is fraught with peril.  In many ways once the trade is on you can become fixated on making that trade work out.  The problem is, when you’re doing the research and working out your trade, you’re perfectly rational.  Once you’ve placed the order however, you can start lying to yourself and costing yourself money by convincing yourself to stay with a trade that’s turned against you.  By always trading with a stop, you can set the extent of your trade while you’re still acting completely rationally.  This can be a huge money saver.

When you’re deciding to enter a trade, you should be deciding a priace at which you’ve been proven wrong.  You have reasons why you think the market is going to move in a certain way, which is why you’re considering entering the postion.  You also need to set at what price your analysis no longer holds true and it’s time to get out.  By doing this while you still have all your pros and cons fresh in your mind you can make the best decision and prevent yourself from taking unnecessary chances.

Moving the Stop

SPY With Parabolic

We’ll discuss Parabolic in another article, but it provides a useful visual of how a stop might move during a trade. It also illustrates that this also doesn’t apply only when going long but when going short as well. You should always be looking for when you’ve been proven wrong and cut your losses when you have been.

You Don’t Have To Always Be Right

No one is right all the time, and trading with stops are simply a matter of managing your money to reflect this. If you are right only one half of the time but make more when you’re right than you lose when you’re wrong, you will have success. You are trying to play the odds and you want to make sure that when you’re wrong, you minimize the damage and that when you’re right, you maximize the reward.

Ultimately the stop is your protection from catastrophe. Many people don’t want to be wrong, but I’d rather be wrong with money than right without it. One key thing that many traders forget is that being stopped out of a trade doesn’t mean you can’t retake a position, it simply means it’s time to re-evaluate and make sure your trade still makes sense or wait until it does again.

Photo Credit: Kass & Rachel

One thing that this book does that is rarely seen in these kinds of tomes is the author explains exactly the mathematics behind each indicator he presents.  I have literally used this book to write implementations of the indicators.  While you may not want to do any programming any time soon, having a basic understanding of the math also helps you understand exactly what the tool is telling you.  You may have a vague understanding of the MACD and what it means, but if after reading this book you will understand it so much better.  This can only lead to making better trading decisions.

For those who only trade stocks and their derivatives, like myself, the focus of the book on futures may require an extra step to make sure that you understand how it applies to stocks.  In reality though, almost all of the information is almost immediately applicable to any market.  When the book was written, technical indicators were not so en vogue in the stock market.  Additionally the money management techniques he describes are just as valid for just about any kind of trader.

Ultimately the value of this book is in developing a strong fundamental education in technical trading.  Learning by rote, without understanding the indicators you’re trading on is a dangerous game that sounds more like gambling.  Buy Alexander Elder’s Trading for a Living if you really want to have the kind of background that can help you make quality decisions.