Trading

Trading & Investing in Stocks & Options

Department of Social Science & Policy Studies

Worcester Polytechnic Institute

Michael J. Radzicki, Ph.D.

[email protected]

http://www.michaeljosephradzicki.com/

New York Stock Exchange – 4 August 2006

Outline Of My TalkOutline Of My Talk

Hierarchy of Stock & Options Price Movement

Some Basic Macroeconomics

Inter-Market Analysis

Sector Rotation

Market Breadth

Trading & Investing

Options




Economy

– Actions of central bank(s)– Fiscal policy

Markets

– Currency Markets– Commodity Markets– Bond Market– Stock Market

Sectors

Industry Groups

Individual Stock Prices

Individual Stock Option Prices


Some Basic MacroeconomicsSome Basic Macroeconomics

Gurus: John Maynard Keynes, Hyman Minsky, Abba Lerner, Warren Mosler & L. Randall Wray


Capitalist economies have a trend & a cycle(s)



Trend due to self-reinforcing processes:

– Supply Side

• Population Growth

• Technological Innovation & Ideas

• Capital Accumulation

– Demand Side

• Fiscal Policy



Cycle (primarily) due to:

– Consumption Spending

• Since 1980, due to consumer credit

– Investment and the dynamics of its financing

• Which includes speculation (a self-reinforcing process)

– Countercyclical Government Spending



Inflation/deflation and involuntary unemployment are the traditional evils that policymakers try to combat

– Other evils exist too

Capitalist economies are often “demand constrained”

– Which results in unused production capacity

– In both the long and short runs



Minsky’s Theory of the Cycle

– Investment spending & its financing is the key

– Hedge Firms/Sectors

– Speculative Firms/Sectors

– Ponzi Firms/Sectors



Central banks in capitalist economies are said to (implicitly) follow a Taylor Rule:

It = Inft* + rt* + a*(Inft- Inft*) + b*(yt – yt*)

It = Target Federal Funds Rate Inft = Rate of inflation (measured by GDP deflator) Inft* = Desired rate of inflation rt* = Real interest rate consistent with full employment (usually

thought to be 2%) yt = Real GDP yt* = Potential real GDP




Economy of the Rest of the

World

U.S. EconomyPrivate Sector Balance

Gov’t Budget

Current Account

Federal Reserve System Open

Market Committee

Fed Funds Target Rate; Bond

Purchases & Sales

Taylor Rule, Current Account

& Exchange Rates


During the expansion phase of the cycle (fearing inflation) the Fed starts to raise the Federal Funds rate target

– The term structure of interest rates responds

Generally speaking, rising interest rates & fear of inflation:

– Drives bond yields up and thus bond prices down

– Slows the housing market & thus household sector spending

– Slows the economy (and thus slows earnings growth) [maybe]

– Drives stock prices down

– Drives commodity prices up

– Can strengthen (or weaken) the dollar



S&P 500 PE Ratio Moves Opposite of the Federal Funds Rate

S&P 500 PE Ratio Moves Opposite of the Federal Funds Rate


But fiscal policy cannot be ignored!

Actually, the quantity of money in the economy is determined by fiscal policy

“Monetary policy” simply consists of setting the federal funds rate

Lerner-Mosler-Wray story



Levy-Kalecki Profits Equation:

Gross After Tax Profits (Includes Interest, Rent & Dividends) =

Investment Spending + Consumption Out of Profits - Saving Out of Wages +

[Gov’t Spending – Gov’t Tax Revenue] +

[Exports - Imports]



Thus:

[Gross After Tax Profits – Investment Spending – Consumption Out of Profits

+ Saving Out of Wages] -

[Gov’t Spending – Gov’t Tax Revenue] -

[Exports - Imports] = 0



That is:

[Saving Out of Profits + Saving Out of Wages] -

[Budget Deficit/Surplus] -

[Trade Deficit/Surplus] = 0



That is:

[Private Sector Balance] -

[Current Account Balance] =

[Government Sector Balance]



Currently:

Private Sector Balance (+2% of DPI) -

Current Account Balance (-6% of DPI) =

Government Sector Balance (4% of DPI)



Other Levy-Kalecki Profits Equation Relationships :

– The Unemployment Rate closely tracks the Private Sector Balance

• When the private sector goes into deficit it reduces the unemployment rate but also accumulates debt

– The Value of the Dollar closely tracks the Government Sector Balance

• As the budget deficit increases, the value of the dollar falls



Thus, any private sector surplus (i.e., any accumulation of wealth by the private sector) coupled with any current account deficit must be offset by a government sector deficit and vice versa!

So, how loud should we applaud the federal budget surpluses during the late 1990s?

Government surpluses are deflationary and directly associated with the loss of private sector wealth

– Which is bad for stock prices

– Which decouples the relationship between stock & bond prices



Inter-Market AnalysisInter-Market Analysis

Guru is John Murphy

– http://stockcharts.com/charts/performance/Intermarket.html

– 2004. Intermarket Analysis: Profiting from Global Market Relationships. Hoboken, NJ: John Wiley & Sons, Inc.

– 1991. Intermarket Technical Analysis: Trading Strategies for the Global Stock, Bond, Commodity, and Currency Markets. Hoboken, NJ: John Wiley & Sons, Inc.



Three key relationships:

– U.S. Dollar & Commodities => Negative

– Commodities & Bonds => Negative

– Bonds & Stocks => Positive (Unless Deflation)

• Bond market typically leads stock market by 6-8 months


Source: StockCharts.com




Main idea:

– If you’re going to successfully trade stocks and stock options, you have to pay attention to the bond, commodities and currency markets

– Therefore, you also have to pay attention to the economy, fiscal & monetary policy, and to world events


Sector RotationSector Rotation

Guru is Sam Stovall of Standard & Poor’s

– http://www.businessweek.com/investor/list/stovall_toc01.htm

– 1996. Sector Investing. McGraw-Hill.

– 1995. Standard & Poor’s Guide to Sector Investing. McGraw-Hill.

Murphy & Cramer are into it too!



Over the macroeconomic cycle, institutions move money out of certain sectors and into other sectors

Thus, a good investing/trading strategy is to follow the institutional money to the hot sectors

http://stockcharts.com/charts/Carpet/


Sector Rotation – Relative Strength

Sector Rotation – Relative Strength



Gurus are Greg Morris & John Murphy

Morris, Gregory L. 2006. The Complete Guide to Market Breadth Indicators. New York: The McGraw-Hill Companies.

Market BreadthMarket Breadth


Advance/Decline Indicators

New High/New Low Indicators

Up Volume/Down Volume Indicators

McClellan Indicators

Vix

Technical analysis applied to the main indices



Not every close of the S&P 500 below its 200 day EMA signals a bear market, however every bear market starts with a close of the S&P 500 below its 200 day EMA.

If the 50 day EMA of the S&P 500 crosses below its 200 day EMA the odds of a bear market increases

– Called a “death cross”

– Opposite is called a “golden cross”




50 Day EMA

200 Day EMA


Weekly Moving Average Cross-Over System (from John Murphy)

13 Week EMA & 34 Week EMA

Works best on S&P 500

– S&P crossed briefly & then recovered

– NASDAQ has crossed




False Signal

(Quickly Corrected

) Bull

Bear

13 Week EMA

34 Week EMA

See Next Slide



Convergence But No

Cross

Small Cross & Recovery


S&P 500 100 Day (20 Week) & 400 Day (20 Month) Exponential Moving Averages

– Closing below the 100 Day EMA is a minor sell signal (bearish)

– Closing below the 400 Day EMA is a major sell signal (bearish)

– 400 Day EMA is major area of support




Minor Bearis

h

Bullish

Major Bearish

100 Day EMA

400 Day EMA

400 Day EMA

ProvidesSuppo

rt



Bullish

Bullish

Bearish

400 Day EMA

Bollinger Bands +-

2


Generally speaking, it’s better not to trade against the market

Bull market: Buy stocks & call options

Bear market: Sell stocks short & buy put options

Trading & InvestingTrading & Investing


Select Your Style:

– Scalping

– Day Trading

– Swing Trading

– Intermediate Position Trading

– Long Term Position Trading

– Investing

Trading Vs InvestingTrading Vs Investing

As you move from micro scalping to investing, you hold your positions longer (thus tying-up your capital longer) & can earn more $ on each trade. But you must also know more about why a stock is moving [Financial Economy (news, earnings, splits, fundamentals, etc.) & Real Economy (FDA approval, new products, mergers & acquisitions, etc.)].

Pattern Day

Trading Rule

Applies


Three Tools Required for Trading & Investing:

– A method for finding stocks & options to buy & sell

– A trading platform for timing entries to, and exits from, trades

– A method & strategy for executing trades

• Broker

• Trading Plan

Trading & InvestingTrading & Investing


Stock Shepherding

Stock Screeners

– Business Week (Free)

• http://prosearch.businessweek.com/businessweek/general_free_search.html?mode=advanced

– Short Term Stock Selector (Free & Cost)

• http://home.flash.net/~hesler/

• Neural net picks stocks to swing trade

– HotScans (Cost)

• http://www.marketgauge.com/

Market Carpets & Heat Maps

– http://www.smartmoney.com/MARKETMAP/

– http://screening.nasdaq.com/heatmaps/heatmap_pmi.asp

– http://www.spdrindex.com/sectortracker/

Top Ten Lists

News: e.g., CNBC & Bloomberg

Pundits: e.g., Cramer (Boo-Yah)

Value & Growth Investing

Finding Stocks & Options to TradeFinding Stocks & Options to Trade


Technical trading is nothing more than support & resistance!

– http://www.stockconsultant.com/

Need a charting program to identify support & resistance levels & thus to time entries & exits

– http://www.marketbrowser.com/mbzzzq2.asp (Free)

– http://www.bigcharts.com/ (Free)

– http://www.tradestation.com/ (My Personal Choice)

Trading PlatformsTrading Platforms


Like the economy, individual stock prices have a trend & a cycle

Up-Trend: Higher highs & higher lows

– Bullish: Buy stocks; Buy call options

Down-Trend: Lower highs & lower lows

– Bearish: Sell stocks short, Buy put options

No Trend: Price just oscillates

– Neutral: Sell call options on stocks you own



Must identify up-trend, down-trend, or no trend

Plotting stock price data

– Line plots

– Western bar plots

– Japanese candle sticks



Apply Well-Known Technical Indicators to the Stock Price Data

– Moving Averages & Trend Lines

• Shows changes in trends

– ADX – Average Directional Index

• Shows the strength of a trend

– Oscillators

• E.g., RSI & Fast & Slow Stochastics

• Shows over-bought & over-sold conditions – i.e., when a stock price will reverse

– An Indicator that Utilizes Elements of Both the Trend & the Cycle

• MACD – Moving Average Convergence Divergence



Fundamental InvestingFundamental Investing

Growth Investing

– Guru is Cramer (among many others)

– http://www.thestreet.com/

– http://www.cramerwatch.org/

– Main Idea:

P/E = [Price ($/Share) / Earnings ($/Share)]



P/E = “Multiple” = M

M * E = P

Find stocks that have a lower M and a higher historical growth rate of E than the average firm in the S&P 500

PEG useful



But:

M * Expected Future (E) = Expected Future (P)

So, should try to predict future earnings growth too

– Conference calls– Analysts– New product introductions– Small debt– Better sales & margins, & lower costs than rivals– Secular or cyclical stock?



Value Investing

– Guru is Warren Buffet

– http://www.coattailinvestor.com/

– Main Idea: Analyze a company & determine its intrinsic value. When its share price drops below that value => buy.

– Bible is Security Analysis by Graham & Dodd

– Must know basic accounting


Method & Strategy for Executing Trades

Method & Strategy for Executing Trades

Broker

– Keys to selecting a good broker

– Cash & margin accounts

Trading Plan

– Money management

• Risk-Reward Ratios

• Order entry & exit strategies

– Order types

– Setting stops


ExampleExample

http://scansstaging.marketgauge.com/login.asp?reason=denied_empty&script_name=/Scans/OpeningRange.asp&path_info=/Scans/OpeningRange.asp&fid=8969

Paper Trading:

– http://simulator.investopedia.com/


OptionsOptions

Derivative markets are exploding!

Options provide leverage (a small percentage move in the underlying asset means a large percentage move in the value of the corresponding option) & a way to manage risk

Options require a smaller outlay of capital

Many options strategies are quite simple; some are complex


OptionsOptions

Some options strategies only work if the underlying asset moves in a particular direction

Some options strategies only work if the underlying asset moves in either direction

Some options strategies only work if the underlying asset doesn’t move


OptionsOptions

An option is a contract that gives the owner the right, but not the obligation, to buy/sell an underlying asset (e.g., 100 shares of stock) at a particular price (the strike price) by a particular date (the expiration date).

– It’s an asset

Two types of option contracts:

– Calls & Puts

Two styles of options contracts:

– American style & European style


OptionsOptions

The writer of an option has the obligation (a liability) to buy/sell an underlying asset (e.g., 100 shares of stock) at a particular price (the strike price) by a particular date (the expiration date).

– This obligation will not need to be fulfilled unless the strike price is passed


OptionsOptions

A contract has two parties: a buyer & a seller

Call Put

BuyBullishMax risk limited to premium paidMax reward unlimited

BearishMax risk limited to premium paidMax reward = strike price – premium paid

Write

BearishMax reward limited to premium receivedMax risk unlimited

BullishMax reward limited to premium receivedMax risk = strike price – premium received


OptionsOptions

Time decay

– Ice cube melting on a sidewalk

Options Valuation

– Time value

– Intrinsic value

• ITM, ATM, OTM

• Volatility

• Other factors


OptionsOptions

Simple strategies

– Buy a call instead of the underlying stock

– Buy a put instead of shorting the underlying stock

– Buy/Write or Rent Your Stock

– Write a (naked) put to purchase a stock you feel is currently over valued


OptionsOptions

Free information on options:

– http://www.888options.com/

– http://biz.yahoo.com/opt/education.html

Trading

Economy & Finance

Transcript of Trading