Category: Market Psychology

Why Should You Paper Trade Options
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“Will you skydive without knowing how to operate your parachute?”

Investing and Flying are similar, in some ways.

Many new traders doubt if Paper Trading is still relevant? does it do any good at all. They claim that it is a different “feel” when your actual hard earned money is at risk.

“Your emotions are your biggest baggage when it comes to trading and investing and so you need to go through the “real-pain or gain” to know “how it feels like” to be a trader”…many think that way…

There’s no denying on “feeling part”; albeit, emotions is just one aspect and in my opinion, it is not very important while you are beginning to learn trading. It’s importance, however, grows over time.

So why should you pay attention to paper trading? why is it still relevant and will continue to be relevant?

I trade on paper money even now…why?

Let’s categories the reasons into four broad categories:

To Know The Trading Platform

If you think education is exepnsive, try ignorance. – Derek Bok

When you want to drive a car, you need to understand your car’s operations. You need to know how to start, stop, drive, turn, reverse, park etc., and the list goes on and on. Similarly, in order to execute your trades, you need a trading platform which is usually provided for free by your broker who opens your account and allows you to trade.

And guess what, you might have wonderful ideas, trading systems and strategies, but you can only execute those if you understand the trading platform.

So what are some of things you need to learn before you could place your first REAL-MONEY trade?
1. You need to understand your account information which includes deposits, withdrawals, current balances and so on.
2. You need to learn how to analyze, open, monitor and close positions for your desired trading srtategy and system.
3. Trade identification is one of the first areas you will have to spend time on so knowing how to find, filter and identify trades on your trading platform will be extremely useful.
4. And if you are like most traders, you would want to watch market action and create watchlists, stock filters , etc. for keeping an eye on potential future opportunities.
This is just the beginning.

As you can see, you don’t wanna experiment all this with real-money.

By Paper trading or simulating real-trading environment on a virtual trading account, a newbie trader can avoid painful mistakes that are often triggered due to trading platform ignorance.

To Understand Options Better

Options are different. Different from stocks, forex and other financial instruments that you might’ve been familiar with.

In order to avoid single biggest mistake that new traders commit when they start trading options, I suggest that you may want to read TOP 10 things about options. This will provide you with a primer on what is an option, call option, put option, option buying, option selling and some other characteristics of options such as expiration date etc.

Trading options usually involves more steps then simply buying and selling shares. The option price also changes differently to different market conditions. Paper trading first will help you understand how options are different from other instruments.

To Manage Yourself Better

Prove you can follow the process first, commit capital later.

Just like any other other business, Trading business also involves a process. And process is best summarized via your, lets call it, standard operating procedure (SOP) that lists who you will find, filter, enter, manage and exit a trade.

Before you commit to real money capital, you need to show, prove to yourself that you can actually follow your own trading systems and strategies. Notice, I didn’t say Profit & Loss; for a new trader learning and mastering the whole process is more important.

Do you do proper preparations? do you have patience, persistence and perseverance to follow through your complete trade’s process?

Paper trading thus becomes an invaluble tool so you could check your discipline and adherence to your trading plans. The more you practice your trading process on paper money, the more painful mistakes you will avoid in future.

That leads me to emotional aspect of the trading process.

There are two very powerful human emotions that can affect the outcome of your trading results massively. Fear and Greed.

“Trading without emotions requires 3 things. Practice. Practice. Practice.”

Let’s go through a recent example:

US Markets have been running a wild rally for a long time. Going up and up and turning into a parabolic rally in Dec’17 to Jan’18.

Look at the chart below; while witnessing a parabolic rally compared to the mild rally over the last year, one should unemotionally start reducing long positions, even though the crazy rally could have made you more money had you kept your long positions for just a little longer.

Experience makes you appreciate that although in a bull market the probability of continuing the trend is greater than stopping for a correction / consolidation / ugly crash, it doesn’t mean that the unlikely will not happen — unlikely is not equivalent to impossible.

Thus, veteran traders would have begun to reduce their long exposure.

It is the experience and the appreciation of risk that empowers these traders to survive and become veterans.

This is what happened next. The Dow Jones Industrials Index dropped over 2500 points in a matter of days, wiping out the whole parabolic rally and some more!

Though Dow Jones has recovered much from it, the deep dive has wiped out many traders with emotional bias such as “This is just a pull back”, “I shall not quit at the darkest hour before dawn” — Market remained irrational just for a few days, before they could remain solvent.

Let’s take PP33 (a powerful strategy taught in OptionPundit’s ProfitPath Intensive Program) as another example.

Not every time the stock breaks through the threshold level smoothly, does it? Therefore, experience here comes to aid as it keeps you calm and patient when the stock makes a false breakout or dancing around the threshold levels.

Experience means a large number of trials, a big sample, statistically sound prediction.

Thus you could sit calmly when the stock is going sideways or going against you — you understand such cases are bound to happen, and they are not the ones (that make you money)! So you will and give them up and give yourself a break, rather than feeling a little frustrated having to cut loss short on the false breakout.

How to get the large amount of experience without financial ruins? You know it now.

With paper money, you will gradually stop thinking profits and losses as tangible stuff such as an iPhone, a camera, a month’s rent or salary. When you stop thinking money as stuff but multiples of risks involved, you are closer to emotionless trading.

Examples:
- I risked 1R (100% of risk parameter, which could be 5% of account size) and made 3R.
- I risked 2R and cut loss at 1.7R, etc.
Since it is not real money, you:
- stop wanting home runs in one trade because the fake profits don’t get you better houses or cars.
- feel OK to obey the rules for capital allocations
- feel OK to cut loss and cut loss short.
Before you know it, these practices become habits and then become you. The idea of “show hands”, “be tough and hold on” stop occurring to you. Then your trades look like these, managed losses and occasional great wins…

With enough practice, You become extremely impatient with losing trades but very patient with winning trades.

Wouldn’t you like this? — I hope someone told me these words when I began trading!

To Develop A Trading Edge

Now, lets move one of the key reasons I still paper trade.

Market dynamics change, and so do the market internals. Being an options trader, my trades are structured and designed as per my biases around Delta, Gamma, Theta or Vega.

Whenever I have an untested trade idea or hypothesis, especially one whose risk is undefined or unclear to me, I trade those on paper money. I develop my hypothesis, trade plan, key points to watch out during the life of the trade. I develop comprehensive trading system summary and my scorecard for that new trading hypothesis.

Then I trade that hypothesis. Trade develops through various market moves. I take note and revise my hypothesis, if need be.

I do that again.

Then I repeat the process, all over again. I do it many times before I start testing it with small amounts of real money…and again…before committing large capital to it.

Paper trading or simulating your trades is essential for your long term success in trading. There is no short cut. It can save you from potential emotional disasters and/or financial ruins.

Did you paper trade before diving into real-money trading? What did you learn during paper-trading? Was it worthwhile to paper trade? What will you suggest to a new trader?

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July 12, 2018
US Presidential Elections- How Will Stocks React?

Do presidential elections affect US stock market? How will stocks react to Mr Trump’s or Mrs Clinton’s win?

The End Of Presidential Second Terms (8 year cycle)

Based on historical data, it may not be smooth sailing for the stock market this year. Since 1900, On average, The S&P 500 has dropped an about 1.2 percent in 4th year of second presidential terms. 2008 was specially notorious, when market pulled back approximately 40%, and it also happened to be Mr Bush’s last year of his 2nd term in the office.

2008 was a year you probably you don’t want to remember; a year when many people were re-structured, unemployment was surging and the housing crisis was its peak. Even the serious, professional investors were suffering from the stock market collapse.

It is also worth noting that even though the S&P 500 was down an average of 1.2 percent during year eight of the presidential terms since 1900, it experienced positive growth in some years. Forty-four percent of the years in that period saw a rise in the S&P 500. Although that data point doesn’t convince some analysts this year could see gains in the market, it may offer some investors a glimmer of hope for a recovery from recent declines before the year is over.

Road Ahead: Known Unknowns or Unknown Unknowns

As widely know, Presidents can be a bit unpredictable during their final year of a second term as they come to face their limited time left in office. Unpredictable behavior combined with a lack of consensus of who the next president will be can fuel a lot of uncertainty that can upset the stock market.

Jeff Hirsch, editor in chief of the Stock Trader’s Almanac, describes exiting commander-in-chiefs as “lame duck presidents with little political capital left,” who as a result “push through policy initiatives by executive orders and any other means possible.”

Hirsh also said, “The eighth years of an incumbent’s term in the White House have all been pretty horrible for markets with the exception of 1988 when Ronald Reagan was leaving office. And the first five months of an election year are generally very telling. If you’ve got a down year, that’s usually indicative of the incumbent White House party being ousted. That clearly puts a dampener on Mrs Clinton’s prospects. As they say, the stock market is like a voting mechanism.

Through the lense: A 4 year presidential cycle

As per historical data, The fourth year of a president’s first term tends to fare much better. Some associate the general trend of incumbents getting reelected as a reason why there is less panic in the stock market during those years as compared to year eight. Since 1900, 83 percent of the time year four of a president’s first term has seen an average gain in the S&P 500 of 11.5 percent.

Pre-election years have performed the strongest when looking at four-year cycles, which clearly stand out in the below chart.

Here is visual, simple yet powerful chart describing market action during various phases of election cycle. (h/t : SeasonCharts.com)

Party Impact

Yes, parties to impact the outcomme for the stock market. Which party is likely to be voted into office during an election year can also affect how stocks perform, especially as the election date approaches. Typically when people believe the incumbent party will get elected, the market goes up. If consensus points towards a new party taking over, however, the stock market tends to go down. Uncertainty and fear can cause increases in volatility compared to feelings of confidence and the familiar.

There can be inductry specific impact based on which party the new president is from. For example, pharmaceutical companies could experience gains with a Republican taking over since many Democrats want to cap drug pricing. FYI, just recently Eli Lilly (LLY) stock price pulled back sharply when Mr Sanders tweeted about the cost of Humalog insulin.

Coal is another industry that might rebound with a Republican in office since they typically are not as strict with air-quality regulations and the industry experienced close to an 80 percent decline in 2015. There are many notable plays that are waiting for some breathing space.

Role of November and Post-Election

First, lets go back to 1960 to view Nov only data, we find that there is a bias for the month to end positively 61% of the time. In other words, 3 out of every 5 months finished in positive territory, which is why it is included in the seasonally strong period of the entire year. Furthermore, the average and median returns for the month top 1% over the course of that time.

However, when we look at just the November months when elections are being held, we find 50/50, well almost, split of wins and losses. Even though the number of months are evenly split between gains and losses, the average and median returns were still positive over the given time frame.

Unfortunately, average and median returns aren’t representative of the capital loss hat have taken place historically, such as the massive drawdown during the 2008 election. Importantly, in order for the market to have an average return of 1.01%, it means there has been a variability of returns both above and below that average.

However, during election years, we see the same periods remaining weak, but more dramatically so, as the volatility of election years skews the average of all years. In other words, regardless of who is elected on the 8th, look for a relief rally on the 9th, followed by a sell-off over the next few days? The traditional post-Thanksgiving rally tends to be stronger performance-wise during exceptionally light volume trading days.

How can you profit/protect your portfolio?

One way is that you trade directionally, do a through analysis, find out the appropriate sectors/companies that will benefit from most likely candidate’s winning. However, with so many uncertainties lying ahead, one thing seems sure; the probability favors for volatility of the overall market to rise until the time the results of the elections are out in Jan 2017. Also don’t forget that we are within 5-7% range of all time high.

Using volatility as the main instrument, the best strategy might be LONG VEGA strategies or simply buy those products which benefit from positive Vega like long VIX Calls or long shares of VXX.

I am of the opinion to sell 90% probOTM VXX puts until results are clear.

Selling Put options is a bullish strategy. Thus by selling put, essentially, it is long volatility trade. However, by compbining with high probability factor, it gives us higher chance of being profitable, even if we are wrong.

(Disclaimer- This trade idea is intended for education and entertainment purpose only. You should talk to your investment adviser and do due diligence before taking any action based on what’s written below).

If you are looking for a quick, easy-to-understand, simpe primer/intro on options, here is our most popular ebook. You might want to download as long as we are distributing it for FREE.

Let me know what do you think? or should you have another idea that you would like to implement for trading the markets during this cycle.

Profitable Trading, OP

(Disclaimer: This post provides you with key observations, collected from various well documented sources such as Yahoo Finance, Motif investing, Seasonal Cycles, etc. I have added few additional thought on how can you use these conclusions to trade markets in the near short-term.)

November 3, 2016
A Trader’s Second Most Important Virtue

In the first part, we reviewed VIRTUE OF PREPARATION i.e. that the very first quality to succeed in financial markets is PREPARATION which includes everything e.g. know-how, practice, patience and continuous improvement process for increasing your odds of success.

Once your are well prepared, the next quality that will shape a trader’s success is PERSEVERANCE.

So lets understand what perseverance is and then I will explain how it is linked with succeeding in trading the markets.
per•se•ver•ance
noun \ˌpər-sə-ˈvir-ən(t)s\

Perseverance is the quality that allows someone to continue trying to do something even though it is difficult …or saying differently steady persistence in a course of action, a purpose, a state, etc., especially in spite of difficulties, obstacles, or discouragement.

At times, many people confuse persistence with perseverance. While both persistence and perseverance require discipline, focus and determination, Perseverance is much more than just persistence. Yes, you would need persistent desire to succeed, to stick to your preparation and to follow through your plan! Mr Market will toss your trading around. One day up, another day down and you will most likely see losses first before seeing consistent profits. You have to have that burning desire to succeed. And thus you have to have persistence.

(OPN subscriptions are currently open, If you would like to join a POWERFUL, PROVEN AND PROFITABLE trading ideas newsletter, please click here).

However, wrong persistence will lead to frustrations. Sticking to your unproductive actions and doing the same thing over and over again without learning from your mistakes will turn out to be a recipe of disaster.

Persistence is a skill whereas perseverance is a virtue.

So how do you PERSEVERE? Let’s take it step by step.

It all starts with the PURPOSE.

Your purpose for trading and goals will provide you with a strong desire to achieve. As I like to say “Discovering WHY will lead you to HOW“. That purpose driven, persistent desire to achieve your goals will allow you to persevere.

No matter what others would like you to believe, the fact is Mr Market is brutal and doesn’t care for anyone. There will be ups and down. There will be irrational days questioning even the best systems or strategies you had in your toolbox. You might see Murphy smiling at you. Times when nothing seems right. During such moments, it is that PERSISTENT DESIRE to succeed that will keep you going. Trading/ Investing or Financial Freedom is a long journey and one needs to persevere through this tough journey by continuously working on what’s working and removing what’s not. I would like to quote Dev for one of the best definition of PERSEVERANCE

Perseverance is persistence applied towards positive outcomes.

I have done my share of mistakes, plenty in fact and it is still an on-going journey. It is the persistent desire, to continuously upgrade my skills to deliver best ideas for OP subscribers or train new traders so they can see success they never saw before, which keeps me going. It’s not easy but it’s not impossible either.

Your positive feedback adds motivational fuel to my desire too taking it to the next level.

PREPARATION and PERSEVERANCE are the basic building blocks that are going to determine your trading success. Well not just trading, but almost any business you are going to get into. The third virtue is specially true for trading or investing business. Without this 3rd virtue, both preparation and perseverance will dry out after sometime.

(OPN subscriptions are currently open, If you would like to join a POWERFUL, PROVEN AND PROFITABLE trading ideas newsletter, please click here).

What do you think? Share your thoughts or your personal experiences where you found these virtues to be of utmost importance. What else did you find to be very useful to be a successful trader?

Profitable Trading, OP

December 11, 2014
3 Things You Need To Know To Be A Successful Trader

So you think you can trade? Many traders, especially the beginners tend to think that trading is easy.

Attracted by glitzy returns promised by various marketing campaigns, new traders tend to think that investing or trading is going to be an easy money making machine. And I am often asked why is it so?

One of the key reasons is that contrary to traditional business, it is much easy to start a trading business. Have extra cash, open a discount brokerage online account and voila, you are all set. Money rolling in!!

The reality is much different. Ask any experienced trader and he is going to tell you that trading is probably the toughest thing you will do for an easy life. There is no doubt that many traders have made a lot of money, much beyond what one could do from day-to-day job, but this also a fact that even professionals find it difficult to trade market. Ever heard of Warren Buffett’s famous bet where he says that majority of the professionals can’t beat simple S&P500.

I personally think that one needs to experience at least one full market cycle before concluding that trading business is yours. In current market cycle term, it means having at least about 7 years of experience i.e. Bear market of 2007-09 and then bull market from 2009 onwards. While some may say this market is different from XYZ times, yes it maybe but just like any other business trading and investing also boil down to some common attributes.

It goes without saying that in order to operate a business successfully you need to understand it well i.e. all inputs, all the levers that control the output. Be it things like why should you trade, which market, long-term or short-term, which strategy and why, which broker, which system and the list goes on.

(OPN subscriptions are currently open, If you would like to join a POWERFUL, PROVEN AND PROFITABLE trading ideas newsletter, please click here).

I have been searching to find what makes a good trader, what allows some people to excel, while others continue to languish? In this quest I have been talking to many successful traders and based on my research and conversation, I have summarized into three human qualities. The good news is that all three can be learnt. The bad news is that you have to TAKE ACTION.

So lets get started.

(more…)

November 10, 2014
Structure, Not Strategy, Gives You Freedom

Time and again, I am asked about the ultimate profitable option trading strategy i.e. which is the best strategy to trade markets? Which is the best strategy to trade options? and so on …as if there exists a HOLYGRAIL for trading and winning in the markets. My answer, has always been –

“IT IS STRUCTURE, NOT STRATEGY, THAT GIVES YOU FREEDOM”

I will explain more about that later but before let me share with you a great video, a very powerful one which is appropriate for traders as well. So here it is >>> BE WATER, MY FRIEND:

Trading requires one to be like water as well, you have to adapt to changing market conditions. What worked in 2006/07 doesn’t mean it will work in 2014 too. Yes, there are things that won’t change i.e. fundamentals e.g. profit will still matter, valuation will matter too. Even though markets are rising non-stop, reality will return to normalcy as well. However, once you have acquired necessary skills and systems to profit from market, you have to choose what works best in current market conditions. Markets are dynamic and so should be your strategy selection.

Once a trader is like water, it is important to determine the shape he or she needs to take.

Strategy is not going to give you freedom. Structure will.

Strategy is like a set of code that enables one to achieve certain results. Let use a simple example first- You want to got to the top of the building, you can take elevators, or walk-up the stairs? or maybe a mix of both. “Reaching at the top” is the objective and which method do you use under the set of condition you have is going to be THE STRATEGY.

For instance – if time is utmost important factor for you, you may choose elevators but if the goal is to get healthy and fit, you may use both elevators and stairs or just stairs. But how do you choose the strategy, how do you determine the goals, objectives, how do you measure the outcome, this complete process is THE STRUCTURE.

It is THIS STRUCTURE that will give you freedom.

Do you have a structure in place?

A structure consists of a PROCESS FLOW, a set of rules that drives your behavior BEFORE, DURING and AFTER the trade.

A structure of a trade consists of PREPARATION, PROFIT with Discipline and PRESERVATION of capital.

Becoming a consistently profitable trader just might be the hardest thing you will ever do in your life. And even if you become one, enjoying the freedom and money will still require a process, a structure to be in place. So why not start it from the beginning. Respect the Structure and Pay attention to the process.

Hope this helps. Let me your views about Strategy vs Structure.

Should you have any questions, post it in the comments section or let me know via Ask(at)OptionPundit(dot)com

Profitable Trading, OP

July 24, 2014
Why Isn’t Warren Buffett Saying This Now?
Image source – Biography.com

Ever since I met with Mr Warren Buffett in 2004, my respect for him has been growing by leaps and bound, year after year. Even though I have read many major books written about him, there is nothing quite like meeting in person. I consider him my mentor, someone, who has always inspired me from investing perspective ever since I was kid.

A very famous quote Mr Buffett is the following-

“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful” – Warren Buffett

Wise words indeed!!

And the worth of those words was again proven right in late 2008 when Mr Buffett announced “BUY AMERICAN. I AM” via an Op-Ed in NY Time in Oct 16 2008. I read it too with lot of enthusiasm. In Fact, as long time OPN members may recall, we started preparing for bull market on Oct 14, 2008, just two days before that OP-ED (just a pure coincidence). I shared a list of stocks, with target valuations and purchase prices with Margin of Safety built in. The sheet is still there, if you are an OPN Member, find it here.

Just like what Mr Buffet said-

I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

There was further weakness in the markets (which means one could have purchased stocks even cheaper than his purchase price), but since then S&P has more than doubled. That was an advice that must have produced fortunes for many.

That was then in 2008. How about now and going forward when Dow is at 17,000 and S&P almost 2,000?

Based on the same famous quote, we have two choices now..
1. Are people still FEARFUL >>> So should we continue to be GREEDY ? or
2. Are people GREEDY now >>> So should we be FEARFUL?
Buying cheap was a good idea, in fact a fortune making, once in a decade opportunity. SELLING is different. You will have to decide it for yourself because I don’t think we are ever going to see an Op-Ed that will say SELL AMERICAN. I AM; Markets moves in CYCLES and in between there are TRENDS. You will have to decide for yourself when is your entry or exit. No one has better interest in it but you.

So while thinking about Buying/Selling/Timing etc, I tried to recall other wise words, here is what I remember >>
1. Know what’s the security is worth AND
2. Know when is it worth buying
By “when”>> he was not referring to technical charts but more so from a long term investor’s perspective who understand the business, numbers and the concept of margin of safety. So if you are struggling with decision to buy or sell, go find hard facts, revisit your assumptions, your calculations behind what the security is worth and then decide for yourself if it is time that you should sell or buy more. It’s your hard earned money and you don’t want to leave it for “chance” or “speculation”..

Profitable Trading, OP

What is your opinion about current state of markets? Kindly leave your questions/thoughts/comments in the comments section. I will respond within 24-48hrs!!

(Disclaimer– The words I quote here are my interpretation of his teachings and is by no means endorsed by Mr Buffett. I might have understood it right or wrong, but whatever it is, that’s my interpretation. I have very high regard from Mr Buffett. You should not buy or sell based on above. Consult your financial adviser and do your own due diligence before making any investment decision).
July 9, 2014