The Option Investor Newsletter Sunday 04-20-2003 Sunday 6 of 6 In Section Six: Stock Picks: DOW, JCP Traders Corner: Money Management Part I Options 101: Special Delivery From The Easter Bunny – A Basket of MONEY!!! Futures Corner: Extreme Stochastics ************************************************************** Note to our readers: This email is comprised of the articles that were left out of the Sunday Email Publication. We apologize for the error. ************************************************************** *********** Stock Picks *********** Where is the Dow Going? By Steve Gould I have a friend who is a chiropractor. She is considered one of the leading experts in the chiropractic technique that she uses. She told me that she would attend literally hundreds of seminars and after enduring 12 hours of her weekend time, should would come away with one jewel. I recently had an experience like that. I was at a stock trading seminar not long ago. We had an excellent speaker. He was very knowledgeable about his subject and had a great rapport with the audience. He said one thing that was my take away jewel. He was analyzing a stock. He pointed out all his indicators and explained why the stock was headed higher. He spent about 10 minutes discussing all the indicators and why they signified that the stock was headed higher. Then he made this brilliant comment. He said, "And then the stock will go higher...unless it doesn't." Chart: Dow monthly 4/17/2003 http://www.OptionInvestor.com/oin/images/commentary/newsletter/2003-04-20/DOW042003a.gif Above is a monthly chart of the Dow as of 4/17/2003. We can see that the Dow has traced out a classic wave I with a very distinct 5 wave subpattern. In late 2002, the Dow retraced with a wave II and has since been in a wave III down. According to this chart, the Dow is headed down even further...unless it goes up. Without being facetious, I say that because the Dow could still go up. One of the criticisms of Elliott Wave theory is that you don't know the exact wave labeling until the wave is complete. Well, duh! If I knew exactly what a stock would do, I would be trading from a lounge chair in the Caribbean while sipping Mai Tais. As we watch a wave unfold, we have to keep in mind at least two different counts. Each count carries a confidence level. The one with the highest confidence level is called the preferred count. We trade off of that one. However, we keep the other counts in mind, because we could be wrong and we need to account for the other possibilities. If the Dow continues its present course of unfolding the III wave, then we would expect the Dow to behave in the following fashion. Chart: Dow 4/17/2003 monthly Preferred Count http://www.OptionInvestor.com/oin/images/commentary/newsletter/2003-04-20/DOW042003b.gif What this chart is saying is that within the III wave, we will see a 5 wave basic pattern. So far, wave 1 and wave 2 have traced out and we are just starting wave 3. Within wave 3 we will see a 5 wave basic pattern. It has so far traced out the (1) wave and the (2) wave and is just started the (3) wave. If this pattern continues we will see a downward thrust until the end of wave (5) of wave 3 and then see a substantial wave 4 retracement. In other words, we should see a bear market rally, probably during the summer, and then the 5 wave drop around the fall to winter. Unless of course, it doesn't. (I really like that expression. I think I am going to adopt it.) What would the alternate count be? Chart: Dow 4/17/2003 monthly alternate http://www.OptionInvestor.com/oin/images/commentary/newsletter/2003-04-20/DOW042003c.gif In the alternative count, the Dow has not yet completed the II wave up. The Dow is undergoing a much larger A-B-C correction and is in the beginnings of a c wave of the C wave (III, C, c). If this scenario plays out, then the Dow could go as high as 9350 (62% retracement of wave I) before heading back down. We will know this scenario is playing out should the Dow breach the top of the a wave at 8522. The next couple of days are going to be critical. We will not know which way the Dow is headed until one of the two scenarios is confirmed. I personally believe the preferred count is in effect, but should the Dow breach 8522, it ain't. In either case, the Dow is heading down. It is just a matter of what time frame are we looking at. --- Elliott Play Update By Steve Gould JCP It doesn't get any more classic than this. Chart: JCP 4/17/2003 http://www.OptionInvestor.com/oin/images/commentary/newsletter/2003-04-20/JCP042003.gif On 4/11/2003, I predicted that JCP would fall a bit more before retracing and then continuing back down to complete the 5 wave. This is exactly what JCP is doing. Note the first three waves of a 5 wave basic pattern. Within the 1 and 3 wave, we can see a subdivision of a 5 wave basic pattern. This is classic Elliott Wave. Over the next week or so, JCP will retrace to about the 18.50 level to mark out the 4 wave before continuing back down on the 5 wave. If you haven't already done so, exit the trade and chalk one up for the win side. ************************Advertisement************************* ”If you haven’t traded options online – you haven’t really traded options,” claims author Larry Spears in his new compact guide book: “7 Steps to Success – Trading Options Online”. Order today and save 25% (only $15) by clicking on PreferredTrade and clicking on the link to the book on its home page. http://www.PreferredTrade.com/CF/Home.CFM?ID=OIN ************************************************************** ************** TRADERS CORNER ************** Money Management Part I By Steve Gould One of the biggest problems I see in traders is money management. You had best have a plan and stick to it, otherwise you are going to get caught up in the emotion of the trade and fall into the fear and greed black hole, never to be heard from again. (Guilty, guilty, guilty.) Ya, sure, you could have made more money had you let your trade ride and ya, sure, the set up was absolutely perfect and the stock is going to turn around any day. Yadda, yadda, yadda. The people who make money aren’t necessarily the best stock pickers, although it helps. The people who make money are the ones who make a plan and stick to it. Period. If you have a plan, you can be wrong a lot and still make money because your stop loss will minimize your losses. Let me state the obvious. If you lose all your capital you can't even step up to the plate. The hardest part for any trader is to take a loss. Get over it. It is the cost of doing business. Take the loss and get on to the next trade. I want to present some money management techniques. There are many different types. The important thing is to find the one that works best for you and stick to it. The first one is a standard technique that works well for a lot of people. It is based on the premise that you want to make a certain percentage off of each trade and are willing to risk a certain percentage to achieve it. A typical risk/reward ratio is a risk of $1 to make a reward of $1.50. Let’s see how that works mathematically. Let’s say that you place 100 trades over the course of a year. Let’s also say that you are wrong on half your trades. Doing the math using the above ratio yields 50 trades X $1.50 = $7,500 50 trades X -$1.00 = -$5,000 ---------------------------- 100 trades $2,500 What the math is saying is that if you started with $10,000 and made $7,500 but lost $5,000, you ended up at the end of the year with $12,500. Not a bad return. What would happen if you increased your profit target to $1.75? 50 trades X $1.75 = $8,750 50 trades X -$1.00 = $5,000 ---------------------------- 100 trades $3,750 Now your return is $13,750. If your profit target is $2.00 then your return would be $15,000. What would happen if you used a $1.00/$1.50 risk/reward ratio but increased your percentage correct to 60%? 60 trades X $1.50 = $9,000 40 trades X -$1.00 = $4,000 ---------------------------- 100 trades $5,000 Now your return is $15,000. Gee, what if my profit target is $5.00 and I am correct 75% of the time? WAKE UP, WAKE UP. You are dreaming. Set a reasonable target and stick with it. One person I know sets a target of $2.00 but as soon as he makes 80% of his target ($1.60), he takes profits. Not a bad strategy, because from the above discussion, you can see that if you can somehow increase your percentage correct just a little bit, you can increase your percentage return quite a bit. Let’s see how this strategy would work on a stock option. XYZ stock is selling for $47.00. The Sep 50 call sells for $5.00. If we expect to make $1.75, we would exit the trade when the option sells for $6.75. If we are wrong, then we would exit the trade when the option loses $1.00 or sells for $4.00. This scenario does not give us a lot of wiggle room. We could be out of this trade in 10 minutes if we timed the entry wrong. Let’s try using percentages instead. If we expect to make $1.75 for every $1 we risk, then our profit exit point is $5.00 * $1.75 = $8.75 and we would earn $3.75. Our stop loss would be calculated like this. If $3.75 corresponds to our $1.75 profit, what does the $1.00 risk correspond to? The ratio would be (SL = stop loss) 1.75 3.75 ---- = ---- 1.00 SL Doing the math we get $1.75 * SL = $3.75 SL = $2.15. In other words, if we profit $3.75 we would risk $2.15. Subtracting $2.15 from $5, our stop loss would be $2.85. Exit the trade if the value of the option decreases to $2.85. Let me repeat that. EXIT THE TRADE IF THE VALUE OF THE OPTION DECREASES TO $2.85. Sure it may turn around. You can always reenter the trade. On the other hand, the option may decrease even more. Stick to the original plan. A variation on this technique is to expect to double the value of the option as a profit target and the stop loss would be a decrease of 50%. This is the same as the above risk/reward ratio technique using a profit target of $2.00 for every $1.00 at risk. It is just that the math is a lot easier. Let's look at an example. XYZ stock is selling for $47.00. The Sep 50 call sells for $5.00. We would exit the trade when the option sells for $10.00. If we were wrong, then we would exit the trade when the option sells for $2.50. This obviously is a lot easier to do the calculations. If you combine the 80% partial profit rule (yes I know it throws the ratios off), you would take at least some profits when the option reaches 80% of the $10.00 target or at $9.00. ($5.00 * 1.80% = $9.00) Although this is a very popular money management technique, it does have its flaws. The most obvious flaw is how do we know that the option is going to double in value? Depending on the option that you buy, you are going to have to see about a 20% move in the stock for most options to double in price. So, for a $40 stock, there must be an $8 move in the price of the stock for the option to double. In part II, I am going to explain how Elliott Wave analysis allows you to target your profits as well as precisely define your risk. Elliott Wave analysis lets you know exactly when the stock is moving against you and that it is time to get out. Elliott Wave analysis will also tell you how far a stock will move so that you can calculate the amount of profit attainable and compare that against the risk. You can therefore make a more informed trade decision. And if that were not enough, statistically analysis has shown that by entering trades at the two sweet spots, you increase your accuracy to 80%. *********** OPTIONS 101 *********** Special Delivery From The Easter Bunny – A Basket of MONEY!!! By Mike Parnos, Investing With Attitude How do we account for an incredibly profitable month for the CPTI? Hell! It's becoming S.O.P. Perhaps we're just damn good. Perhaps we're just damn lucky. Who cares? We've got money to count – lots of it. We began tracking our CPTI portfolio in the November, 2002 option cycle. Through March we had accumulated $16,010 in profits. That's an average of about $3,200 per month for five months on a trading account of about $50,000. This option cycle (April) we're proud to add a whopping $6,100 to our stack of dead presidents. It doesn't get much better than that. The new total is $22,110 (for six months). Ever notice how dead presidents always seem to function better than live presidents? ______________________________________________________________ April CPTI Portfolio Results Position #1 – OEX Iron Condor – closed Thursday at $453.71. We created an Iron Condor with a 70-point range of 420 to 490 for April. The objective was for the OEX, at April expiration, to finish anywhere within the spread – and that's exactly what it did (bless its little heart). The total credit for the Iron Condor position is $2.35. Profit: $2,350. Position #2 – BRCM Short Straddle – Closed at $16.60. This month we sold 10 contracts of BRCM April $15 calls and sold 10 contracts of BRCM April $15 puts for a total credit of $2.60. Our safety range is from $12.40 to $17.60. BRCM is schizophrenic. Personally, I didn't care for any of its personalities. It was like being married again. We were on a roller-coaster ride most of the month. A week ago Monday, we were presented with an opportunity. The market spiked up. BRCM traded as high as $13.90. To buy back the $15 put would have cost $1.60. When BRCM moved down to $13.80, we bought back the $15 put for $1.65. We had taken in $2.60. Our profit is $950. Position #3 – MMM Iron Condor – Closed at $129.98. We created an Iron Condor with a 15-point range $115 to $130 for April. We were able to take in $1,550 for our 10-contract position. The objective was for the underlying, to finish anywhere within the spread. The market has gone up too far and much to fast. Did calmer heads prevail and return MMM, to a more reasonable level? Did Fibonacci come through for us? Sometimes it's better to be lucky than good. Well, I can't complain. It looked like we were going to get a spanking (and not the fun kind) on our MMM Iron Condor position. Then, Wednesday morning, the skies opened up, the sun shined and a very nice fellow at J.P. Morgan came to our rescue by downgrading MMM. The market reacted and sliced $5 off the price. Since stocks have a tendency to rebound the day after a big move, I closed the MMM bear call spread by buying back the $130 short call for $.45. We took in $1,550 when we initiated the position. It cost $450 to close the position. Our profit was a very hefty and very fortunate $1,100. Position #4 -- QQQ ITM Strangle – $26.82. This is a long-term position we created four months ago. We own the January 2005 $21 LEAPS calls and the January 2005 $29 LEAPS puts. We sold 10 contracts of the QQQ April $28 the QQQ April $22. Our cost basis for the position was $5.30. We closed this four-month position with a $400 profit. Position #5 – OIH - Diagonal Calendar Spread – $55.63. We felt there was a great deal of uncertainty built into the price of a barrel of oil. When, and if, the war is resolved, the price of oil would work its way down. We bought 10 contracts of the July OIH $55 puts and sold 10 contracts of the March OIH $50 put at a debit of $3.85. According to plan, the March $50 expired worthless. Our cost basis was now $3.15. On Thursday morning, OIH traded down to $53.15. It was just too tempting. We had bought back the April $50 put for $.05 and today closed out the rest of our position by selling the OIH July $55 put for $4.50. The amount taken in was $4.45. From selling near term options over the last three months, our cost basis had been reduced to $3.15. Our profit was a delicious $1,300. _____________________________________________________________ New CPTI Portfolio Positions for May New Position #1 -- SMH Baby Condor. SMH is the Semiconductor Holder Trust. It's basically an index of semiconductor stocks. It seems that semiconductor stocks have moved up a little too far and too fast. My crystal balls are telling me: a) people who live in glass houses shouldn't expose their crystal balls, and b) semiconductor stocks could very well pull back for awhile. With SMH trading at $26.43 lets: Sell 10 contracts of SMH May $25 puts for $.70 Buy 10 contracts of SMH May $22.50 puts for $.25 Sell 10 contracts of SMH May $27.50 calls for $.80 Buy 10 contracts of SMH May $30 calls for $.20 Total credit of $1.05 Our maximum profit range is $25 to $27.50. Our safety range is $23.95 to $28.55. We're only exposed for the 2 1/2 point difference between the strikes ($25/$22.50 or $27.50/$30) less what we've taken in ($1.05) = $1.45. Our potential return on risk is 72.4%. Maximum potential profit is $1,050. ____________________________________________________________ New Position #2 – BRCM Short Strangle I guess I'm just a glutton for punishment. BRCM took us for quite a ride last month. It ended up profitable, but wasn't without a little concern. BRCM had a monster day on Thursday due to earnings and upgrades. With BRCM trading at $16.62 lets: Sell 10 contracts of BRCM May $15.00 puts for $.50 Sell 10 contracts of BRCM May $17.50 calls for $.75 Total credit of $1.25 Our maximum profit range is $15 to $17.50. Our safety range is $13.75 to $18.75. Both of the sold options are naked, so it's imperative that you be attentive to the position. It's a nice wide range, but there is still significant risk. Maximum potential profit is $1,250. ______________________________________________________________ New Position #3 – SPX Iron Condor The S&P 500 closed at 893.58. Since I believe the market is a little ahead of itself, we're going to put our money where our mouth is. Lets: Sell 5 contracts of May SPX 825 puts for $3.60 Buy 5 contracts of May SPX 800 puts for $2.10 Sell 5 contracts of May SPX 950 calls for $2.35 Buy 5 contracts of May SPX 975 calls for $.90 Total credit of $2.95 Our maximum profit range is 825 to 950. Our profit range is 822.05 to 952.95. This is a huge range and the market would have to really go nuts to violate this range. But our exposure is substantial – 25 points less the $2.95 we took in = $22.05. That's why we're only doing five contracts. 500 X $22.05 = $11,025. Our maximum potential profit is $1,475. In entering the position, my calculations include stealing an extra $.20 out of the posted spread for the 950/975 call spread. ______________________________________________________________ New Position #4 – MSFT Menage-A-Qua. Microsoft just came out with respectable earnings and unenthusiastic guidance. There's no reason to believe it's going anywhere for awhile. So let's have some fun and try an experiment. With MSFT at $25.50 Sell 10 contracts of MSFT May $25 calls for $1.15 Buy 10 contracts of MSFT May $27.50 calls for $.25 Sell 10 contracts of MSFT May $25 puts for $.65 Buy 10 contracts of MSFT May $22.50 puts for $.20 Total credit of $1.35 Our maximum profit occurs if MSFT closes right at $25. Our profit range is from $23.65 to $26.35. Our risk is only $1.15 with the potential to make $1.35. Maximum potential profit is $1,350. _____________________________________________________________ Are You A Believer? Like good Easter Bunnies, we're going to be trying to reproduce (profits, etc.) this month. And since April showers bring May flowers, it's possible we'll have to deflower May along the way. We're on a roll and there's no end in sight (but we're keeping our eyes open for a shapely one). Some months will be better than others, but I don't recommend you bet against the CPTI. It's something you can believe in. Are you a new Couch Potato Trading Institute student? Do you have questions about our plays or our strategies? Feel free to email me your questions. An excellent source for new students is the OptionInvestor archives where we've been discussing strategies and answering questions since last July. To find past CPTI articles, look under "Education" and then click "Traders Corner." They're waiting for you 24/7. ______________________________________________________________ Happy trading! Remember the CPTI credo: May our remote batteries and self-discipline last forever, but mierde happens. Be prepared! In trading, as in life, it’s not the cards we’re dealt. It’s how we play them. Your questions and comments are always welcome. Mike Parnos CPTI Instructor ************** FUTURES CORNER ************** Extreme Stochastics Most traders who use the stochastic use the crossovers of the %K and %D as their trading signal. Last week I discussed the concept of stacking multiple stochastics settings to create a single indicator, using rollovers/crossovers as potential trading signals. I've also mentioned that trendlines can be drawn along the tops or troughs of the stochastic oscillations, and that breaking above or below these trendlines can be useful signals as well. To complete the discussion of stochastics as an indicator, we will look at one more way to view the information that it presents us, and, along the way, bring up another method of trading the futures. Traditionally, when stochastics crosses the upper or lower boundaries, traders tend to view the underlying stock as entering overbought or oversold extremes. Yet, another often mentioned aspect of trading is how indicators like the stochastic can stay overbought or oversold for long periods of time while price continues to print higher highs or lower lows. Let us consider the concept of actually using the entry into these extreme areas for trading signals. For example, let us say that you have a stochastic setting of (14,3,3), with bands set at 75 and 25. The idea is to actually go long when the fast line crosses the 75 level, and to go short when the fast line crosses the 25 level. When the stochastic lines cross, you exit the trade. On the chart below, you can see how once the 5 minute bar closed with the stochastic crossing the 75 horizontal line, a long is taken at 881.25, and when the stochastic lines crossed back down, it signaled to sell at 883.75. A fairly decent scalp off of a 5 minute chart. Stochastics Extreme Chart 1: Using this level to enter a trade long or short most likely goes against much of what you may have learned about stochastics, and grates your nerves like nails on a chalkboard, so let's take a look at another example. The chart below shows four more trades, three long and one short, using this same method where a trade is initiated when the extremes are crossed. The results end up positive by 2.75 points. Half the trades worked, the other half did not, which is close to what I had expected when I started looking into this idea. Stochastics Extreme Chart 2: Now that we have a potential idea, let's try and refine it to try and see if we can improve the results. The first thing that I tried was lowering the extreme lines from 75/25 to 65/35. In addition, instead of getting out as soon as the stochastics cross over, why not wait for the lines to re-cross that same extreme line before getting out of the trade. The theory is that although you may end up with more small losses, you end up catching those longer trends while stochastics chop around inside the extreme area. In the following NQ chart you can see how, in the first pane where extremes are set to 75/25, there are four signals to go long, but all of them were false (losing) signals. On the bottom pane where I set the stochastic to a slightly tighter value of (14,3,2), the extreme lines are set to 65/35, you can see that signal (A) to go short was a 3 point loser, the next two signals, (B) and (C) gave over 19 points in profit. Please Note: The second pane where stochastics shows a setting of (27,9,4) is a labeling mistake. The actual stochastics setting is (14,3,2). Stochastics Extreme Chart 3: Looks much better, and the longer moves were captured nicely. However, what happens when price is indecisive and there is no trend, or, momentum is attempted but continues to fail, creating a lot of fits and starts that go nowhere. This atmosphere gives you a chart like the following. The red boxes show where price crosses the extreme lines and then crosses again, causing multiple small losses. In between there is a nice profitable trade, but those results are negated by all the small losses. So, although we've identified a potentially useful way of trading, it is highly dependent on a fair amount of momentum to give decent overall results. Stochastics Extreme Chart 4: For another example, let's take a look at the ES 5 minute chart from April 17. The normal extreme boundaries shown in the first pane aren't even worth marking as they would have given poor results. The second pane shows four trades, three of them losers, for a net gain of 4.5 points. Not too bad for a very simplistic trading strategy. Stochastics Extreme Chart 5: Let's take a look at the NQ chart from April 17. The NQs were much more bullish than the ES on this day, and from the chart below you can see a single trade dominated the day, returning +22 points, with two losses adding up to -4, the total for the day would have been +18 points. Stochastics Extreme Chart 6: While the results are acceptable, we still want to increase our odds of a successful signal to trade. Using the extremes to enter a trade may look nice on a marked-up chart, but what this article is aiming for is to ADD a tool to our trading methods, not to create a standalone system. Let's take a quick look at an 5 minute ES chart that shows us entering a trade when the stochastics lines cross the centerline, and exit the trade when the stochastics lines cross each other (against the direction of the trade). The following chart shows stochastics set to (14,3,3) and the extreme lines back in their normal 75/35 area. This day of trading returns +6 points from three winning and two losing trades. Taking trades on a centerline crossover is more commonly accepted as a valid signal, and here you can see that it moves you into a potential change of trend sooner. Taking a trade at the extreme crossover catches a point or three from stronger momentum moves, and occasionally allows you to ride that momentum for even better gains. Stochastics Extreme Chart 7: There is also the idea of entering a trade when stochastics crosses the extreme line in the reverse direction. Meaning, if price is above 75 level and crosses below that level, then go short. If price is below the 25 level and crosses above it, then go long. This will also give some mixed results, sometimes good, sometimes bad, just like the first few examples from this article. So if centerline crossover is an acceptable strategy, and extreme crossings have their value, then why not combine all three ideas into a single trading method. The following chart shows how well this methodology can work. Stochastics crosses from below 25 to above 25, and you go long a third of a position (a). Stochastics then crosses the centerline and you add one third position at (b). Stochastics then crosses over the 75 line and you add a third contract long (c). As soon as the stochastic lines cross, you exit your entire position. An alternate way to trade this, is to exit two-thirds of your position when %k and %D cross, but to let the last third go until stochastics crosses back below the 75 line. In this instance, it crosses over the 75 line rather quickly, but if the move had extended into a high momentum, long term move, that last third had the potential to catch a larger piece of it. The red text shows the same tactics we just saw, except with a short trade. From here I'd like to point out two important items. The lower red arrow shows that we go long again when stochastics moves above the 25 area. I would not take this trade because the stochastics are giving this signal due to a gap up at the open. While some gaps hold, and others fail, I prefer not to take any technical trades that are triggered by a gap. Just wait for the second signal after the gap, and in this case, it would be going long as the stochastic crosses over the centerline. Here is the other item I'd like to point out: the upper red arrow points to where stochastic closed when it crossed the upper line at 75. You can see that the crossover of the 75 line was done so that stochastic finished at a value of 90, much too high to safely take another contract long on top of the one taken at the crossing of the centerline. Therefore, there is a caveat to the Long-over- 75, Short-under-25 scalp trade entry: don't take them if the crossover is so strong as to put stochastics into extremely overbought/oversold levels as it is not worth the risk. Stochastics Extreme Chart 8: Here is another example. Long one contract when stochastics crosses the centerline (a) and long another contract when it crosses 75, trade (b). You then exit one contract as soon as stochastic %K and %D crossover at 823, and hold on to the other contract until it does one of two things: 1. Crosses back down over the 75 line 2. Crosses below the last lows that the stochastics made. In the example below you can see where I drew a red horizontal line at the previous stochastic low, and as soon as stochastic fell below it, this was a signal to get out of the long trade. Stochastics Extreme Chart 9: Another example below shows how two long positions are taken at (a) and (b), but not when stochastics crosses over the 75 area because it closes that bar at a value over 90, and is too extreme for adding a third contract. One contract is closed out when the stochastics cross over. However, there is one more thing that you can do when trading off stochastic: if you see that price momentum is high, when stochastics cross over in the direction of the trend, add a contract, as was done at (c). Stochastics Extreme Chart 10: Putting It All Together As interesting as all this is, it is just one of many tools available in analyzing whether we should take the trade or not. So, putting what we've seen above in context with other technical indicators, we may be able to verify or ignore the signals that see. The chart below has a 78 period regression channel with standard deviation of 2 (purple lines), moving averages of 7ema (blue) and 13ema (red), and RSI(10) with a moving average of 21 of the RSI data (pink). You can see that we take stochastics crossing up at (a) as a long signal because the RSI verifies this with a crossover above its moving average. A second long signal at the centerline is verified by the 7ema crossing over the 13ema. The third long signal is given at (c) and the RSI is still in a strong uptrend and the moving averages are still diverging, showing no weakness. You don't need to get the stochastics crossover to exit at least part of your long trade because you can see price has pierced the upper regression channel, a good sign that price may be topping out. A second push above the regression channel produces a negative divergence, and this should be your sign to get out quickly. The short trading on the way down is nearly a mirror image of the trade long, with RSI and the moving averages verifying the stochastics signals. When RSI reaches a strongly oversold extreme by moving below the 25 level, price is hitting the bottom of the regression channel, two strong signals to get out of any shorts. Stochastics Extreme Chart 11: Here is an ES daily chart showing how trading with the various tools can help bolster your signals, or make you wary of the signal. You can see how the last third of the long signal is not taken because stochastics crosses the 75 level just as price reaches the upper regression channel. You can also see how the short should not be taken when stochastics crosses back below the 75 level because RSI is not confirming because it is still well above the moving average. After 3 more days of price trying to move up, RSI crosses below its moving average giving a sell signal and the 7ema crosses below the 13ema, also bolstering the short signal. Stochastics Extreme Chart 12: That about wraps up everything and anything that I have to say about using stochastics as a trading tool. On its own, it can work well. The false signals can be reduced by using other tools like regression channels, moving averages and RSI to verify or question the signals that one gets. As always, I urge you to play with the stochastics and RSI settings. Use your favorite moving averages and any other tools that you prefer like Macd or CCI, and see how well they complement some of the above ideas. Experiment, and find the path that works best for how you like to trade. ************************Advertisement************************* If you trade options online, then you need an online broker that: offers true direct access to each option exchange offers stop and stop loss online option orders offers contingent option orders based on the price of the option or stock offers online spread order entry for net debit or credit offers fast option executions PreferredTrade offers these online option trading features and more; call 1-888-889-9178 or click for more information. http://www.PreferredTrade.com/CF/Home.CFM?ID=OIN ************************************************************** ********** DISCLAIMER ********** Please read our disclaimer at: http://www.OptionInvestor.com/page/oin/aboutus/disclaimer.html ************************************************************** ADVERTISING INFORMATION For more information on advertising in OptionInvestor Newsletter, or any Premier Investor Network newsletter please contact: Contact Support
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