Option Investor

Daily Newsletter, Wednesday, 05/18/2005

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Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews
  4. Trader's Corner

Market Wrap

Bulls STEEL Today's Bullish Showing

Bulls STEEL Today's Bullish Showing

Bolstered by a merger in the steel sector with Metals USA (NASDAQ:MUSA) $21.12 +52% agreeing to be bought by private investment firm Apollo Management for $22 per share in cash, the Dow Jones Steel Index (DJUSST) 143.16 +5.23% was among today's top percentage sector gainers, where speculation of consolidation in the group found its way to Olympic Steel (NASDAQ:ZUES) $16.99 +24.5% and Insteel Industries (NASDAQ:IIIN) $11.08 +12.6% in the form of speculative buying and short covering.

I can't say that economic data out of China spurred buying in the steel sector, as pre-cash open reports regarding April industrial output went relatively unnoticed. The Chinese government said industrial output surged 16% in April to $68 billion U.S. (564.7 billion yuan), which is further acceleration from March's 15.1% on-year increase. Eight economists surveyed by Bloomberg had China's industrial production slowing, but at a still healthy rate of 14.6%.

A 0.5% increase in the April Consumer Price Index, which was driven by a 4.5% increase in energy price looked alarming just before this morning's cash open, but inflation fears were quickly calmed and had stock futures reversing pre-market losses when the core rate, which excludes the volatile food and energy components came in at unchanged. 

The core rate figures sent bonds markedly higher in Wednesday's session with the benchmark 10-year yield ($TNX.X) falling 4.9 basis points to 4.068%, its lowest yield since early February. The calming fears for inflation at the consumer level had broader equities putting together another impressive day of gains with the S&P 500 Index (SPX.X) 1,185.56 +1.00% jumping a healthy 11.76 points.

Volume is what I would consider "heavy" at the big board with more than 2.2 billion shares changing hands. Bears had been taunting bulls with the "light volume rally" and buyers look to have served up a helping of volume among 1, 2 and 3-lettered stocks. NASDAQ volume which has been running about 1.71 billion shares per day on average for the month of May was brisk at 1.96 billion shares.

Dow component Hewlett Packard (NYSE:HPQ) $22.81 +4.64% lead today's percentage gainers and sparked a strong round of buying in price-heavyweight IBM (NYSE:IBM) $76.36 +2.78%, with the Dow Industrials (INDU) 10,464.45 +1.28% gaining more than 130-points to close above both its converging 200-day SMA and 50-day SMA resistance of 10,390.

Dow Industrials Components - Sorted by Price Weighting

Some "not as bad as feared" words from Hewlett Packard (HPQ) in last night's quarterly earnings report continued to spark interest from bulls in broader technology with the NASDAQ-100 Index (NDX.X) 1,509.26 +1.28% extending gains after closing above its 200-day SMA (1,485) on Tuesday. 

On a Wednesday-to-Wednesday monitoring (5DyNet%), it would appear that Home Depot (NYSE:HD) participates with the Building Products (BUIL) sector bullish % action noted in last Wednesday's "Sector Bell Curve" from Dorsey/Wright and Associates. 

Watch out Wal-Mart (NYSE:WMT) bears should consumer sentiment rebound with lower unleaded gas prices.

Early buying in June Crude Oil futures (cl05m) soured quickly below the $49.42 level (see Wednesday's wrap) with this contract putting in a floor trade high of $49.40 before sellers showed up to push the contract lower ahead of this morning's 10:30 AM EDT weekly inventory report. The Energy Department said U.S. crude oil supplies rose by 4.3 million barrels in the week ended May 13. June Crude futures (cl05m) settled down $1.72, or -3.51% at $47.25, its lowest settlement since February 10.

While the bulk of sectors followed in my U.S. Market Watch were green, the Oil Service Index (OSX.X) 126.23 -0.66% was a percentage loser Wednesday, and for the week (5DyNet%). The Energy Select Spyders (AMEX:XLE) $39.24 -0.20% showed up once again in the daily top-20 most actives with near-term inflection high/low very round at $40.00 and $38.00.

Closing U.S. Market Watch - 05/18/05

Airlines as depicted by the Airline Index (XAL.X) 48.40 +5.56%% was an additional sector winner in Wednesday's session, and it 8.56% Wednesday-to-Wednesday gain didn't hurt the Dow Transports (TRAN). I thought the economy was "going into the tank on Thursday" didn't you? 

Dow Transports (TRAN) - 10-point box

Jack Lemmon? Tony Curtis (Some Like it Hot)? Dustin Hoffman (Tootsie)? Robin Williams (Mrs. Doubtfire)? All four actors could change roles quicker than an ex-hedge fund manager could tell his/her clients to switch industry groups based on new "dynamics" taking place in the market. 

The "trannies" as they are sometimes called have exploded from a Friday kiss of their May lows, when on Friday it would have looked as if the economy, and perhaps the markets were about to make a second-leg lower. However, a powerful 3-day rally now sets the stage for a major collision at 3,650.

I think the TRAN will work its way higher with this strong 3-day build of demand showing somebody has "thrown the switch" to the bull side. While United Parcel Service (NYSE:UPS) $74.90 +1.32% may be seeing some May "Max Pain Theory" in play at the $75.00 strike, I liked the UPS Oct. $75 Calls (UPS-JO) in today's Market Monitor as a TRAN exposure. Not unlike Federal Express (NYSE:FDX) $89.11 +1.80%, UPS is also starting to build gains after a successful test of its longer-term bullish support trend.

Dow Transports (TRAN) - Daily Intervals

You can almost see the collision between bulls and bears at the 3,650 level and what can happen if bears give way like they did in late March. MACD is rising toward zero and 3,650 looks to be the intersection. I don't have tonight's sector bullish % readings from Dorsey/Wright and Associates, but yesterday's reading was unchanged at 37.21%, up from last Wednesday's 35.29% reading. Both UPS and FDX point and figure charts have "buy signals" associated with their PnF charts. You can view FREE PnF charts at www.stockcharts.com

Is that a wolf in sheep's clothing? Or a guy dressed like a girl? Is that a head and shoulder formation? Yes!... on both counts.

S&P 500 Index (SPX.X) - Daily Intervals

The "trannie" theme takes hold in the SPX's bar chart. Bulls could make the case that April's lows was a "head" of a reverse h/s pattern. Bears will hold their convictions that it isn't over until the "fat lady sings" around 1,211.

Tonight, I also make a benchmark dating back to February 3 when the SPX's MACD oscillator was approaching the zero level. That day, the SPX closed 1,190, which I think traders can use along with the TRAN at 3,650.

Now hold on a minute! Let's step back and review some VERY SIMILAR things we saw last summer. 

I REMEMBER outlining a possible reverse head/shoulder pattern in May of last year, when the SPX fell to 1,080. While we saw a strong rebound from that level to 1,145, that "head" failed, or should I say the "right shoulder" (1,087) failed and the SPX went on to make a new relative low at 1,061. Now take notes to my "same level of risk" from the 05/04/05 wrap when we looked at the SPX Bullish % ($BPSPX) chart.

Here... let's take a look at the SPX bar chart on a WEEKLY Interval. We'll use retracement, and compare the past to the present. 

S&P 500 Index (SPX.X) - WEEKLY Intervals

Starting from the left of the chart, I show in GREEN reverse head/shoulder pattern what I alerted traders to in April as a possible reverse head/shoulder pattern developing. Now that one FAILED at the "Fail" right shoulder as the SPX went on to trade a new relative low to 1,060. But I wouldn't give up and not soon after, I alerted traders to ANOTHER possible reverse head/shoulder pattern developing, along with my "short squeeze" alert on a break much above 1,145 (late October). I wish we could go back and review some archives from the October-November of 2004 time frame. If memory serves me correct, there were also alerts to a head/shoulder top formation building on a DAILY interval bar chart. The right shoulder was around 1,125 I think.

OK... things look, perhaps feel just like they did last summer.

Now, the CURRENT bullish % indications, are PRETTY DARNED CLOSE today as to those levels found when the SPX hit that low of 1,060 in August, and the rally that took hold then did take the SPX just shy of its PINK 80.9% retracement, before the pullback to BLUE right shoulder developed and undercut the PINK 38.2% retracement.

My (Jeff Bailey's) mindset at this point is that in combination with TRAN observations, an honest SPX bear is probably looking pretty hard at the 1,211 level right now, and starting to think "I may have to concede strength to 1,200 if 1,190-94 doesn't hold, then I'll pressure 1,211 looking for a "right shoulder" for the H/S top, with a target back to 1,171, which... if history repeats, could be the setup for the inverse/reverse head and shoulder. Hey... that keeps us in the "summer range."

Note the current position of PRICE relative to the 10-week SMA (50-days) and 40-week SMA (200-day). To me, current PRICE relative to SMA's looks a little stronger.

We will see that reflected in the MACD oscillator on the WEEKLY interval chart, relative to when MACD oscillator dipped below its zero value as the SPX made that relative low back in early August of last year.


New Plays

New Option Plays

Call Options Plays
Put Options Plays
None None

New Calls

Editor's note:

We are very encouraged by the bullish breakout in the major stock averages (DJIA, S&P 500, and the NASDAQ Composite). However, with the Dow up three hundred points in three days the market is looking a little short-term overbought. We would like to add new bullish candidates to the play list but we will wait until tomorrow to see if there is any profit taking and thus a better entry point. 

New Puts

None today.

Play Updates

In Play Updates and Reviews

Call Updates

Amerada Hess - AHC - close: 89.08 chg: -0.33 stop: 86.25

Readers may want to take a step back and give AHC a wait and see approach before moving in. The stock traded higher this morning and hit the $91.00 level before succumbing to weakness in crude oil prices. Crude oil traded lower after the Wednesday inventory numbers came in above expectations. More importantly crude oil prices have now broken down below their 200-dma. This could put a serious crimp on any rebound in shares of AHC. If AHC trades under the $88.00 level we would seriously consider exiting this play early.

Picked on May 17 at $ 89.41
Change since picked: - 0.33
Earnings Date 07/27/05 (unconfirmed)
Average Daily Volume = 1.6 million 


Caterpillar - CAT - close: 93.52 chg: +1.56 stop: 89.00

Another triple-digit gain for the Dow Industrials helped lead a broad-market rally higher and CAT followed. Shares of CAT broke through its 100-dma and traded at our entry point of $92.35 to open the play. This confirms the breakout from its inverse H&S pattern that points to a $100 target. Our target is the $99.25-100.00 range. Don't be surprise to see a little profit taking after the three-day rally. Readers could use a dip back toward $92.00 as a new entry point if they missed today's breakout.

Picked on May 18 at $ 92.35
Change since picked: + 1.17
Earnings Date 04/20/05 (confirmed)
Average Daily Volume = 2.8 million 


Federated Dept Stores - FD - cls: 67.94 chg: +1.34 stop: 62.49

FD has closed at another new high boosted by the market's rally. Readers may want to wait for a potential dip back toward the $65 or $66 levels before initiating new bullish positions. Our short-term target is the $70.00 level. 

Picked on May 17 at $ 66.60
Change since picked: + 1.34
Earnings Date 05/11/05 (confirmed)
Average Daily Volume = 2.9 million 


Hovnanian - HOV - close: 56.45 chg: +2.27 stop: 52.49 *new*

Housing stocks soared on Wednesday out performing all other sectors save the airlines. The DJUSHB home construction index added 4.5 percent. Shares of HOV followed with a 4.18 percent gain to breakout over the $54.50-55.00 level. Our target is the $59-60 range. We are raising our stop loss to $52.49. 

Picked on May 06 at $ 54.26
Change since picked: + 2.19
Earnings Date 05/31/05 (confirmed)
Average Daily Volume = 1.2 million 


Invitrogen - IVGN - close: 78.60 change: +0.61 stop: 74.85 *new*

Thus far there has been no post-ASCO conference sell-off in the biotech sector and that bodes well for the group and IVGN. The stock traded to $79.30 during today's market rally. Our short-term target is the $80.00 level and more conservative traders may want to exit early. We are raising our stop loss to $74.85.

Picked on May 03 at $ 75.51
Change since picked: + 3.09
Earnings Date 04/28/05 (confirmed)
Average Daily Volume = 888 thousand 


Eli Lilly - LLY - close: 60.36 change: +0.80 stop: 57.99 *new*

This morning before the open an analyst firm upgraded LLY to a "buy" with a $65 target. This pushed LLY to gap up at the open. The stock added 1.3 percent on above average volume. The move over $60.00 looks like a new bullish entry point to us. Yet some traders may want to wait and see LLY fill the gap from this morning near $59.60. Our target is the $65 level. We are raising our stop loss to $57.99.

Picked on May 04 at $ 60.15
Change since picked: + 0.21
Earnings Date 04/18/05 (confirmed)
Average Daily Volume = 4.7 million 


Reynolds American - RAI - cls: 82.61 chg: +1.07 stop: 77.95

RAI outpaced the rally in the S&P 500 index on Wednesday. The move helped confirm the recent breakout over resistance near $81.25 and volume was above average. Our target is the $85-86 range. 

Picked on May 16 at $ 81.31
Change since picked: + 1.30
Earnings Date 04/27/05 (confirmed)
Average Daily Volume = 866 thousand

Put Updates

L-3 Comm. - LLL - close: 68.59 chg: +0.99 stop: 69.55 

Now that the stock market is breaking out to the upside this is not a safe environment for bearish plays. Readers may want to seriously consider exiting their bearish positions to minimize losses. With that in mind we're encouraged that LLL's rally today stalled under the $69.00 level, which we expected to act as resistance. The stock traded in a narrow 35-cent range for the latter half of the session. We are not suggesting new bearish positions at this time.

Picked on May 10 at $ 68.01
Change since picked: + 0.58
Earnings Date 04/26/05 (confirmed)
Average Daily Volume = 855 thousand 


MGIC Invest. - MTG - close: 60.07 change: +0.52 stop: 61.11

It's time to go to red-alert for MTG. The market's bullish breakout has made this a dangerous environment for bearish positions. More conservative traders may want to exit MTG early to avoid further losses. We're keeping the play open for now. Today's rally stalled under the simple 50-dma and the top of its descending channel. Yet the close over the $60 level makes this a precarious position for the bears. We are not suggesting new positions at this time.

Picked on May 15 at $ 58.91
Change since picked: + 1.16
Earnings Date 04/14/05 (confirmed)
Average Daily Volume = 742 thousand 


Precision Castparts - PCP - cls: 75.16 chg: +1.31 stop: 75.05

No change from our previous update on 05/15/05. We are waiting for PCP to breakdown below support near $72.00 and hit our entry point at $71.95. 

Picked on May xx at $ xx.xx <-- see TRIGGER
Change since picked: - 0.00
Earnings Date 05/03/05 (confirmed)
Average Daily Volume = 492 thousand 


Parker Hannifin - PH - close: 60.48 change: +1.04 stop: 62.01

The market's rally has fueled an oversold bounce in shares of PH. The stock managed to close over its 40-dma and the $60.00 level. Fortunately, the rally failed under resistance near $62.00. Considering the current bullish market environment we are not suggesting new bearish positions and conservative traders may want to exit here to avoid further losses.

Picked on April 28 at $ 59.08
Change since picked: + 1.40
Earnings Date 04/18/05 (confirmed)
Average Daily Volume = 1.2 million 

Dropped Calls

Research In Motion - RIMM - cls: 75.49 chg: +3.04 stop: 66.85

Target achieved. RIMM surged today out performing all the major indices and adding 4.19 percent. The stock also broke out over its simple 200-dma on volume about 40 percent above the average. Our target was the $76.00-77.00 range and RIMM hit $76.25 late this afternoon. It would be tempting to keep the play open considering the breakout in the NASDAQ and RIMM's move over the 200-dma but each individual trader will have to make that decision on their own. 

Picked on May 10 at $ 70.51
Change since picked: + 4.98
Earnings Date 04/05/05 (confirmed)
Average Daily Volume = 10.6 million 

Dropped Puts

Marriot - MAR - close: 64.45 chg: +1.93 stop: 63.37 

We have been cautious on MAR for the last few days and today's market rally was the last straw. MAR rebounded with a three-percent gain on above average volume today. The big move was also fueled by news that room rates rose again and summer rates for the industry are expected to hit record highs. We have been stopped out at $63.37.

Picked on April 28 at $ 63.37
Change since picked: + 1.08
Earnings Date 04/21/05 (confirmed)
Average Daily Volume = 1.2 million 

Trader's Corner

Achieving More Winning Trades: Systems Trading, Part 2

It looks like the rallies in the OEX and NDX have hit or nearly reached the objectives you talked about in your last index article. Do you always get out when your target is reached or are there ways that you modify your strategy if the index trend looks strong still?

I usually take profits on my objectives, but if the trend up or down looks still strong, I may exit on half of my options. 

I do keep raising my exit point on remaining positions; a so-called "trailing" stop, as I try never to give back all of my profit. I will use trendlines most often to find these points and exit calls if the index breaks down below its up trendline; or, with puts, if the index breaks out above a significant down trendline.

I was inclined myself to exit today on all Nasdaq 100 (NDX) calls (recommended on the recent dip to the 1438 area) when the NDX climbed above 1500 today; but, the market looks strong still and I could have as well held some calls and bumped my remaining exit point as noted below. 

My last stated target or objective (Obj.) on S&P 100 (OEX) calls is 565-568, which has not quite been reached. It would be warranted to raise the suggested stop (to protect partial profits) to 558. 

If my objective is reached, and it looks like OEX can get into my target zone here shortly, keep the same protective stop on remaining calls for those who want to hold some calls yet. But raise the stop as the days progress per the below hourly trendline.

I am inclined to exit on all in the OEX, given what I thing will be possible strong resistance at 568. A stop or exit strategy is noted on the hourly OEX chart below...

You were describing how one could use trading system to make your buy and sell decisions. The seems interesting cause I want to do something different than I've been doing which is losing in my options account. I don't have a system and it seems like I react to the market mostly. Later I see that myorignal idea was right, but I forgot about what I was planning at the end of the day. But what you describe seems too complicated for someone who is not a computer person. 

Well, you're right on something. The way I presented the trading "language" for a sample indicator-type strategy (system) was based on an old method where I program the language from scratch so to speak; I'm talking of TradeStation software, which is the one I know that does strategy/system testing and development. 

Today's TradeStation software and I think others are similar, uses something that the TradeStation people call a "Strategy Builder". This allows you to build a rule-based trading system not from scratch but by taking you through what you want to accomplish; where component rules are already set up for you to use, including what "stop-loss" rules, if any. For example, you want an exit signal if, after entering a trade, the index goes X number of points against you. 

As far as exit-if-wrong stops, an example of how they work is that you get home and after turning on your software trading application, a message pops up that you need exit the last calls or puts you bought because the price closed against you by more than your risk point. When you "back-test" the profit/loss of your trading system it assumes you got out at those points. When you build your strategy you put in a dollar amount each point loss or gain represents. It will even figure some "slippage" as we rarely get out just exactly with the loss we pre-figured. 

Let me back up slightly. I said that most trading systems can be generally broken down into ones that use technical indicators or ones that use chart patterns; or, a combination of both of course, but I am trying to be basic here. 

I described having the idea that I wanted to buy an Index (e.g., the S&P 100, OEX) when the OEX Relative Strength Indicator (RSI) goes ABOVE 30 on a daily chart after being under that level; or, whatever level I thing is "oversold", and I can test different levels. I also wanted to exit if I was wrong by 5 points in the OEX. Part of my idea was also that I wanted to be in puts (a "sell short" rule) if the RSI fell BELOW 70, but to exit if the index instead ran up 5 points against me. By the way, setting up the rule this way, is so as to NOT get you into puts when the RSI FIRST goes above 70; RSI may be on its way to 80, back down to 75, then up to 85, before falling! Hey, markets get extreme!! 

This kind of strategy is all relatively easy to set up in these new kinds of software. I say "relatively", because nothing worthwhile is gotten with little to no effort and it takes some hours to learn how to use these kinds of software; more at the beginning. It seems like that only in trading is there the idea that you can put a minimum amount of work for maximum results!

An important concept of strategy testing and development is the TESTING part. You can test your ideas BEFORE you trade by "applying" your strategy or system (like the RSI-related one described), on prior years price data. Just apply the trading system you built and named (e.g., "Leigh's hot-shot RSI strategy") on a chart and it marks every trade that strategy would have gotten you in and out of. After you read the report of how many winners, how many losers, this strategy produced and the dollar profit or loss, you can then decide if it has promise. 

In the foregoing example of an RSI Indicator-type system, you can test the best (e.g., most profitable) RSI "length", the best oversold and overbought levels to use as "triggers", etc.; even, an optimum exit-if-wrong or stop level to use; for example, is it best to risk 5 points from entry or should you give a trade entry a bit more leeway. 

To complete this sort of basic primer on the use of rule-based trading systems I should also describe: 

Most investors and traders that analyze charts based on technical analysis principles will tell you that they are looking for clues to future market direction based on particular patterns that they have found meaningful. For example, we want to spot any period of a few days duration, when a market begins making higher daily highs or lower daily lows, relative to the preceding session. 

You find, for example, that its quite meaningful in terms of predicting a good-sized advance in the indexes or stocks you follow, when there are at least three days of higher highs. The trading system rule that defines this "condition" can be quite simple. The trading rules might look like the following. 

The condition we are looking for: a high greater than the high of one [1] bar ago (e.g., an hour or day on a BAR or Candlestick chart) and that the high of 1 bar ago is also greater than the high of two [2] bars ago and the high of 2 bars ago is greater than all the high of three [3] bars ago all conditions must be true. The reverse situation applies to a series of lows less than the 1-3 bars preceding it. 

If either of these conditions are met, our trading system goes long (e.g., buys calls) or "sells short" (e.g., buys puts). 
This is about as simple as a trading system gets. Exit in the above system is triggered only by the reverse conditions and there is always a position in the market, absent the addition of a stop-loss "rule", which I do. You may think I never met a stop that I didn't like; its true, if it's I never met an 'ENTRY' stop I didn't like, as long as it allows sensible leeway. 3 points on the OEX can be pretty tight but 7 is more than I want to risk. 

Entire trading systems, and very profitable ones at that, are sometimes constructed this simply. The software application usually then triggers an audible and visual alert when a trading system, applied to any index or individual stocks, is triggered for example, when you download your end of day data or are trading in real time with a live (real-time) data feed. 

An exit is assumed if a position contrary to the original is triggered. If your system is long, and short conditions are met, selling triggers both an exit and a new position on the sell side, whether that is a short (e.g., of QQQ) or by buying Index puts. 

Creating the systems "rules" is only part of the process of creating profitable trading systems. 
A trading strategy should have components that govern: 
1. entering the market
2. exiting the market while capturing profits 
3. exiting the market in order to minimize losses 

The above three components often involve three different rules and corresponding "signals" when the conditions (the system rule or rules) are met. For example, if you create a signal that enters the market based on a momentum indicator, you add a trailing stop signal that will capture profits and a stop-loss exit signal that will limit losses. 

A trailing stop is one where the "rule" is that a stop is in place that "trails" the current price by some amount; e.g., 5 points in OEX. An initial stop might be 3 points, then once the Index has moved in your favor, a trailing stop condition kicks in. Again, these are common elements of trading systems but, there are no RULES to say what rules have to be in your trading system. 

Once you have a well-defined set of rules to enter and exit positions and perhaps a system of risk protection or stops (exits), it is then necessary to see how well the ideas comprising the systems performed in the past. This is basically WHY you have to have defined rules only by defined rules, can the software "apply" the system to a market; e.g., show the results of the system to the last 5-7 years of OEX price history. 

Testing involves applying the system to as much price history as can find this could be 5 or 10 years or more. "Optimization" of a rule-based system is often applied here optimization is a computerized test to determine WHICH variables (e.g., which specific moving average or averages) resulted in the most profitable or the most consistent profits for the back period being examined. 

Or, to use our above example, which "length" setting of RSI works best along with which specific overbought or oversold extreme is the most profitable as the "trigger" point for trade entry. What the software does is test all possible combination of lengths and overbought/oversold extremes or, the ones that had the greatest profits. For example, the outcome may be to use a 17 period RSI, and sell after the RSI retreats from a reading above 75 and buy when the indicator rebounds from an extreme below 25. 

Such techniques as "walk-forward" optimization can guard against the tendency to select only variables in indicator or pattern-recognition systems that fit past conditions, but that might not work as well going forward the walk-forward technique involves testing some period for the most profitable system inputs, then applying them for a later period and adjusting the values, then testing "forward" again. 

Regardless of the rules and markets, one of the things that has to be on your checklist when studying results is why did the losing trades lose money? How are they different from the winning trades? It is important to scrutinize the losing trades and investigate what happened on each occasion. The software applications that have well-developed systems testing and development capabilities, have templates and tools that allow the study of all these aspects of trading system results. 

Analysis of the biggest losing trade is a starting point to see how a system doesnt work, so there are no holes in the system rules though which a trade could slip and cause significant losses or more that the maximum you are willing to take. 

A system should be studied on two levels: 
1. As a trading strategy that gives positive trading results or 
the net results of the strategy over time 
2. At the trade-by-trade level to determine is the individual trades are "normal" compared to one another and to the group. For this type of analysis to be correct, all trade results need to be comparable to one another. 

Since we are working in the financial world, this means that we should see all our results in terms of dollars (or monetary units). For example, its not correct to compare the return on investment of buying 100 shares of a 10-dollar stock with buying 100 shares of a 100-dollar stock. The comparison would only make sense if buying or selling some set dollar amount of each; e.g., $10,000. 

Regardless of whether you have any interest or inclination to use trading systems now or ever, it is useful to know that there is an option to supplement (or substitute) what is typically the more subjective and personal methods we use to make market decisions. I find that the more investing and trading experience that I have, the easier it is becomes to define what may be sound rules or conditions that need be met to get into a stock or other market. 

Moving from the stage of ideas that "may be" profitable to back-testing these rules is a fascinating and worthwhile process that serves as a "reality check". Often, through the results of back testing, it becomes apparent that even with a promising system, slight changes will result in an investing or trading method that has even greater profit potential. 

Systems testing and development might be something you are not immediately attracted to, but is something that is may be useful after a lengthily experience in using technical analysis. This was the case with me and I thought I would never warm to the approach of a "mechanical system". 

I became enthusiastic about this type of application when I saw that it could validate or, invalidate, long held personal beliefs about what kinds of technical analysis techniques worked best as a basis for market action. 

Moreover, I found that the more I knew about technical analysis and the more months and years that I had observed the unfolding of many different chart patterns, the more I got out of the ability to create trading systems with the new software seen in the 1990s and later especially this was quite the opposite result of what I expected. 

Systems testing and development is a natural continuation of learning technical analysis, especially for those who are more computer savvy or at least comfortable. 

Good Trading Success! 

Please send any technical and Index-related questions for possible use in my next Trader's Corner article to support@optioninvestor.com with 'Leigh Stevens' in the Subject line. 

Today's Newsletter Notes: Market Wrap by Jeff Bailey, Trader's Corner by Leigh Stevens, and all other plays and content by the Option Investor staff.


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