Option Investor
Educational Article

Fishing For Profits

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By Jim Brown

This article was first published in Nov-1999. The charts and plays are for that period but as an educational piece they are still appropriate. The concept is still the same and the point is easily discernable. "Give a man a fish and you feed him for a day, teach him to fish and your feed him for a lifetime." (Chinese proverb) I hope this helps you learn how to fish. -- Jim

Picture yourself fishing. Maybe you are on the bank of a lake, leaning back against a shade tree. You are thinking about when you went fishing with your dad as a kid. Or maybe you are the dad and your kids are with you. You have several lines in the water angling out in different directions and maybe each has different bait. If you are as successful as my fishing trips then you spend many more hours fishing than catching. In an eight hour fishing day you may spend only 10-15 min catching fish. To some the best part about fishing is the trip itself, not the catching. Sure catching is more fun and it makes it worthwhile. If you are a dad, to pass the time, you might be fishing with your kids for perch in the shallows while back in your mind you are watching that pole that is baited heavy and cast way out from the bank in hopes of catching one of those lunkers you know are out there.

Why should trading be any different? Fishing is fun but you can't do it every day. Trading should be fun also. If it is too stressful then you are over trading and probably not very successful. The key to profitable trading is entry points. Exit points are much easier when you have a great entry.

See if this sounds like more fun than fishing. You get out of bed loaded with optimism and ready to see what the market has for you today. You gather and prepare all your fishing equipment. (PC, quote servers, optionsnewsletter, option montages, news reports, CNBC/Bloomberg, coffee, etc.) You check the weather forecast (pre-open market news). You find a nice comfortable shade tree. (a recliner in front of your PC) Now the hard part. You have to decide what to fish for today. BVSN-walleyes, QCOM-sharks, DELL-trout or the generic "winner" fish, etc. But just because you want to fish for them today does not mean they are worth catching. Have you ever been fishing and caught something you wish you hadn't and had to cut the line to get rid of it? Sure, any serious fisherman has. Turtles, snakes and any number of ocean dwellers. The trick is to only catch the ones worth catching. Did you know that the biggest fish don't live near the top? They live in underwater creeks, canyons, trenches and potholes.

Lets go fishing in the market.

Every week almost every stock falls into a pothole, trench or canyon. The size of this fall and the damage done is directly related to the speed at which they were going when they hit it. Our task is to predict where these potholes are going to be and throw out our lines before the fish/stock arrives. Normally we can see the accident before it happens and prepare for it.

How should we go about fishing in the market. The best method I know we call "target shooting". For the rest of this analogy I am going to refer to it as "fishing for winners".

Broadvison had been on a feeding frenzy for several weeks. In order to fish for BVSN we need to know where the next pothole will occur. Using the regression channel I taught about last week we can see here that BVSN started heading for the bottom of the channel on Wednesday. That was our clue that we should prepare the bait.

The bait in this case is limit buy on the $80 call option (BDVKP). This can be accomplished in two ways. You can place a limit order to BUY OPEN at a specific price. You can also place a BUY OPEN based on the stock hitting a specific price. (see my stop loss article tonight) Either way works. I like the stop on the stock method better because I can chart the stock more reliably than the option to determine the entry point I am looking for. I do not have to guess what the option price might be if the stock does what I expect.

Looking at the option chart. On Wednesday when BVSN started to correct the option was trading for $11-12. Looking at the previous range between the 2nd-8th you could guess that a correction might bring the price back down to the $6 level. You could put in a bottom fishing limit BUY OPEN order at $6.00 on the option itself or a BUY OPEN stop order on the stock at $82. Either way the order gets executed and you are starting out at 40% less basis than the investors that bought the day before. In the example above you would have been filled and have a 66% profit the very next day. Had you not waited for the pull back and bought on the 8th or 9th, because you were afraid it was going to run away from you, the option would still not have returned to the price you paid. If you were trading correctly you would actually have been stopped out on Thursday with a loss. ENTRY POINT, ENTRY POINT, ENTRY POINT. In the example above buying on five of the ten days would have produced a profit. Had you bought on the other five days you would have produced a loss. On which five days do you want to buy? Bottom fishing would have paid off in this instance.

JDSU - An example not so clear.

I apologize for the busy chart. The concept here is the retracement theory. When a stock has had a strong extended run there is a good possibility of a 50% retracement of the gains on profit taking. It is not always 50%, sometimes 40%, sometimes 60% but you understand the concept. If you had started fishing when if fell out of the channel on the 9th you could have bought and sold for a profit but the more likely event would have been a buy that kept going down.

Had you gotten a bite on your limit order on the next drop after it fell out of the channel then you probably would have filled in the $7-8.50 range. In hindsight this would not have been a bad trade but you would probably have sold when it dropped under $6 and lost money. This is a tricky one since we did have a head fake on the 11th that made it look like a rebound although there was no follow through. The correct entry point would have been the rebound after the strong drop took out all the sellers on Friday the 12th. Only a psychic would have known in advance but I really like to confirm the rebound on strong volume before making a buy. If you do catch one that you find out later you didn't want then cut the line fast and cut your losses.

The roadmap to the perfect fishing hole. AOL

This one had buy written all over it. AOL had consolidated for several days after a strong run and a $25 gain. The closer we got to the -50% retracement, the closer we got to the bottom of the channel. This is one instance where the itchy trigger fingers just would not wait for the bottom. Still an astute fisherman would have seen the bottom of the channel approaching and baited his hook.

The bottom was clearly visible on an intraday chart and a limit order at $6.00 or a BUY OPEN stop at $142 for AOL would have been a winner. The option price at $6.00 would have been a 50% retracement from the high and a good place to start bottom fishing.

The concept please !

As I am sure you see by now the concept of bottom fishing, waiting for the big ones, is simply another way to attack the entry point problem. I always have two or three BUY OPEN orders outstanding just in case the market give me a gift. Why would anyone want to buy at market and after two or three up days is beyond me. I guess somebody has to pay too much so someone else can make a profit.

Put it in Practice

So when you are busy chasing some of the little momentum trades, (perch fishing) always leave a couple lines out for the big ones. If you get a bite it could be a big win. If you don't get a bite then it did not cost you anything. If you only practice the methods above and don't get caught up in the flurry of "trading just for the sake of trading" then you will trade less but be more profitable in the long run. You can still have the excitement of fishing with out all the hassle of throwing back the small ones. If you will go back and look at the option charts you will see that the movement of the option price on the rebound is very strong. Much stronger than the normal day to day movement. Isn't that what we are looking for? Could you use less stress in your trading?

Catch a few big ones for me and send me an email with the descriptions.

Jim Brown

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