Option Investor
Educational Article

101 Classics: Increasing The Odds

Printer friendly version

Option 101 Classic:
Sometimes nuances of option strategies need to be revisited and both veteran and novice traders can use a little reminder when it comes to perfecting their game plan. Enjoy this Options 101 classic.

Article originally written 12.19.2000

"Every gambler knows that the secret to survival is knowing what to throw away and knowing what to keep. Because every hand's a winner and every hand's a loser..." Boy, is any song more true this year. Two traders could have traded the exact same stocks all year and the results would have been vastly different depending on their timing. If there was ever a year which highlighted the need for understanding basic fundamental and technical analysis, this was it. Basic fundamental analysis compels you to only trade quality, no matter how good the charts look. Remember, the dot coms looked technically sound for much of the year, but many of their prices are now under $10. Just last year, these same stocks moved that much in an hour.

The fundamental problem for these companies is that they had no earnings. Earnings drive the stock price over the long run. Their eventual doom was sealed because their business model did not work. Yes, a lot of people made plenty of money on these stocks, but like the game of hot potato, the person who holds the potato at the end of the game loses. How could you avoid this situation? Only trade stocks that have solid earnings and are in sectors which will grow over the next several years. When you buy these solid companies, you protect yourself because if you do pick a bad entry point and quickly go underwater, there is a decent chance that the quality will come back. The easiest place to check out a company's earnings compared to other companies in its sector is the Investor's Business Daily. This paper also ranks and charts industry sectors.

Basic technical analysis is extremely helpful for getting into a stock at a good price. At a minimum, a trader should recognize when a stock is in an uptrend, downtrend, or basing pattern and how to trade in these three different scenarios. In uncertain times, a trader should not commit a large amount of money by using just a six month chart. The bull market of the 1990's has conceded to the downtrending market of the past eight months. Therefore, before committing a high percentage of your funds consider reviewing the two year, three year and four year charts. These charts each tell a different story and a few of them are scary. Don't misunderstand me, there is money to be made in short term trading and a lot of it.

On the other side of the coin, many of our favorites are priced at their 52-week low, but on a multi-year chart, it is clear that they could go lower. When playing hot potato, make sure that you will not be hurt if you are left holding the multi-year downturn bag. In an uncertain market environment, a prudent trader would become no more fully invested, or worse yet, margined out than a professional gambler risking his winnings on the hard numbers on a craps table. It just does not make sense.

Speaking of gambling, in the course of my job, I had to take the deposition of a black jack dealer. I asked him if there were consistent winners at his table. He said that there were a few and their secret was to leave the table after winning a predetermined reasonable amount. He said that those players who stayed all night always gave back their winnings and much more. He said the persons that he really could not understand were the people who spent more than they planned, convinced that there losses would be reversed with just one more roll. They always lost. Sounds a lot like this year in the market. By March, most people I know made a fortune. By November these same people were negative for the year. Again, I am not suggesting that you stay totally on the sidelines, just be careful in this environment and use just a portion of your capital.

In short, by trading fundamentally sound companies while using charts can greatly increase your odds of winning. When you trade off charts, you can buy CHKP, BRCM and other high fliers at or near their lows and make short term profits. CHKP has gone from $165 to $89, back to $145 and now to $130 all in the space of three weeks. Some people bought in the $80's or $90's and sold in the $120's, 130's, etc., making a nice profit. Others panicked and sold at the bottom only to repurchase again in the $140's and watch it move down again. Two traders, same stock, different results. The difference is that one guesses while the other plans. A little planning will increase the odds of success.

Options 101 Archives