Option Investor
Trader's Corner

SCALING choices for charts and use of STOPS

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The best topics for articles often come from OIN Subscribers.

You may have noticed, you may NOT have noticed, that when you select a chart in most charting applications, there is usually a check mark for "Linear" scale, but there is also a box that could be checked for "Log" or "Semi-Log" scaling too.

One recent e-mail from an OIN Subscriber -

SUBSCRIBER QUESTION:
"I noted that all your chart examples are "linear scale" - your "Index Trader" discussions are illustrated with linear scaled charts.

Often I use logarithmitic charts. I find similar wedge patterns in the indices. However, for example, for the SPX the logarithmic based wedge hits different rally peaks than you showed for the linear charts.

Question - What is better? linear or logarithmic?"

RESPONSE:
I almost exclusively use the linear or "arithmetic" chart scaling, not a "logarithmic" scale, at least on daily stock INDEX charts.

However, logarithmic ("log" for short) charts can be quite useful on long-term weekly Index charts. It usually is helpful to compare BOTH chart scales on multi-year charts, but I get pressed for time and sometimes don't make such chart scale comparisons all that often however, it's worthwhile to make these comparisons at least occasionally as will be demonstrated.

Since I mostly am writing on shorter-term price swings for the INDEXES, you've noticed of course that I use arithmetic (linear) scale of equal price moves versus equal percent moves of logarithmic scale.

For STOCKS, which can have much bigger PERCENT moves in the same time period, logarithmic charts are another story, which I will also go into in my chart selections.

Neither is "better" per se. Linear for daily charts almost exclusively. Semi-log scale as one choice for multiyear weekly charts or monthly charts for sure. But even with long-term charts I will compare both scales typically.

SCALING CHOICES FOR CHARTS -
With all BUT Point and Figure (P&F) charts, which you see a lot of with the commentaries of OIN's Jeff Bailey, there are two types of scales that can be used. I am not talking about the TIME scale, which is along the bottom of a chart, but the PRICE scale on the vertical line to the right.

For the price scale there are basically two methods in use to measure or scale prices for bar, line and candlestick charts. For P&F charts, scaling will ALWAYS be done using an arithmetic or linear scale the two words are sued interchangeably, but arithmetic is the more precise term.

Arithmetic refers to a price scale where each unit of price is exactly the same distance apart as every other point. "Linear" is usually what the default choice is linear relates to a graph that is a line or straight line. As mentioned already the term linear is not as accurate as arithmetic for what it describes, but I will go with what is common usage.

A linear scale is going to measure equal price moves EQUALLY and make the same price changes an equal distance up and down the right hand price scale; e.g., going from 5 to 15 is the same distance on the vertical price scale as going from 50 to 60.

However, if you think about it in terms of stocks there is a much greater return, based on the money invested, in owning 1000 shares of a stock at $5 that goes to $15 (a 200% gain) than it is to own a 1000 shares of a stock that goes from $50 to $60 (a 20% increase).

To account for this relative difference, a type of logarithmic scaling called semi-logarithmic (it's not "purely" logarithmic), or "log" for short, has come into widespread use.

A chart for each type of scaling for an Index that had a HUGE percent move in the last decade, is seen in the Nasdaq Composite (COMP). LINEAR SCALE first


When we look at the tremendous COMP move from the 1996 low to the top in early-2000, the retracement or rebound over 2002-2004 looks pretty modest. This stems from comparing this later price rebound to a very big prior move, without considering how much of a percentage rebound it was.

However with the "Semi-Log" or log scale, we see a different chart picture -


The 2000-2004 rebound was nearly HALF of the prior ('96 2000) move on a PERCENTAGE basis. You can see that the rally peak ALSO represented a return to resistance (at the red down arrow) implied by the previously broken up trendline. Plotting trendlines on BOTH the linear and log scale produced similar useful trading information.

However, if we looked at a stock chart of a company that has had a big gain (or loss), in this case for Apple Computer, for only the past year or so using a DAILY chart, there is also useful information provided by applying BOTH types of scaling and comparing the two


NOW, looking at a daily chart scaling that shows an unequal price scale, but allowing comparison of equal percentage moves -


On the log chart - distances on the vertical price scale, between those horizontal dashes, represent equal percentage changes.

For Stock INDEXES, this is mostly, or more, useful on longer-term charts. However, for individual stocks, we see some cases where there is a 3/5-fold increase or more within a year period. In those instances, the log scale makes for a useful comparison.

Take the case of AAPL above now I love the looks of those colorful Apple PCs and those cool I-Pods, but in technical analysis terms it may be that the stock has discounted earnings growth into the stratosphere ALREADY - so I try to stay objective and just look at the price pattern of the stock.

I tend to use the typical "default" setting for all my charts including my long-term weekly ones, which is that of the arithmetic scale, but also keep some long-term weekly and monthly charts in log scale for the major indices. Especially so, when I want to see how long-term trendlines might vary.

In general, when there is a major price increase or decline that has occurred, I suggest also making use of log scaling to see if you notice something different on the semi-log chart, especially if a different support or resistance trendline can be drawn on one versus the other.

USE OF STOPS -

I got the following e-mail about the use of Stop-loss or trade exit points after my prior (3/16) Trader's Corner article and it was a very pertinent question for all of us.

SUBSCRIBER QUESTION:
"I am not using my sell stops effectivley. I'm using contract price to state my stop value and I am making it a market order. I set the stop about 20% below the current contract asking price thereby selling at the market if this reduced price hits the stop.

What happens is that momentarily a bid hits my stop price and I am immediately sold out at a loss. Is using a limit order my only protection? Can stop orders "at the market" be targeted in a fashion I describe? I want the protection of sell stops but I feel as though someone picked my pocket. Thank you"

RESPONSE:
Your question is a good one and one that concerns us all, or should concern everyone that is concerned with risk to reward in trading such a concern or focus is the only way usually that you will wind up with a profitable year.

Use of stop (stop-loss) orders, whether entered with a broker or just mentally adhered to, is a tricky business as you point out. You are darned if you do and darned if you don't.

By the way, I almost always use straight stop orders and not stop-limit orders.

BACKGROUND
A sell-stop order is a "suspended" order to sell at the "market" (best possible price) that gets "elected" when the stock or index trades at the stop price; e.g., a sell-stop at 42.00 in Apple Computer (AAPL) attempts to limit your potential loss; for example, if long the stock at 44.00 and it plunges.

Of course if the stock closed at 43.00 and then opened the next morning at 41.00, this trade (at 41) would also activate your sell stop and that order becomes a Market order to sell at the best possible price after that, even if that price was 40.75.

Conversely, a buy stop order is a "suspended" order to buy at the market that gets "elected" when the stock or index trades at the stop price; e.g., a buy-stop at 45.50 in Apple Computer (AAPL) as an attempt to limit losses by being short the stock at 44.00. Only ONE trade at 45.50 will "elect" such a buy stop and turn it into a market order to buy. The order HAS to done at the best price, even if a seller can only be found at 45.75 and that is where you get bought, which offsets or liquidates your short position.

In this example, if my buy stop order was a buy "stop-limit" at 45.50, it would also be elected (activated) with ANY trade done at 45.50 in AAPL, but the buy could only be executed IF the buy could be done at the specified "limit" price of 45.50. If the stock traded "through" this price, without a willing seller, and the following trades were all done ABOVE 45.50 for the rest of trading session, I would end up still short at the end of the day.

STRATEGY in the use of STOPS -
A solution to the problem of getting stops "hit", then seeing the following trade go your way, is to short/buy puts or go long/buy calls only when the stock or index is at or near likely resistance or, likely support - also, when the index or stock in question is overbought or oversold: at an extreme. In such instances, ONLY if there is a significant breakout, up or down, will your buy or sell stop get elected and become a market order.

You also have to accept that sometimes your stop is hit stops are "run" and THEN the market move you were hoping for happens.

Most traders are unwilling to wait only for those "few" opportunities I'm speaking of. It's tough and is the dividing line between the many and the very few great/outstanding traders and the pros. The best traders pretty much all focus on "how much could I lose" (focus on always cutting losses) and not on "how much can I make" if you read Jack Schwager's book, "Market Wizards", this comes across loud and clear, including that of my trading mentor Mark Weinstein, a classic example.

AN EXAMPLE of EFFECTIVE STOP-LOSS STRATEGY
In my Index Trader column of 3/6 [This prior article can be reviewed by clicking here ]

I highlighted the fact that the S&P 100 (OEX) was hitting resistance at 585 and the Index was overbought. Today's updated chart OEX chart is below

The point to make with this recent example was that a put buy when the OEX traded up to the 585 area, calculated as significant technical resistance, could have been protected with a relatively "tight" or close by exiting stop; e.g., exit puts that is equal to the OEX trading at 587 or 588.

A exiting stop in this kind of situation can be set such that the risk is quite small relative to the reward potential. If I was right on the question of where key resistance (selling pressure) lay, OEX would not have been able to overcome selling in the 585 area sufficient to take it above, or much above, this level. Hence an exiting stop was able to be set equal to OEX 587 or 588.


Another example. Assume a put buy when OEX hit anticipated resistance in the 580 area at the same trendline see the FIRST red (down) arrow. An exit (stop out) point would have been if OEX traded through 580 but not by much; e.g., to 582 or 583 this didn't happen and subsequently OEX dipped below 570. Assume I stayed with my those puts and did not take the profit from a 10 point fall in the Index because I thought the index could go to 560.

THE CONCEPT OF "TRAILING STOPS" -
Assume I thought that the OEX could fall to 560, but the index started rallying after its dip below 570. With a strategy employing moving my protective stop points, I trailed price action on my exiting stop point by having it down to 575 by the time OEX dipped under 570, but before it rebounded back to above 580. (This is also being aware of the tendency for trend reversal potential at the even 10 point levels: e.g., 580, 570, 560, etc.)

Assuming an exit on my (trailing) stop at 575, I didn't achieve the profit potential of the 10 point OEX decline to 570, but would have gotten out with some profit and NO loss.

The next time I bought puts when OEX came back up to the resistance trendline (e.g., the 585 strike), I would have gained the profit of the OEX falling to 560 at my profit objective. I tend to exit at my profit objectives and not look for more usually, figuring I probably got the best part of the move.

This may seem like too "ideal" of a scenario it could be considered that, but not if you are waiting ONLY for those FEW situations that fulfill the criteria where stops can be set that are low-risk relative to a high profit potential. Not many of these trades are needed to make for a very profitable year in trading index options. After all, we're not looking to reward our broker with a lot of trades, only OURSELVES with a few.

NOTE -
To Option Investor Subscribers - 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.

Good Trading Success!!
 

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