Some of the trading lessons of 2011 are the same as all 2000 years and before: smart risk management and taking trading breaks when having a losing streak.

In addition, during the course of 2011, including the last 5 crazy (i.e., volatile) months, there was some winning ways to guide trading decisions based on hourly charts, hourly chart trendlines and the RSI indicator. More on the aforementioned topic coming up but first are some other topics of trading interest.

MY TRADER SENTIMENT INDICATOR:

I was asked why I only use the CBOE alone as my way of measuring equities daily call to put volume ratios to determine trader sentiment. Especially since the ISE (International Securities Exchange) has in the past accounted for nearly as much equities options daily trading volume. Why not include those numbers in my calculations? Good question.

In 2007 for example, both CBOE and ISE each accounted for approximately 30% of daily volume in equities options. I have generally considered CBOE as representative of the 7 options exchanges and use Chicago Board Options Exchange volume figures alone for use in my call to put daily volume ratio 'sentiment' indicator.

In November 2011, the most recent complete month, the combined Chicago Board Options Exchange (CBOE) and C2 Options Exchange (C2), the CBOE all-electronic market, traded 88.9 million contracts with an average daily volume (ADV) of 4.2 million contracts.

ISE reported that its ADV for November was a just under 3,000,000 contracts. Some months of this year ISE Average Daily Volume was a bit above 3 million, some months somewhat below.

The CBOE accounted for approximately 25% of the total options volume for 2011, down from the aforementioned 30% in 2007. The other options exchanges, besides CBOE and ISE, have increased their market share a bit. Still, I have seen no reason to think that the daily CBOE call to put volume figures alone are not representative of the total daily call to put equities options volume ratios for the U.S. Bank stocks are garnering a lot of options activity of late. The 5 most actively traded equity options at CBOE during November were Bank of America (BAC), Citigroup (C), JP Morgan Chase (JPM), Apple (AAPL), and Cisco Systems (CSCO). I'll use CSCO as an example in my comments on risk management.

You may have thought that 2011 was a dismal year for trading volume, especially in the second half of this year due to high volatility, etc. Below are the yearly options volume figures since 2000. Total yearly volume numbers for all options, both equity and non-equity, continued to grow substantially as has been true in each year since the turn of the century:

NOTE: "OCC" is the Options Clearing Corp and the 2011 figures are through 12/28/11.

RISK MANAGEMENT AND TAKING A BREAK FROM TRADING:

An aspect of risk management is to suspend trading if you have had a series of losses and your trading capital is getting rapidly depleted. My experience has been to stop trading all together rather than just cut back. I'd rather 'paper trade' during these periods to see how good my trading judgment is without the possible emotional duress of continuing to be in the market.

The idea of suspending trading can also be a good idea when you are unsure of the trend or where there doesn't seem to be a dominant trend as is true during periods of whip sawing price action. I consider our Option Investor.com Subscribers to be a sophisticated bunch and many of you were trading less or just standing aside since May-June of this year. There were some decent trades that came up. But how to calculate the right entry and exit points? More on that later.

DON'T TRADE ON 'BREAKOUTS' AND 'NEWS'

For example the Dow seemingly 'breaks out' above 12000, but when you go to buy DJX call options on this big story, the premiums are quite inflated and the advance doesn't last long. In general I find that trading after market or company-related news comes out to be a losing proposition.

PATIENCE

An important attribute for 2011 as in past years is patience. Many of the best trades that are not strictly short-term oriented take time to mature. It pays to be patient, especially if you have placed a delta neutral options trade. It's generally better to WAIT than to keep reacting to the market's every whim; this was quite evident in the second half of 2011. Since many other traders, including professional ones, are also reacting to the same news, it's often nearly impossible to get an edge by trading on news alone.

Market sentiment or trader psychology can really trip you up. Even experienced traders can get caught up in periods of market euphoria or panic. As much as possible keep to a trading plan and DON'T PANIC.

RISK MANAGEMENT ASPECTS OF TRADING:

I would say that a key to remaining calm, even when a majority of other traders and investors are caught up in fear or greed is to practice sound risk management. I look for trades that have at least a 1 to 3 (or more) risk to reward ratio. For every dollar I risk in terms of an exit or stop out point, I should have an assessment that I could make $3 if the trade pans out. I'll give an example relative to Cisco Systems (CSCO), a Nasdaq/tech bellwether and which was very actively traded in November as mentioned.

CSCO was establishing a 'basing' pattern over June to early-October. The double bottom low made at 15.3 and 14.9 in late-September/early-October was compelling to me in terms of buying calls out 2-3 months. Except for the panic selling that occurred over 4 days in early-August, CSCO was clearly establishing a line of support in the $15 area. I figured that CSCO could rebound from dips to the 15 area to at least $18. Therefore CSCO calls bought around $15 warranted a $1 risk or 1/3rd of the $3 projected 'reward' potential. The plan then was to exit Cisco calls if the stock fell to $14. I thought CSCO could get back to $19 but 18 was a 'conservative' target that I thought could be realized by November expiration.

I tend to base my 'risk' point based on the underlying value of the stock rather than on risking a percentage portion of the call or put premium. I have greater confidence in setting exiting stops in terms of movement in the underlying stock or stock index. Obviously there are times when a stock or index makes the move projected but the sale of the option brings less than 3 times or more of the cost of the option. In the case of a losing trade, I may end up exiting at a loss that's more or somewhat more than 1/3rd the options cost.

What I've outlined here is not all there is to say about risk management but it gives the basic concepts of what I look for in assessing a trade. I generally don't buy puts or calls based on a technical breakout or 'breakdown' due to the resulting inflated premiums. I might add some to an existing position if my assessment is for a major move to follow, but I'll also tend to wait for a pullback or rebound to add to a position.

A 2011 TECHNICAL 'WINNER' IN TRADING GUIDANCE FOR THE INDEXES:

If I scroll back over 2011, the use of hourly index charts, along with the Relative Strength Index (RSI) with a length setting of 21, often provided guidance on what side of the market to be on. Use of the 21-hour RSI was a frequent guide as to when the market was overbought or oversold and the trend in danger of reversing. Trendline breaks tended to 'confirm' that the trend was changing.

During the early part of the year when there was a prolonged advance in the major indexes such as the S&P 500 (SPX), 'overbought' extremes were of little use alone as a sign to exit the uptrend. Additional trading guidance came in when there was such an extreme AND when SPX pierced its up trendline as highlighted on my hourly line (close-only) chart:

Shorter-term price swings occurred frequently in the second half of 2011. Second half advantage went to nimble traders who could take advantage of shorter-term trend reversals.

The period from February to May 2011, as seen on an hourly chart basis below, turned more mixed and choppy, particularly in May. Still, there were a couple of good buy 'signals' and one sell pattern as suggested by the S&P 500's 'overbought' extreme as highlighted on my next SPX hourly chart. Patience as a trading 'virtue' was rewarded by waiting for an hourly chart and RSI pattern suggesting a potential or likely reversal.

The period from late-May into late-August 2011 seen next below presented a couple of bearish sell/short patterns, as well as a couple of bullish 'buy signals' suggested by RSI oversold extremes and in one instance by a clear cut double bottom that formed in the hourly line/close-only chart.

My last hourly/60-minute chart covers the period from late-September through 11/28/11. Two 21-hour upside overbought 'extremes' coupled with a possible double top is suggesting that we may see another sell off coming up in the New Year and a possible disappointing early start for investors who would like to see stocks do more than mostly break even as in 2011.


GOOD TRADING SUCCESS & HAPPY NEW YEAR!