The second section teaches you that underlying asset groups have different characteristics, and it is important to learn how each type of asset can be traded. It will show you that some markets are ideal for trading and other markets are simply impossible to beat. Once you learn what markets can be played, you need to see how they look when you study them, the patterns that constantly repeat, and how to spot those patterns. In addition, you must be able to communicate to the broker or to your software execution platform the trades that you want to make. Options have a distinct vocabulary and you must learn certain terms in order to participate in the market.
The third section is devoted to the option model, how it is unique in the world of finance, and why you must familiarize yourself with how it is priced in order to succeed. Simple mathematical examples are given to help you adjust your vision of markets to the viewpoint of an option trader. The option chain is introduced and how comprehension of this vehicle will be all-important to your trading success.
The second-to-last section deals with four simple trades that you can continuously make. It explains when and how the trades should be initiated, what market conditions give you the best chance for the individual trade to succeed, and how to manage the trade once it is in place.
The final section demonstrates how to manage your greatest asset – cash. It clarifies how to utilize your capital in a manner that will ensure that you don't run the risk of ruin when the inevitable capital drawdown occurs, and it identifies which trades can be employed using your available capital levels.
After the final chapter, there is a final exam made up primarily of questions that you have been asked before. If you can score 90 percent or better, you should be ready to tackle the big players in the option market!
Acknowledgments
I would be remiss if I didn't start this section with mentioning the influence of my parents on my life and trading career. My father, “Lefty,” and mother, Rita, introduced me to the wonderful world of numbers when I was a small child. My parents would best be described as “characters,” immense personalities with a positive view on living that enhanced my life and all those who were fortunate enough to meet them.
Cards were the pastime in our house, and it was my father who introduced me to probabilities and odds. At the time I didn't know what they were, but Lefty taught me that if you held a pair of aces, you were a big favorite going into the draw. That simple explanation helped me to understand how to make certain decisions based on probability. I had a magical childhood, great parents, and have had good luck throughout my life.
I want to thank Ablesys Corporation, Dr. John Wang, Grace Wang, and Jesse Wang for their help in getting this book to be printed and for their permission to use the charts and graphs from the AbleTrend and Abledelta platforms as illustrations.
I want to thank Todd “Bubba” Horwitz for his Foreword section and for all of our years together working with students on how to trade, as well as for his input into many of my trading models.
I want to thank Ryan Seifert for his contribution and the time that he spent editing the manuscript. And finally, Bonnie Pittenger, without whose support this project would never have been completed. Not only did she help me with the text of the book, but her positive attitude toward life and her ability to overcome adversity continue to inspire me and all who know her.
Chapter 1
Market Psychology: The Mind-Set of a Trader
“90 percent of the game is 5 inches wide, the length of the space between your ears.”
“Anyone who has never made a mistake has never tried anything new.”
“You can observe a lot by just watching.”
“Greed is good.”
“Bulls and bears make money; pigs get slaughtered.”
“Coulda, woulda, shoulda.”
The Herd Mentality: Bubbles
History is our great teacher. As Yogi Berra, the Yankees great, once said, “You can observe a lot just by watching.” The past is the key to the present; if we do not learn from observing past events, we are doomed to repeat them.
In the spring of 2014, we still have a vivid memory of the financial meltdown in the summer and fall six years ago. TV commentators pleaded with investors to “get in there and sell, Wilson sell.” Irate investors looked to hang their broker. Pictures of hysterical homeowners seeing years of hard work going out the window in a matter of months were gut-wrenching. Fingers pointed and tongues wagged. Crooked politicians, dishonest mortgage brokers, greedy Wall Street traders, shady rating agencies – there was enough blame to spread around.
Who could have possibly seen this one coming?
Comedians had a field day. Internet cartoons of stick figures explained to other stick figures where their money went. Hitler learning that his generals had tied up all of his cash in AIG and Lehman Brothers stock. Surely, this was the first time such a financial disaster had affected so many so quickly.
Or was it?
Because of its impact, it is crucial to recognize that the Great Recession was not an isolated incident. The market psychology that triggered this disaster goes back at least as long as history has been recorded. The panics will come in all forms and will start with many different patterns. Usually, the common thread is that some commodity or new technical revolution has no upper end. Demand for the product will be so great that it can only get bigger. There will be no upper limit to price, and any naysayers will regret their doubt. The thought process is:
“This time will be different.”
Let's review a few of these “bubbles” that have occurred in the past 300 years and see what they have in common.
The South Sea Bubble 1711–1721: Trade, War, and Government Collusion
The South Sea Company was established in 1711 as a partnership between the British Treasury and the merchant class. England had been in a battle with Spain since the early 1700s in what is referred to as the “War of Spanish Succession.” The war had been very costly; the Crown need to finance its debt, and the Lord Treasurer Robert Harley came up with a good idea: Sell a franchise!
He granted exclusive trading rights to a group of merchants in the “South Seas.” It is a common misconception that the “South Seas” were in the Pacific, but in eighteenth-century Europe, the term referred to South America and the Caribbean Sea, not the Pacific.
The first round of financing granted the company “exclusive” trading rights for the sum of £10 million (approximately £500,000 million in 2014 £). In effect, the merchants convinced investors to take stock in the company and replace the bonds issued by the English Treasury. In exchange, the government granted the company a permanent annuity paying a little more than 5 percent. The merchants quickly resold the notes and guaranteed a profit to investors from the Treasury “in perpetuity.” Today, we would call this arbitrage, and it is the way many investment banks generate billions in profit: Buy debt for one price, sell it for a discounted amount to investors, and take the difference and put it in their pocket.
The British government viewed the transaction as a layup. It would