Path to High Accuracy Option Trading - Chuck Hughes

Here are some of my notes from a great article by Chuck Hughes called Path to High Accuracy Option Trading

http://www.youtube.com/watch?v=Eljh8QEv7rI&feature=related

Step 1 – Use trend following systems to select stocks

Step 2 – Use historical price data to select time length with high accuracy

Step 3 - Purchase in the money options with low time value

Option Time Value Characteristics

•        Options consist of time value and intrinsic value
•          Options lose all time value at expiration and consist of only intrinsic value
•          The time value of an option is a wasting asset
•          In the money options have more intrinsic value
•          Out of the money options consist of only time value
•          Goal is to minimize time value and maximize intrinsic value

Advantages of In the Money Call purchases versus Out of the Money

•          In the money calls allow us to employ money management to limit losses
•          In the money calls contain less time value and more intrinsic value
•          Does not require large stock price increase to break even or profit
•          Helps prevent a total loss of investment
•          Less overall risk
•          Higher percentage of wining trades

Reduce risk by setting stop loss at 25% below premium

Check the 50 day and the 100 day moving average for areas of support

Check the 1 month and the 20 month moving average for areas of convergence

Trend Confirmation:

At any given time there can be hundreds of stocks in a price up trend

Trend confirmation indicators can help us narrow the list of eligible buys

•          Volume
•          New 52 week high/low
•          Industry grouping
•          Price level confirmation

On Balance Volume Line:

Need to see up sloping line to confirm trend is supported – buying pressure is exceeding selling pressure

Buying pressure must continue to exceed selling pressure in order to sustain a price trend

Confirmed up trend – stock price is trending up, volume increasing on the days the stock closes up, volume decreasing on the days the stock closes down.

A new 52 week high confirms the price trend

Important Information

Always trade stocks with high volume of at least 500,000 so you can get in and out of your trades with more confidence…you can’t trade if there is no one to trade with.

Risk Management

Risk management is key as well.  If you are trading options and the price is falling check the news on the stock.  Only hold the option if you think it has a chance of getting back to where you want it to go in enough time to make a profit.  If it is a major development about the company and they are going bankrupt you better pull the stop on your trade and save whatever money is left.  If that whole industry is falling on some long term news, get out.  Sometimes you can stay in the trade because there is no news and the stock is just reacting to technical data.  As long as you have time to recover your losses and realize a gain you should be fine.

Also don’t overexpose yourself to the same industry.  Get options that are in different sectors like technology, retail, energy, etc.  However, don’t buy a stock that you know nothing about.  Familiarize yourself with the industry and the stock you are potentially trading.  Watch how it reacts to different market conditions.  Look at the price spread of the option to see how long it takes for the option price to increase to the level you want it.  Options prices don’t move like stock prices unless the Delta is large and even then volatility and other factors affect the price.  Study how the stock’s options prices move to better anticipate what will happen when you trade it.