There must be a more compelling reason for you to trade stock other than just for the movement, if only 20% is unique to the underlying equity in question.  Consider this, in context of the Fundamental Analysis or stock picking software that you bought on a per $1 basis.  For each $1 dollar you spend, you “outsourced” the analysis at a cost of 80 cents, only to receive back 20 cents worth of work. Shouldn’t the 80:20 rule of “outsourcing” be the other way round? The problem is that you are still stuck with 80% of the work, to analyze price movement!  Plus, the more you use FA techniques/stock picking software, the more trading capital is stuck in equities alone.Now, you can say “special” research papers help you pick stocks.  Let’s have a look at some of the more common fundamental metrics in these research subscriptions:1. Dividend Yield: the problem is in the variability of yields as firms are in different stages of their business development.  A Mature company that dominates in a well established sub-segment/sector is able to afford a different dividend yield; versus, a Young company in a growth-oriented field; versus, a Small firm in a growing area that may not be able to afford a dividend payout.  Bear in mind there is nothing special about firms that pay a dividend.A company that gives away a portion of it’s retained earnings – which is what a dividend is – effectively gives away part of its valuation, which means it is not worth as much as a company that does need to give investors candy to commit capital to it.  So, a dividend paying stock has to be far superior to a non-dividend paying stock for reasons other than the dividend.  If it is not, there’s no point looking for dividend paying products to trade, there are plenty of non-dividend paying Indexes to trade.2. Price/Book Ratio: the problem is this metric varies across industries and from company to company, as the asset base and capital structures of companies change over time. It lacks cross sector applicability and accounting complexity arises from a firm’s capital structure as it changes due to acquisitions/divestments/CAPEX for new product lines; or, product line cut-backs, as recently seen in the restructuring of major US car companies.3.  Price/Cash Flow Ratio (the cousin of the P/E): accounting laws on depreciation vary across Asia, Europe and US.  As accounting rules are driven by tax codes, which change considerably across regions despite adoption of global accounting standards, there is a lack of uniformity in homogenizing a fundamental ratio that will fit as a common benchmark across geographies. These metrics fail to help you compare say a Dell parented in the US to an Acer parented in Taiwan; but, is listed as an ADR in the US, even though both are competitors in the same sector as computer manufacturers. Furthermore, the current dislocated cost of capital in credit markets, impairs the ability of corporations to optimize the operating cost of their balance sheets.  In essence, corporations are left with the working capital cash flows remaining on their balance sheets, as testament to their financial strength. Do not waste your money on Fundamental Analysis software or research paper subscriptions.As there is a fundamental flaw in fundamental analysis and stock picking, how do you select trades? Trade the options of a broad-based Equity Index to replace single stock exposure.  To replace Fundamental Analysis, use the Relative Strength measure based on Point & Figure methods.What is Relative Strength?  It is nothing more than taking one price as the Numerator, divided by another price as the Denominator, then multiplied by 100.  RS = (Price 1 / Price 2) x 100.  Typically, RS calculations use daily closing prices.  Though simple in its mathematical construction, RS is ingeniously powerful when it is applied not only within a sector; but, across sectors and between asset classes.Let’s start of within a sector.  For example, if you choose 2 semiconductor stocks trading at different prices, how do you know if one stock is outperforming the other in the same sector, when the 2 stocks have price changes at different rates; plus, the sector’s price itself is also changing?SOX = Semiconductor Sector Index, trades up from 452.24 to 467.81.Numerator1:      Price1 = BRCM 33.15    RS1 = 7.33    Price2 = 33.80    RS2 = 7.23Numerator2:      Price1  = TSM 9.91    RS1 = 2.19    Price2 = 13.43    RS2 = 2.87Common Denominator:      SOX  Price 1 = 452.24           Price 2 = 467.81BRCM’s RS1 = (33.15/452.24) x 100 = 7.33. BRCM’s RS2 = (33.80/467.81) x 100 = 7.23.  TSM’s RS1 = (9.91/452.24) x 100 = 2.19.  TSM’s RS2 = (13.43/467.81) x 100 = 2.87.BRCM’s price rises from 33.15 to 33.80 and TSM’s price also rises from 9.91 to 13.43.  Simply because BRCM is a larger stock, does that mean it benefits from the SOX trading up? No, the RS reading (RS1 compared to RS2) shows BRCM’s RS reading dropped (7.33 down to 7.23) against TSM’s RS reading, which increased (2.19 to 2.87).  RS confirms TSM as the outperformer rising in price strength versus BRCM’s weakened price.  RS is constructed on pure price rules.  Using an Index as the denominator, acts as a much more durable benchmark and is structurally more reliable, compared to any “magical” TA indicator; or, combination of income statements, balance sheets and cash flow statements touted in stock picking programmes.You can replace BRCM or TSM with Indexes or ETFs.  Using Indexes with Relative Strength enables a common denominator to compare Equities against Bonds, Commodities and Currencies, to crossover into asset classes other than stocks to trade.  It’s not that Relative Strength is infallible.  But compared to the fundamental metrics cited above, Relative Strength fails the least.  Break the mould on what you learnt about stock option trading.Is there an example of an optionable and consistently profitable portfolio that trades using Relative Strength across multiple asset classes? Yes.  Follow the link below, entitled “Consistent Results” to see a retail online option trading portfolio that excludes the use of single stocks and Fundamental Analysis, using broad based equity Indices, Commodity ETFs and Currency ETFs.  There is no need to trade FX directly. Just trade the options of Currency ETFs.

Chapter 3: Understanding the Profit/Loss Patterns over Time. This chapter evaluates the profit and loss in terms of Time Units (typically day and week) feeding into Time Spans, Average Profit versus Average Loss, Standard Deviation, Sharpe Ratio, Median P/L, Percentage of Winning Days versus Losing Days, Drawdown and Correlation Analysis. This section focuses on the core metrics of trade performance, for a given period:

In calculating the metrics, it becomes clear if your strengths are in trading long debit spreads, short credit spreads, directional trades (be it up/down) or non-directional trades. Trade in line with what you are intuitively profitable at, be that debit/credit spreads or directional/non-directional trades. The metrics help you guard against trading counter-intuitively in opposition to your strengths. Chapter 4: The Risk Components of an Individual Portfolio. The emphasis of this chapter is on Historical Volatility, Correlation and Implied Volatility and Value at Risk (VaR). While it is educational to understand how these various risks can be aggregated up into a single, portfolio measure of exposure, it is not useful for option traders trading retail portfolios from home.  Why?  To re-simulate the test scenarios on the portfolio cited in the text, requires specific types of data. The Account Statement of most retail option trading platforms only record each trade’s profit, loss and date. The additional data of each day’s Historical Volatility, Implied Volatility, Correlation coefficient values and Standard Deviation/Variance values will need to be sourced from outside the trading platform.  Unless you are trading multiple portfolios on behalf of other individuals, VaR simulations make sense. If you are trading just your own portfolio, it more useful to get an Implied Volatility tool that forecasts IV rising or falling by X% over 30-60-90-120 days.  This is a much more affordable way to assess the total impact of IV and Correlation in IV on your portfolio.Chapter 7: The Risk Components of an Individual Trade. The section to focus on here is the Core Transaction-Level Statistics. This includes the Trade Level P/L, Holding Period, Average P/L, Weighted Average P/L, Average Holding Period, P/L by Security or Asset Class and Long Side P/L versus Short Side P/L.  The main point here is to monetize the Average Holding Period of a long or short position. For example, as a guideline:

In conclusion, the critical points to focus on are the 3 types of targets at the portfolio level, the core metrics of trade performance, identifying your intuitive trading orientation and monetizing the average holding period of long and short trades for efficient trade turnover.  Translating these specific elements of trading risk into methods you can rely on every day, builds the required consistency in the profit and loss of your trading account.

Call option is a financial contract between two parties, the buyer and the seller of this type of option. It is the option to buy shares of a stock at a specified time in the future.

The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular stock from the seller of the option at a certain time (the expiration date) for a certain price (the strike price).

However, the seller (or “writer”) is obligated to sell the stock should the buyer decides to exercise his/her right on the option. The buyer pays a fee (called a premium) for this right.

Put option is a financial contract between two parties, the seller (writer) and the buyer of the option. The buyer acquires a short position with the right, but not the obligation, to sell the stock at an agreed-upon price (the strike price).  If the buyer exercises his right to sell the option, the seller is obliged to buy it at the strike price. In exchange for selling his/her stock to the buyer, the buyer pays the writer a fee (the option premium).

Strike price, also referred to as exercise price is the price at which the owner of an option can purchase, in the case of a call, or sell, in the case of a put, the underlying stock. It’s the price at which the stock will be bought or sold when the option is exercised.

Premium is the price that buyer pays the seller for carrying the risk for the obligation.  This is similar to insurance premium where you pay the insurance company a premium, so in case if anything happens, the insurance company is obligated to compensate the damage.  The price of the premium depends on many different factors such as strike price, time left until expiration date, interest rate, volatility, etc.

Expiration Date – Options is a wasting asset, meaning that it loses value as time goes by.  Once the option expires, the option no longer has any value and become worthless.  The expiration date is found in each option contract when it is bought.

American Style and European Style Option – There are two different types of options.  American style option is one where buyers can choose to exercise the option any time up until the expiration date whereas the European style option is where buyers can only exercise on the expiration date.

These are just some of the most common terms you will come across when starting out in option trading.  If you are serious about learning how to trade options, then you should adhere to some of the common option trading tips that every option trader would abide by..

Where can I see this step up function in a consistently profitable portfolio, with these portfolio measures and trade performance metrics? Follow the link below, entitled “Consistent Results” to see a model retail option trader’s portfolio that shows these traits.Moving onto the hard metrics.  There’s 2 ways to count the Return on your trading capital.

In both cases, you can minus the Total Cost of Commissions from Total Profit, to get a Total Net Profit number.  The, divide the Total Net Profit by the Start of Year Cash Balance; or, Net Liquidating Value.  Net Liquidating Value is how much your entire trading account is worth, which is equal to Total Cash + Options Value + Stocks Value + Commodities Value + Bonds Value. The Start of Year Cash Balance is straightforward – it is the money in the account at the beginning of that trading year. Cash increases when you are short securities; but, cash decreases, as you get long on securities.To review your performance, calculate these metrics using the Profit (wins) and Loss (losers) from your account:

The Average Win divided by the Average Loss measures how RESPONSIVE you are in taking profits and cutting losses.Combine the Accuracy ratio with the Responsiveness ratio to get your Performance Ratio.Performance Ratio = (Win/Loss Probability) x (Average Win / Average Loss).  Always aim to maintain the Performance Ratio above 1.00. Why?  The commonly known money management rule is to allocate 2%-5% of (60% x Net Liquidating Value of the account) per trade.  What is not commonly practiced is the discipline of moderating a +/- 1% in trade allocation between the 2%-5% allocation.

This is how to achieve a ladder effect in stepping up profits and stepping down losses. This mechanism of stepping up/down is an indispensable tool for rewarding profit and to discipline the risk of losses.  It forces you to improve both ACCURACY and RESPONSIVENESS before raising your position size.

Where can I learn more about portfolio measures and trade performance metrics as part of a total trading system? Follow the link below, for 55 hours of video-based learning of online options trading from home.

Where can I learn how to trade options with consistent profits focused on Implied Volatility without Historical Volatility? Follow the link below, entitled “Consistent Results” to see a model retail option trader’s portfolio that excludes the use of HV and focuses on trading only IV. I’ll cite these actual historical events, to bolster the argument for removing Historical Volatility from your trading process altogether.27 Feb, 2007: Widespread Panic from the sizeable China sell-off in equities. If you were trading the options of an index like the FXI which is the iShares product of China’s 25 largest and most liquid Chinese companies though listed in the US; but they are headquartered in China, you would have been impacted. While you can argue it’s possible to have market events recreate the ranges of the Dow, Nasdaq & S&P, how do you recreate the scenario of the VIX and VXN soaring 59% and 39%?22Jan, 2008: Fed cuts rates by 75 basis points prior to the scheduled policy meeting on Jan 30th, whereby the FOMC cut another 50 basis points on the date of the meeting.  If you were trading interest-rate sensitive sectors using the options on a Financial ETF or a Banking Index like the BKX; or, the Housing Index like the HGX, you would have been impacted. And in the current environment of rates being near zero, the FOMC while they still have a rate policy tool, they are unable to cut rates by the same number of basis points like before. What was a historical event is not successively repeatable going forward, not until rates are raised again and subsequently they get cut again.Question: How do you reconstruct history?  That is the history of events forming Historical Volatility.  The answer is in the real examples cited, as with any other financially related historical event – you cannot reconstruct history. You may be able to mimic parts of HV but you cannot repeat it in its entirety.  So, if you continue using HV-IV crossovers, you visually confuse yourself by searching for volatility “mispricing” patterns that you would like to see; but, you will end up with poor profit performance instead.  It makes more practical trading sense to focus purely on IV; then, diversify the trading of volatilities across multiple asset classes beyond equities.Where can I learn more about trading IV across multiple asset classes using only options, without having to own stock? Follow the link below (video-based course), that uses IV Mean Reversion/Mean Repulsion and IV Forecasting, as reliable methods to trade the implied volatilities across broad-based Equity Indexes, Commodity ETFs, Currency ETFs and Emerging Market ETFs.

For those who are not familiar how actually options work, it may be a little bit confusing in the beginning. Options actually share a lot of same characteristics like insurance policies, which most people should be able to understand. We will get a clearer picture of how literally options work by checking through the features that options and insurance policies have.  

For an insurance policy, the policy is actually a contract between the purchaser and the underwriter of the insurance policy. Underwriter of the insurance policy is the company, whose sells the policy. Whereas; option is a contract between the option buyer and seller when there is an initial transaction taking place. Stated in the contract, option buyer has the right to buy an amount of stock from the seller at an agree price within a specific period of time; whereas, seller has to obligate to sell an amount of stock to the buyer at an agree price within a specific period of time.  This agreed price is called strike price.  

For insurance policy, purchaser pays a premium to the insurance underwriter. The probability payout is influenced by a number of factors, which the premium is dependent. Premium will be charged higher if the risk payout is higher. Whereas for option; purchaser of the option contract pays premium to the writer of the option. A number of factors, which will affect the overall likelihood of a particular stock price being reached, will also affect the amount that needed to be paid as a premium. When the premium for the option is higher, the likelihood of a stock price can reached also higher. 

In term of time period, the validity of the insurance policy is within a specific length of time. The passing of time works in favour to the insurance underwriter but against to the purchaser of the insurance policy. For option, it works exactly same as the insurance policy, that is option contract is valid within a specific length of time. When the time passes, it does not favour to the option buyer but favour to option writer.  

Upfront is the risk for the purchaser of the insurance contract. The policy is paid by the premium. The insurance underwriter risk is open-ended depending on the terms that are insured. In options trading, the options buyer risk is also known as upfront. The option is paid by the premium. Here are the differences between insurance policy and the option. The option buyer can gain more than premium that he or she has paid for the option but not less than the premium. On the other hand, option writer has open-ended risk potential, which may cause unlimited loss.  

In term of payout, if there is any event that has been stated in the insurance policy has occurred, the payout from the insurance company will be a lot more than the original premium paid. If the market direction favours the option buyer, then he or she has unlimited profit potential. The option buyer may make a lot of money, which is many times more than the premium that he or she has been paid. 

You can apply this calculation to the VIX, or any optionable product that you have identified a trade on.Why divide the front month’s volatility by 16?  As you know, volatility is expressed as an annualized number.  So, to get the daily volatility number, we divide it by the square root of the number of trading days in a year, which is 256 (rounded off).  There is no trading on weekends and exchange holidays, because prices cannot change on these days.  There are some years with more or less than 256 days, but using 256 is the norm.  The square root of 256 = 16. As part of your pre-market preparation, calculate on a spreadsheet the market ranges of the day (Dull, Normal or Big) for the DJX, MNX, SPY and the VIX at minimum. This is not to pick direction, as you will not know if the market will open to the upside/downside and STAY there, even if futures indicate an upside/downside bias. The calculation gives you a measured gauge, once the market opens to see if the trading range of the day is leaning towards a Dull, Normal or Big Day. Then, assess if it makes sense to theoretically price a spread, be it a Calendar, Iron Condor, Vertical, etc.  This guards you from chasing price near 1 Standard Deviation, to get your orders filled on a Big Day.  Doing this pre-market work, determines if you will be filling orders or scaling off for profit; alternatively, reducing exposure to losses, when the market opens.Want to see a consistently profitable portfolio that prices entries on Dull/Normal Days but takes profit/limits losses on Big Days, at work? Follow the link below, entitled “Consistent Results” to see a retail online option trading portfolio that practices this daily discipline.Statistically there are more Dull and Normal Days to price spreads for entry, especially during mid-July till August, as many floor traders go on leave.  On Dull and Normal Days aggressively pricing the order 0.10-0.15 below Theoretical Price for a debit spread; or, 0.10-0.15 above for a credit spread just means it takes 1-2 hours more to get filled.  If your order is filled within 5 minutes, you were lax in working the entry hard; versus, getting filled in 1-2 hours.  Diligence does make a material difference in the trade’s price-performance.  In avoiding entries on Big Days, you are not missing out on not getting in, when most retail traders are chasing price to get filled.  One key factor of the consistency in your account’s P/L is the price you got in and out of.  The discipline of staying consistent is to get filled within a sustainable range of the spread’s fair value for that particular trading day.  Remaining in the business of online options trading requires as much sense to stay out of trades, as it does to get in to trades.