Improving Trade by Playing Both Sides

During my early days of trading in the 1990s, I had a lot of luck. At the time I started trading, the market was trending upward. Covered call writing was my first method, and it worked so well in tandem with a rising market that I hardly ever lost money. Take a moment to consider... It's simple to buy a stock at $9, sell a $10 call for $1.50, and then let your stock get called away from you for some very handsome profits when most companies are increasing and the options are filled with premium.

That was fortunate, because now that I'd "burned my bridges," I had no choice but to try to make a success of it on my own. When I think back on those instances, I am very grateful for my incredible streak of good luck. It could have been much worse! Time and hindsight (along with some life-changing events) taught me that no market, good or bad, is permanent and that change is the only constant. As a result of being forced to "go with the flow," I am now able to adapt my business tactics to the ever-changing state of the market.

Adapting Markets

My biggest worry has been whether or not my strategies will be effective in the face of a dynamic market. Which ones are successful in a growing economy? When the economy drops, what should you do? There are probably already many books written on that topic; instead, I'd like to zero in on a specific type of trade we make in the AfterHours Trading Lab. If you're not familiar with it, it means that I get together with other traders after work to plan out deals that we'll execute on the way to work the next day. The AfterHours Lab prioritizes trades with a horizon of 30–90 days as well as those with a horizon of 90 days or more. Our "getting wealthy" account, Net Worth Growth, and our daily cash flow, generated by trades executed in the morning Short Term Trading Lab, benefit from these investments. I'd like to take a quick peek at the mid-term deals.

Deals With a Time Frame that is Somewhere Between Short and Long Term

I've already mentioned that the covered call is the medium-term strategy I prefer. Using this method, I was able to keep track of my finances by scheduling trades to "mature" 30, 60, or 90 days in the future, providing me with a steady stream of cash to tide me over any lulls in my day-to-day income. Writing covered calls became increasingly challenging as the available premium evaporated. As a replacement for covered calls as a medium-term strategy, I started looking for stocks that were turbulent but still somewhat predictable. I'll tell you what I've been up to so far.

Changes in Stocks

Find a stock that has a lot of volatility, and we'll focus on it. By using the system's built-in algorithms, Chart Navigator may compute the average daily range of stock prices over the past month or so and supply this information. As a result, I'm only going to focus on stocks that fluctuate by $1.50 or more on a daily basis. Because of our extensive experience with ADRs in the trading laboratories, it has become second nature for us to just discard the ones with minor daily swings on most of our techniques. But noticing stocks with large price swings isn't enough.

The thorn in the ointment, especially in a volatile market, is that you need to know which way they are most likely to move. Therefore, we further restrict this high-volatility stock search to only include stocks that behave similarly to "channeling" stocks, i.e., by staying inside a limited trading range. An example stock with a price range of $32 to $42 that is now trading in the middle of the channel is shown here. The stock fluctuates by about $2.40 on a daily basis, on average.

With this information at hand, let's try to identify some other hallmarks. First, keep in mind that the stock has traded within or very near this range for a long time now. Furthermore, each "oscillation" travels from the top of the channel to the bottom in roughly a month. Ultimately, this stock is volatile but largely flat. Alright, let's make a medium-term trade on this one. If we can maintain this pattern, we may no longer need to fret over the lack of opportunities for covered call trading.

The Exchange

Knowing the stock's expected direction of movement is essential prior to making any trades. Well, that's the catch! You're only guessing unless you're into predicting the future (crystal balls), using technicalities (detailed crystal balls), or having highly positioned buddies within the company to aid (illegal). It could go either way... We are well aware that it fluctuates frequently; therefore, tomorrow's price is highly unlikely to be the same as today's. It fluctuates a lot, so it could go up or down, but it's unlikely to stay the same at $35. Eureka! Finally, that's all there is to it! Sell high and buy low with it. It can only go one of two ways (remember the high daily movement).

Since we can't buy and short the stock at the same time (at least in the same account), we might as well buy a put and a call instead. We could invest in the $35 put and the $35 call. This strategy, known as a "long straddle," allows us to benefit regardless of which direction the stock swings by selling off the losing leg of the straddle as the trend becomes clear. The straddle is not a novel concept, but it does offer the chance to eliminate the need for a "crystal ball" in your trade.

Assuming It Is Excellent

That's fantastic up to this point, but, as I said, this one's been around for a while, so if it's so wonderful, why isn't everybody doing it? The key is effective trade management, which will be discussed in our future newsletter.