AbouttheBookThis is a pioneering book on trading Indian futures and optionswritten by anexpertwho does so for a living. It is an insider's guidewhich spans the threeaspects of successful trading: charting and entry techniques,money and trademanagement,andtradingpsychology:

How to figure out whether the market is trending or range-bound; thetechnicalindicatorstoapplyindifferentphasesDay trading, swing trading, andposition trading—profitable approachesandappropriateprecautionsforthesethreefuturestradingstrategiesCashandfuturesarbitrage—howtogetrisk-freereturnsfromidlecashMoney-makingoptionsstrategiesHowtotradewithdisciplineThecriticalimportanceofmoneyandtrademanagement;rulesforlimitingyourriskpertradeandhowtoworkoutthesizeofyourtradingpositions.

Basedonaninsider’sexpertiseandexperienceoftradingIndianfuturesandoptions,thebookispackedwithprovenstrategiesandexamplesofrealtradesintheIndianderivativesmarket.

Theauthorboldlyasserts that“derivativeshavechanged the Indian tradinglandscapeforever...Itis,finally,possibletomakeafortuneontheIndianstockmarket.”

“Gujralhascementedhimselfasapioneerinthisfield.”

—JamesHolter,Editor,FuturesMagazine,USA“Ashwani Gujral has the natural ability to show traders how it works.”— Jim Kharouf, Editor,Trader’sSourceMagazine,USA“ThemoreIread,themoreIfascinatedgot”—SaikatDasgupta“Ifoundyourbookinteresting,enlighteningandpractical”

—AravindGandhi,Mumbai

“Theuniquethingaboutthisbookisthattheauthorshareswithushisexperiencesonaparticulartrade.Ithasspecificpinpointedexamplesratherthanmoreconceptualknowledge.Inrecenttimes,thisisoneofthebestbooksontradingandmanagingmoney.”—www.traderji.com

AboutTheAuthorAshwaniGujral’sbrilliantacademicbackgroundspansengineeringandfinance.He is BE (Electronics and Communications) fromM.I.T.Manipal, 1993, andMBA(Finance)fromGeorgetownUniversity,WashingtonDC,USA,1995.

Mr Gujral writes regularly for the leading US specialist magazines andjournals on trading and technical analysis, includingTheActive Trader,USA;Stock Futures and Options,USA;Futures, USA; Trader’s Source, USA, andTechnical Analysis of Stocks and Commodities, USA. He is also a TechnicalAnalysisConsultanttoReutersIndiaLtd.

MrGujralalsofeaturesregularlyasanexpertoverCNBC,NDTVandZeeNews Channels to offer comments on the Indian economy and the stock andderivativesmarkets.Since1995,hehasbeentradingstocksandderivativesforaliving.

HowtoMakeMoneyTradingDerivativesishisfirstbook.

“AshwaniGujral has taken great strides at bringing technical analysis totheIndianfinancialmarkets.Thisbookencompassesall facets . . . . It’samustreadforanyoneinterestedintechnicallytradingtheIndianmarkets.”

—JayanthiGopalakrishnan,Editor,TechnicalAnalysisofStocksandCommoditiesMagazine,USA

“India is the world’s largest and most exciting frontier of speculativemarkets.AshwaniGujralhascementedhimselfasapioneerinthefieldandwill help numerous Indian market participants graduate from passiveinvestorstotraders.”

—JamesHolter,Editor,FuturesMagazine,USA“Asa trader andwriter,AshwaniGujralhas thenatural ability tobreakdownacontract,marketorproductandtelltradershowitworksandwhatitmeanstothem.Hisstraight-forwardstyleshouldhelpanytradertryingtofilteroutwhatisneededintradingIndia’sderivativesmarkets.”

—JimKharoof,Editor,Trader’sSourceMagazine,USA

“Gujral’s book is heavily under-priced for the great ideas it offers soliberally.”—HinduBusinessLine

Dedication

Thisbookisdedicatedtomybiggesttradesofarmywife,Anubha

andmyhighestprofitmydaughterRtunjya

andIamstilllongonthem.TheystoodbymenotonlywhileIwrotethisbook

butalsowhileIlearnttradingandthroughtheinevitableinitialfailuresbutcontinuedtobelieveIcouldsucceed.

www.visionbooksindia.comALLRIGHTSRESERVED.Nopartofthispublicationmaybereproduced,

storedinaretrievalsystem,ortransmittedbyanymeans,electronic,mechanical,photocopying,recording,orotherwise,withouttheprior

writtenpermissionofthepublisherandthecopyrightholder.AVisionBooksOriginalFirsteBookEdition,2016

FirstPublished2005,Reprinted2005(5times)Reprinted2006(5times)

RevisedandExpandedEdition2007Reprinted2007(4times),

Reprinted2008(4times)Reprinted2009(Twice),2010(Twice),20113rdEdition2012

Reprinted2014,2015(Twice),2016eISBN

eISBN10:81-7094-931-9eISBN13:978-81-7094-931-2©AshwaniGujral,2005,2016

PublishedbyVisionBooksPvt.Ltd.

(IncorporatingOrientPaperbacksandCARINGimprints)24FerozeGandhiRoad,LajpatNagar3

NewDelhi110024,India.Phone:(+91-11)29840821/22e-mail:visionbooks@gmail.com

Contents

AbouttheBookAbouttheAuthorPrefacetothe3rdEditionPreface

1.TheIndianEquityandDerivativeMarketsͰTheIndianStockMarketͰTheDifferencebetweenaTraderandanInvestorͰDerivativesͰAspectsofSuccessfulTrading

2.ADX—TheAnatomyofaTrendͰTechnicalAnalysisͰTypesofTradingͰTheAnatomyofaBarͰTrendsͰTheBigQuestion:IstheMarketTrendingorTrading?

3.TechnicalMethodsͰIndicatorsͰOscillators(orMomentumOscillators)ͰFibonacciMethodsͰCandlestickCharting

4.ApplyingTechnicalstoTrading

ͰSwingTradingͰSuccessfulRetestͰBullandBearFlagsͰSupportandResistanceDiagramsfortheSwingTrader

5.DayTradingRulesandSetupsͰDayTradingSetups

6.CashandFuturesArbitrageͰWhytheCostofCarryVariesAccordingtotheMarketSentimentͰAdvantagesofUsingCashandFuturesArbitrageͰPossibleOutcomesoftheCashFuturesArbitrage

7.GettingtoGripswithOptionsͰOptions:SomeImportantConceptsͰFactorsThatDeterminethePriceofanOptionͰTheGreeksͰFactorstoKeepinMindWhenBuyingOptions

8.StrategiesforTradingOptionsͰIntroductionͰVerticalSpreadsͰRollingOptionsUp,DownandOutͰStraddles

9.TheCoveredCall:WhoSays4%ReturnsperMonthareHistoryͰWhyCoveredCallWritingMakesSenseinIndiaͰWhatKindofReturnsAreWeTalkingAbout?ͰHowCoveredCallWritingCompareswithSimplyGoingLongͰDecidingontheStockstoBuyandtheStrikestoWriteͰFollowupStrategiesͰWritingIndexCoveredCallOptionsͰAdvanceImplementationͰBenefitsoftheCoveredCallStrategyͰWhyDon’tManyOtherPeopleDoIt?

10.DerivativeStrategiesforSpecialSituationsͰWritingCoveredCallsJustBeforeImportantAnnouncementsorNewsͰBudgetͰCompanyResults

ͰElectionResultsͰCabinetCommitteeMeetings

11.TradingDisciplineͰWhatisDiscipline?ͰQualitiesofaDisciplinedTraderͰTraitsoftheIndisciplinedTraderͰMyTradingManual

12.MoneyManagementͰTheSizeofYourTradingPositionsshouldbeBasedonͰWhatisMoneyManagement?ͰPositionSizingStrategiesͰStopsͰExits

13.SelectionofStocksandFuturesͰBottomUpAnalysisͰTopDownAnalysisͰRateofChange(ROC)ͰAddingaFundamentalValuationParameter

14.MyTradingDiary—TheBubbleandtheCrash:February-June2006

15.TheAGLastHourTradingTechniqueͰWhat’sSoSpecialabouttheFirstandLastHoursofaTradingDay?ͰTheContextoftheMarketͰHowtoSelecttheRightStockstoTradeͰExamplesͰConclusion

Appendix-1:PermittedContractSize.Appendix-II:CalculatingImpliedVolatilit.Appendix-III:UsingthePeterHoadleyOptionsStrategySoftware

January2012 ASHWANIGUJRAL

Prefacetothe3rdEdition

AlotofwaterhasflownunderthebridgesincethisbookwasfirstpublishedinFebruary 2005. The book has been widely read and appreciated by IndianinvestorsandtradersandIwouldliketothankthelargenumberofreaderswhohavesaidsomanykindwordsaboutit.Indeed,itwerethemailsIreceivedfromreadersfarandwidecoupledwithmypublisher’sinsistencethatmotivatedmetoaddtwoextrachaptersinthebook’ssecondeditiononsomeenduringlessonstobe learnt from the way the markets moved between February 2005 and June2006.

The first of the new chapters (Chapter 13) deals with stock selection, inwhichwelookathowtochoosesuitablestocksfortrading.Personally,Ibelievethatthischapteristhesecondmostimportantoneintheentirebook,nextonlytothe one onmoneymanagement (Chapter 12). This is so because it’s futile toapplytherighttechniquestowrongstocks.

Intheothernewchapter(Chapter14),IdescribehowIdealtbothwiththetop forming around May 2006, and then the 40% correction from that topthroughJune2006.Asthemarketwentthroughahugerallyandthenanequallysharp40%correction, I thought itwasanappropriateoccasion toaddsomeofmynewlearningandexperienceforthereadersofthebook.

Forthebook’sthirdedition,Ihaveaddedanewchapter(Chapter15)whichdescribesthelasthourtradingstrategywhichIhavehonedandperfectedduringmytelevisionshowsonET-NOW.Itprovidesanewdimensiontothewaydaytradersapproachthelasthourinthemarket.

Iplan tocontinuallyaddmorechapters asmy trading lifeunfolds, sharingmyexperiencesandresearchwiththereaders.

While you won’t become an expert technical analyst or trader merely byreadingthisbook,Ihopeitwillneverthelesssensitizeyoutotheissuesfacedintrading.

Preface

Let’sfirstbeclearwhatthisbookisnot.This is not a book on technical analysis although it does discuss technical

methods,specificallyinchapters2,3and4andusesitinalmostalltheothers.Technicalanalysisisavastfieldandit’snotpossibletodiscussitinitsentiretyinonebook.Neitherisitnecessarytodosoinabookonstrategiesfortradingderivatives. Profitable trading does not depend on the knowledge of a largenumberoftheories,ratheritdependsonsuccessfullyimplementationofafew.Ihavetriedtodiscusstechnicalanalysisinasimplemannerandonethatcanbeimplemented by traders having elementary knowledge of the subject. Animportantpartofsuccessfultradingisalsomoneymanagementandpsychologywhichmostbooksdonotgetaroundtodiscussingatallbutwhicharecoveredinsomedetailinseparatechaptersinthisbook.

Secondly,thisisnotabookwrittenforatheoreticalviewofeithertechnicalanalysisorderivativesbutasfaraspossibletriestodiscussthepracticalinsightsI have gained in more than eight years of trading — a period which sawrecessions, booms, busts and liberalization policies of different Indiangovernments.All thederivationsand technical theoryhavebeenpurposely leftoutbecausemostofthesearenowprogrammedintothesoftware.Theimportantpointisunderstandinghowyoucanusethemethodsratherthanthetheoryitself.Traders wanting to enhance knowledge can buy some of the other literaturewhichdiscussesthetheoreticalaspectsingreatdetail.

Nowwegettowhatthisbookisallabout.This book is about using derivatives for the purposes of trading or

speculation. Speculation is not a dirty word and neither is it gambling.Speculation is the art of making short term trading and investment decisionsbasedonknowledge,researchandtradingphilosophies.Iwouldrecommendthattradersstudyatleastacoupleofbasicbooksontechnicalanalysistogetabetterhandleon thestrategiesused in thederivativesmarketsas thebasisofmakingderivativetradingdecisions,isgenerallytechnicalanalysis.

This book starts with the first discussing the Indian economy, the Indiancapitalmarketsandthebasicsofderivativesinstruments.

ThesecondchapterdiscussestheconceptofADXwhichhasbeencriticaltomy trading since it is one of the few indicators which helps a trader identifywhether themarket is trendingorrangebound.This isvitalbecauseonlyafterthis can a trader choose the tools and the methods appropriate for these twodifferentmarketconditions.

Thethirdchapterdiscussesavarietyoftechnicaltools,liketheRSI,MACD,stochastics, moving averages, Fibonacci, etc. I have deliberately limited thenumberof technical toolssincea lotof indicatorsprovideessentially thesameresults. I have chosen to focus on two trading indicators and two trendingindicators. Then I have discussed the Fibonacci methodology which helps indetermining theprice levels. Itwoulddonoharm to the trader to improvehisknowledge on these subjects by reading more detailed books on technicalanalysis.

The fourth chapter pulls everything together, and shows the practicalapplication of technical tools and methods discussed in chapters 2 and 3 inmakingderivativetradingdecisions.

Thefifthchapterdiscussesdaytradingusingintradaychartsandprovidesthebasic strategies for a day trader. Traders should remember that day tradingremainsoneofthemostdifficultartstomasterintrading.

Thesixthchaptertacklescashandfuturesarbitrageandhowidlecashcanbedeployedwhenthereisnoprofitabletradingopportunityavailable.Thisisariskfreestrategy.

Chapter6thusconcludesthediscussionintradingfutures.Theseventhchapterintroducesthetopicofoptionsanddiscussesthevarious

attributesofoptionsand factors thataffectoptionpremiums.Thischapteralsodiscussesthecalculationofimpliedvolatilityandhowthiscanbeusedtojudgewhetheranoptionisexpensiveorcheap.

Theeighthchapterdiscusses theoptionstrategiesuseful for Indian traders.At theendof thischapteryoushouldbefairlycomfortablewithstrategies thatareusefulinIndianmarkets.

The ninth chapter tackles covered call strategies. This strategy producesincredible returns in the Indianmarket as option premiums tend to be high inIndia.Ingoodmarkets,thisstrategycanprovidereturnsupto5%permonthonaportfolio.

January2005 ASHWANIGUJRAL

Thetenthchapterfocusesonderivativetechniquesbywhichyoucanprofitinspecialsituationstypical toIndia.Thischapterdiscusseselections,companyresults,budget,etc.

Theeleventhchapterdealswiththecrucialelementoftradingdisciplineandhowit’simportantforatradertodevelopadisciplinedapproachtotradingandmakingtradingdecisions.

ThetwelfthandthefinalchapterdealswithwhatIconsider tobe themostimportantaspectofthisbookandonethatdeterminesatrader’ssustainabilityinthis business—money management. This chapter discusses various methodsyou can use for limiting the amount of capital risked on every trade, and theconsequencesofoverexposurerelativetoone’saccountsize.

After finishing thebook,novice traders shouldpracticepaper trading forawhileandchecktheeffectivenessofthevariousstrategiesandthebestsituationsfor implementing them. Subsequently in real life trading, keep your initialexposuresmallandincrease itgraduallyasyoudevelopabetterunderstandingoftheIndianderivativesmarket.

Finally, I must caution you that trading is one of the most difficultprofessions to master. Those who are able to master it, have huge rewardswaitingforthem.Hereiswishingyougoodluckinmasteringthiswonderfulart.

Chapter1

TheIndianEquityandDerivativeMarkets

WhenIbeganwritingthefirstchapterofthisbookearlyin2004,Indiaappearedto be making rapid economic strides. The economy was being systematicallyunshackled and customs duties were being reduced to allow all comers freeraccesstotheIndianconsumer.Politicianswereheardsayingthattheywantedtocreatealevelplayingfieldratherthanthinkingofprotectionistways.Indiawasbecoming the most favoured destination of outsourcing, from services tomanufactured products. “Made in India” was slowly becoming a brand ratherthanaliability.Agoodmonsoonensuredthatagriculturalgrowthwasrobustandruralincomeswereontherise.Interestratesstoodattheirlowestlevelseverandthegovernmentwastakingstepstoreducethefiscaldeficit.Onthegeopoliticalfront,peacetalkswithPakistanseemedreadytostart.

Scarcelythreemonthslater,resultsofthe2004Indiangeneralelectionledtothe unexpected fall of the Vajpayee-led NDA government, and everythingseemed to change overnight. A new Left-supported dispensation was widelyperceived set to reverse some deregulatory policies and slow others down. AnervousIndianstockmarketlost$22billioninasingleday—itsfourthlargest-everone-daydebacle.

Real-life often outdoes fiction in surprises, a lesson every trader needs tokeepinmind.

TheIndianStockMarket

India now has several home-grown multinationals listed on the stock marketwhichhavebroughtlaurelstothecountry.India’sstockmarketshavealsomadeseveral structural changes to improve their security and efficacy. The days ofHarshadMehtaandKetanParikhareoverasthecashandderivativesegmentsofthemarkethavebeenseparated.Today,investorsnotonlyhaveequitysharesbutalso their derivatives, such as futures and options, to hedge risk and trade. So

fromasituationwhereonlyalinearproductwasavailabletill the1990s,todaythereexistthenewnon-linearderivativeproductsaswell.

When trading derivatives, you are generally dealing with big stocks andthesehavetherequiredfundamentalsinplace.Theyareunlikelytohaveabruptshareholder-unfriendly moves. Smaller stocks which have limited institutionalholdings are more prone to abrupt moves which cannot be explained eithertechnicallyorfundamentally.

MythsAbouttheIndianStockMarket

At thispoint it ispertinent forme todispel some fears about the Indian stockmarket that new traders and investors may have based on past events. It isimportanttodosobecauseallequityfuturesandoptionsarederivativeseitherofstocks,ormarketindices;andarethusapartandparceloftradinginthestockmarket.

TheIndianMarketCanHaveaScamatAnyTime

Indianinvestorsandtraderswhohavebeeninthemarketsince1990havehadtoface a scam at some time or another. Actually, most of these were not stockmarketscams.Rather,theywerescamsinotherfinancialinstitutions,butitwaseasierandmoresensationaltoblamethemonthestockmarket.InbothHarshadMehtaandKetanParikhscams,financialinstitutionsviolatedRBIguidelinestolend money to both these gentlemen which they used to inflate stock prices.Couldchartshavesaved tradersand investors fromthesescams?Absolutely. Ibelievemosttraderswhofollowedchartsdidnotgetbadlyhurtbecausetheyhadstoplossesinplaceanditwasclearthatstocksweregettingdistributed.

Infact,nimbletradersevenmademoneybysellingshortintheensuingbearmarket.Mostbullmarketsworldwideendwithscams.Ilookatitasfootingthebillforthepartythathappensbeforethescam.Thekeyistorecognisewhenitisthatthemarketstartsactingsillyinpayingvaluationsforcompanies.Chartsplayaveryusefulroleinthisastheygiveanindicationofthemarkettoppingout.Asreaderswould recall, thegreat bullmarket of the1990s in theUSendedwithWorldCom and Enron.Usually, scams trigger the end of bullmarkets.We inIndiaaresousedtosecureassetsthatwetendtooverreacttoscams—andveryemotionally at that. But investors and traders who take the time to study themarketcanhedge,andeventradeprofitably,throughthesescamswiththehelp

ofderivativesnowavailable.Structurally, after ten years of reform, Indian markets today are probably

amongthesafestintheworld.TheVAR(ValueatRisk)systemofmarginsonderivativescollectsupto50%of the totalvalueofa transactionwhenmarketsbecomevolatile.Thechancesofdefaultbyanyoftheexchangesorbrokersarethusminimal.TheIndianmarketregulatorSEBIalsohasalotmoreteethtodayandisveryvigilanttomanipulationbyanymarketplayer.Iwouldliketopointout here that insiders andmanipulators are there in allmarkets. Equally, theiractivitiesareclearlyvisibleonthecharts.Iwouldstronglyurgeallinvestorsandtraders todevelopa feel forcharting; itcanhelpyousavea lotofgrief in themarkets.

Also, in the last few years there has been consolidation of the regionalexchangesandnowtherearereallyonly twoexchanges,BSEandNSE,whichruntheentirebusinessofequitiesinIndia.Mostregionalexchangeseitherhavenobusinessorhavetakenbrokingticketsfromtheselargeexchanges,sotheriskofalocalisedscamhasalsoreduced.

LossesfromSystemicDelays

Therewas a timewhen physical shares used to be traded on the Indian stockmarketsandtherewerealotofhasslesingettingthemtransferred;formsneededtobefilled,therewerecasesofbaddelivery,etc.(Theprocesswassoirritatingthat I almost left this business at one point.) But now things have totallychanged.Allsharesandderivativeproductsaretradedintheelectronicformandhencethereisnoprocedurallosswhiletradingthem,andthereisnopaperworkat all. Today, Indian markets are one of the most sophisticated in terms ofproceduresandsystemsandareatthevergeofexplosivegrowth.

LackofTradingTools

Thebesttradingsoftwareandtradingtoolsarenoweasilyavailable.TelevisionchannelssuchasCNBCandNDTValsoservetobringthestockmarketsclosetotraders.

Some of the good charting software available are Trade Station andAdvanced GET. People not wanting to invest a large amount can also buyMetastock.The price of the software does not determine success. Even a freesoftwarefromtheInternetcandothejob.Sotheplayingfieldisallsetup,thetools are there and achieving trading success now depends on the individualtrader. Inmanyways, the enemyof the trader lieswithin him andwinning at

trading, in a large part, is the outcome of a trader overcoming his ownweaknesses.

IndianEconomyHasNotFulfilledItsPromiseSoFar

This isan issue thatholds relevance for the investorbut isnot important foratrader. In factmost traders, includingmyself,enjoygoingshorton themarket.Thisisbecauseallmarketsfallfasterthantheyrise.Soatraderisnotbotheredaboutwhat isgoingonin theeconomy,or in thepoliticalestablishment.Heisable to findopportunities inallmarketsandunderallcircumstances. In fact,atradershouldfocusmoreonimprovinghistradingskillsandleavetheworryingovertheeconomytoeconomistandpoliticians.Thisaspectdoesnot,andshouldnot,affecttradingresults.

TheDifferencebetweenaTraderandanInvestorIntheIndiancontext,atraderisapersonwhobuysandsellssharesatrelativelyshorterintervalstoearnaprofit.Thetraderisnotaversetogoinglongorshortonthemarketorindividualstockderivatives.Thetradercouldbe:

Adaytrader,whobuys,sellsandsquaresuphispositionduringthesameday;Aswingtraderwhotrades thevariousupanddownswings, i.e. fromonepivottoanother;orApositiontraderwhoholdshislongandshortpositionsforperiodsrangingfromseveraldaystoseveralweeks.

Most trading is done based on charting since that is possibly the onlyconsistent method of making money. Traders are active participants in themarket.Theyriskacertainamountbasedonchartpatternsandindicatorsandtrytoearnseveraltimestheirrisk.

Then there are the investors who buy and hold stocks for years. Theseinvestors generally do not trade the swings of the market and make buyingdecisionsbasedonfundamentalsandmarketnews.Inmyexperience,investorsgenerallyloseexceptwhentherearesecularbullmarketsforseveralyears,orifthey cangetmulti-baggers.But suchbullmarkets are so fewand far betweenthat I have not found it worth waiting for one. When the market moves insmaller swings, however, these investors often lose 80 to 90% of theirinvestment because they often buy atmarket peaks. I believe these long-terminvestors are people who finance the traders’ profit. Basically, I would

characterise anyone holding positions for less than a year as a trader, and theothersasinvestors.

Derivatives

Derivatives, as the name suggests, are financial instruments whose value isdependent on another underlying asset. The underlying security in the case ofequityderivatives is an equity share, or thewidely followedNifty andSensexindices.Ashareofequitycanonlyprovideanunhedgedpositionwhetherlongorshort,andtheentireriskofthetransactionlieswiththetraderorinvestor.

Therearetwotypesofderivatives.Oneisthefuturesproductandtheotheristheoptionsproductandtradingstrategiescanbecreatedusingthemindividuallyor in combination.Derivatives adda lotof flexibility to a trader’s tools.Theycanbeusedfortwopurposes,namelyspeculationandhedging.

Speculation

Contrarytowhatmanypeoplebelieve,speculationisnotgambling.Speculationis the skill of analysing data and taking positions on the various marketsituationstoprofitfromfavourablepricemovements.Inthestockmarketarena,this activity is also called trading. Throughout the remainder of this book,speculation in the stockmarket will be referred to as trading, which includesgoing both long and short on the market. Also, contrary to popular opinion,trading is neither about predicting the direction of the stock market nor is itabout predicting prices. The most important aspect of trading is moneymanagement.Thereisacompletechapterlaterinthisbookwhichdealswiththeissueofmoneymanagement(Chapter12).

Briefly,moneymanagement involvesriskingaparticularamountofmoneyto make several times the amount risked. There are various situations, calledsetups on the technical charts, which increase the probability of successfultrades.But,andIwanttostatethisloudandclear,sincenoonecanpredictthestockmarket,thekeytomakingmoneyintradingonasustainedbasisistomakebigprofitswhenyouare rightand limityour losseswhenyougowrong.Alsoimportantisthesizeofyourtradingpositionsinproportiontotheoverallsizeofyourtradingcapital;correctpositionsizesenableyoutostayinthegameforthelongestpossibletimeandhenceincreasethechancesofmakingmoney.

Anyonewhohas bought this book in the hopeofmaking easymoney canstopreadingitrightnow.Tradingisaskill thatislearntoveraperiodoftime.

Nooneisbornwiththistalent.Noonehasaholygrailwhichcanpredictstockpricesconsistentlyoveranylengthoftime.Thisisthemostimportantlessonofthisbook.Onceyoustopchasingtheimpossibledreamofpredictingprices,youwill save all the time otherwisewasted in trying to find the perfect system. Ioftenseepeoplepredictingpricesinthemediawhichcanleadnovicetraderstobelieve that this is a skillwhich can be acquired. Iwill only say that if theseexperts had any such magical knowledge, they would not be sharing it ontelevision with the rest of us for free, but, instead, be sitting on a beach inCalifornia.

Trading,infact,isaskillthatcanbelearntand,oncelearnt,youcanmakehugeamountsofmoney.Todosotradersshouldgetusedtothenotionoflossesat theveryoutset.Trading isbothaboutprofitsand losses.Thekey is tokeeplossessmallandprofitsbig.

Hedging

Theideaofhedgingismoreimportantinthecommoditiesandcurrencymarkets.Intheequitymarket,hedgingcanbeanexpensiveexercise.Oftenpeoplethinktheywill be fully protected if they take a positionwhich profits if themarketstartsmovinginthereversedirection.Truetheywillprotectthemselvesbutnottotallybecausehedgingcomesatacost,forwhilehedgingcanreducelossesbutitalsolowersyourprofits.Inmyexperience,itisnotworthwhilefortraderstohedge their positions. Instead, when a trade starts moving contrary to theexpected direction, you need to quickly get out. Often in the media we hearrecommendations about buying stock futures and hedging it by buying a put.Thisstrategysoundsgreatbuttheputcomesatacostwhichisdeductiblefromthe profits that you earn on futures, assuming that the profit on your futurespositionishigherthanthecostoftheput.Moreonthisinlaterchapters.

FuturesAnequityfuturesproductisaderivativeofeitheranunderlyingstock,orastockindex. In other words, the value of futures depends on that of its underlyingstockorindex,asthecasemaybe.

Duringtherestofthisbookwewilldistinguishthestockmarketconsistingofallthelistedstocksbycallingitthecashmarket.Thetermderivativesmarket,orfuturesmarket,willbeusedtorefertothefuturesandoptionsmarket.

Here, it is important tounderstandhowa futurescontract isdifferent fromtheunderlyingstock:

When you buy a stock you pay the full value of the transaction (i.e. thenumberofsharesmultipliedbymarketpriceofeachshare).Thereisnotimecomponent,youownthestockforalltimestocome.Youmakealossorprofitonlywhenyousellthesharesyouown.Youmayormaynothavealong-termviewonthestock.You can go long on a stock only if you own it (because of rollingsettlement).Youcannotshortsellunlessyouborrowthestock,somethingwhichisneithercheapnorconvenient.Thereisnowayoftakingapositionontheindexthroughthecashmarket.Thecashmarkethasamarketlotofone,i.e.youcanbuyanystockinthemultiplesofoneunit.

Whenyoutradefutures:Long is the equivalent of initiating a futurespositionbybuying a futurescontractandthensquaringupbysellingit.Short is the equivalent of initiating the position by first selling a futurescontractandthensquaringupbybuyingitback.You pay only the margin which is a fractional portion of the totaltransactionvalue,generallyabout15%inthecaseofindexfutures,andupto50%inthecaseofindividualstockfutures.All futures contracts are dated. For example, Indian futures and optionssettlementscurrentlytakeplaceonthelastThursdayofeverymonth.Sothecurrentmonth’sfuturesexpireonthemonth’slastThursday.Ifatraderhasto carryhisposition to thenextmonth,hehas to shift hisposition to thenextmonth’sfutures.Futures are generally traded using technical analysis because the productfacilitatesspeculation;futuresarenotaninvestmentproduct.Youcangolongorshortonthefuturesdependingonyourshorttermviewofthemarket,oraparticularstock.Thefuturesmarkethelpsyou takeavarietyofviewson themarketandaparticularstock.A futures contract is the smallest unitwhich you can trade in the futuresmarket. A contract consists of different numbers of shares for eachunderlyingstock.Thefuturesmarketlotsaredecidedonthebasisthattheminimummarket lot should beworth at leastͲ2 lakh. For example, onecontractofReliancefuturesisworth600shares.WhenyoutradeReliancefutures,youcandosoonlyinlotsof600sharesofReliance,whichisone

futurescontract.

Theoretically,FuturesPrice=CashPrice+(Monthly)CostofCarryIntheory,thecostofcarryshouldalwaysbepositivebecauseafuturestrade

isreallyacarryforwardproductsimilartotheerstwhilebadla.Butjustasbadlarates sometimes became negativewhen themarket sentimentwas bearish, thecostofcarrycanalsosimilarlybenegativewhenthemarketsentimentispoor.

Presently, in India the currentmonth’s stock or index futures are the onlyfuturesproductswhichcanreallybetraded.Futuresforthesucceedingmonthsareusuallynotliquidenoughfortrading.

For example, during January, only the January futures would be liquidenoughtobetradedduringmostofthemonth.TheFebruaryandMarchfuturesareunlikelytobeliquidforactivetradingformostofJanuary.OnlyinthelastweekofJanuarymighttheFebruaryfuturesbecomeliquid.ThisisbecausethefuturesandoptionssettlementtakesplaceonthelastThursdayofJanuary.

Henceforth in this book, which is about derivatives, whenever we talk oftradingwewillbetalkingabouttradingfuturesoroptions.Tradingotherwiseisatermalsousedinthecontextofstocksofindividualcompanies—butnotsointhisbook.

OptionsOptionsarethesecondtypeofderivativeinstrument.Anoptionisavailableinitsmostbasicformsintwoversions,namelya:

Calloption,andPutoption.

Calloptionistherighttobuyacertainassetatanagreedprice,andbeforeacertaindate,bypayingapremium.

Putoptionistherighttosellacertainassetatanagreedprice,onorbeforeacertaindate,bypayingapremium.

AlotofIndianinvestorswillrelatetooptionsasbeingakintotheadvanceorbayanagivenorreceivedatthetimeofsaleorpurchaseofaproperty.Abetterunderstandingofoptionsisgainedbyseeinghowthesedifferfromfutures:

Anoptionisanon-linearproductwherethelossislimitedandtheprofitisunlimited. A future is a linear product where profits and losses are bothunlimited.

Anoption has two components built into its premium, a time componentand an intrinsic value component.The value of a future is the cash priceaddedtothecostofcarrypermonth.Onceanoptionisbought,theonlycostandlosscanbethepremium.Inthecaseof futures,mark tomarket lossesneed tobepaid at the endof eachtradingsession.Optionsdependmoreontheavailabilityofabuyerandasellerandarenotnecessarily liquid at every price point. Most futures contracts are liquidenoughtoensureexcellentpricediscovery.WeshalltalkmuchmoreaboutoptionsinChapter7.

MythsAboutTradingDerivativesNowlet’stacklesomeofthemythsabouttradingderivatives.

It’sTooRisky

Iwouldreckonthattradingderivativesisaboutasriskyasdoinganythingelsethatyoudonothaveknowledgeabout,suchasdrivingacarorflyinganaircraft.Anduntilyouequipyourselfwithappropriateknowledge,youhavenobusinessto be trading anyway. It is important to understand that successful tradingrequires behaviour completely opposite to how we normally behave. Forexample,beingacontrarianisoneofthemostsuccessfulstrategiesintrading.Inmost situations in life, on the other hand, there is comfort in being part of agroup. Averaging downwards, for instance, is a wrong strategy that traderscommonly use. Booking losses is yet another difficult area that traders mustcontendwith,somethingweinstinctivelyshunfrom.

It’sOnlyfortheExperts

It canbe categorically stated that noneof the experts are perfect in predictingeitherthestocktrendsorprices.Anylaypersonwithsomepractice,hardwork,andbylearninggoodmoneymanagementisatparwiththeDalalStreetexpertswho talk so intelligently on television. Talking and trading are as different astaking a shower and swimming. A one-line description of trading is: trendfollowingandmoneymanagement.Ifyoucanmasterthesetwo,youcanmakeabetterlivingthanmostothersoutthere.Therearenosecretorhiddenstrategies.Thepointoftradingistotrytogetontoatrend,andifthemarketgoesagainstyou,tolimityourlossestoonlyasmallpercentageofyourequity.

YouCanLoseAllYourMoney

Yes, you can. But so can you lose your life while driving, or for thatmatterwhile playing cricket, or even just walking down the road. The most criticalaspectswhichdetermine a trader’s survival are theuseof properposition sizeandmoneymanagementtechniques.Whenyouaredrivingyourcarataspeedat100 kmph, the chances of a fatal accident are at least 50% higher thanwhendriving at 50 kmph. Similarly, in trading it is important to use leverage in amanner thatdoesnotborderon thedangerous. It’s important toremember thatbigmoneyismadebyhavinganumberofbig-wintrades.Thisnumberdoesnothavetobelargerthanthenumberoflosingtrades;thekeyisthatthequantumofeachwinning trade shouldbe several timeseach losing trade.Thegoalof thisbook is to help you achieve this objective.Anyonewho says there is anothersecrettomakingmoneyintradingisjusttakingyouforaride.

DerivativeMarketsAreManipulated

Mostmarketsoftheworldaremanipulated,includingthemotherofallmarkets,theUSmarket. So, this is generally an excuse trotted out by losing traders. Ibelieve that through a system of proper money management and a workingknowledge of charting, investors and traders can see what is going on in themarkets. Whether or not the markets are manipulated should not affect thetrader.Heshouldhavehisdefinedsetofrulesbywhichheplays.

AspectsofSuccessfulTrading

Successfultradingconsistsofthefollowingthreeaspects:Chartingandentrytechniques;Moneymanagement;andPsychology.

InFigure1.1,youcanalsoseetherelativeimportanceofeachofthesethreeaspectsofsuccessfultrading.

Figure1.1

Mosttradersgobustevenwhilelearningthefirstaspect,whichactuallyhappensto be the least important of the three.Most novice traders often start tradingwithout understanding the far greater importance of money management andpsychology, and it takes themyears to do so.Most books and seminars focuschieflyonchartingandentrytechniqueswhicharetheleastimportantthoughthemostglamorous.Iknowenoughentrytechniquestofillupanentirebookanditwillsellbythemillionsbecausemostpeoplejustwanttoknowthatonemagictechnique which will lead them to riches. The fact is that charting and entrytechniquesarerelativelylessimportant.Onceyoucanunderstandthis,youwillsaveyourselfalotoftime,moneyandheartburn.Trustme,Ihavebeenthere.

As for charting, all we can realistically do is label patterns which have ahigherprobabilityofworkingout.But in real life tradingpatterns fail aswell.Also,most times theydonotworkout in thepictureperfectmanner inwhichthey are shown in books. A trader should therefore never risk more than hisusual risk capital and should use position size according to the moneymanagementtechniquehehaschosentofollow.Thekeytosuccessfultrading,asI have noted earlier, is to get a few big winners and keeping losses small.AlthoughIamchartist,butIamawareofitslimitations.Thereareanumberoftimeswhenchartpatternsdonotworkatall,oraswellastheyaresupposedto.Thekey is tocapture those5-,6-,7-baggerprofitswhen thepatternsdoworkout,andexitatbreakevenoratsmalllossesalltheothertimesthatthepatternsdonotworkout.Aswewillseethroughoutthebook,moneycanonlybemadeifthesameamount is riskedevery time,and thepatternsare tradedanumberoftimes. The focus should be on protecting one’s capital, not risking it. Theaveragepositionsizeshouldnotbeincreasedjustbecauseafavourablepatternisshaping up. This should be done only when the size of your trading accountgrows tobe largeenough toaddmorecontracts.Themethodsofdoing soaredescribedinthechapteronmoneymanagement(Chapter12).Thisisthereason

why it is extremely difficult to find consistently successful day traders; theycannothavehugewinnersbecausetheyneedtosquareupattheendofeachday.

Last, butbynot themeans the least, ispsychology.There isnothingmorepowerful than the mind. The human brain can process lots of informationsimultaneously.Thehumanmindcanalsogetfearfulandgreedlydependingonsituations. The logical mind avoids being a contrarian. It is precisely theseaspectsofhumanpsychology thatworkagainst the trader. If traderscanavoidbeing led astray by the behaviour of others, theywillmake consistent profits.Successful traders try to make all their buying and selling decisions asmechanical as possible, and eliminating all emotion so far as possible.Whilewatchingthestocktickerontelevision,Ikeepthevolumeatmute.Idonotwantto hear what other people are saying about the market. Trading is not aboutarriving at a consensus. Trading is about getting on to big trends as often aspossible—andkeepingyourlossessmallwhenyoucan’t.Duringthecourseofthisbook Iwill repeat thismantrasomany times thatyouwouldbebetteroffwritingitonapieceofpaperandstickingitonyourtable.

Successful traders also try to buy a market on retracement because thatreduces the risk in the trade. They do not chase the market but wait for theshorter trend to move contrary to the main trend to make their entries. Theyremember that themarkets get strongerwith each successive fall, andweakerwitheachrise.Theyavoidmakingentriesintoagitatedorviolentmarkets.Theyavoidmakingtradesduringthefirsthouroftrading.

Mostimportant,theyarenotafraidoflosses.Theyunderstandthatnotonlyare losses inevitable, but that losses are the price of gaining entries into bigrends. The one thing they do understand is that losses need to be kept to aminimum and should only be used as an entry ticket. They understandwhichphasethemarketisin—whetheritistradingortrending.Theyknowit’stimetokeepoutofthemarketwhenthemarketistrendlessandmovingonlyinverysmall swings. There is no point trying to win from amarket which is totallytrendless. A complete chapter later in the book discuses the finer points ofpsychology(Chapter11).

At theendof thisbook,a tradershouldhaveanswers to the followingkeypoints:

Whatisthetrendofthemarket.Whatarethesetupswithwhichyouarethemostcomfortableforanentryinthemarket.What is the size of the position you should take based on soundmoney

managementprinciples.What stop loss to place thatwould not only protect your capital but alsokeepoutthemarket’sdailynoise.Whenshoulda traderkeepoutof themarketbecause themarketshowsaveryweaktrend,whetherupordown.At what point, depending your account size, should you increase yourpositionsize.Also,whenshouldyouexityourtradingpositions.

Chapter2

ADX—TheAnatomyofaTrend

TechnicalAnalysis

Technical analysis is the most useful and consistent approach to trading themarkets.Althoughthisisnotabookontechnicalanalysis,butitiscriticalthatatraderbeagoodtechnicianinordertotradefuturesprofitably.

Simply put, technical analysis is the art and science of putting stockinformation on a chart in the form of various kinds of bars and detectingdifferentpatternsandindicatorstoassessthemarket’sdirection.Whilealotofpeopleknowatleastalittleabouttechnicalanalysis,veryfewreallyknowhowtouse it.Technicalanalysis isnotanastrological science forpredictingpricesand market direction. The main function of technical analysis is to show thecurrentdemand-supplypositionof themarket,oraparticularstock,defineriskand reward of each particular trade, and help in following market trends.Technicalanalysisisnotanendinitself;theendisitseffectiveuseforprofitabletrading.Afterhavingspentmanyyearstryingtolearneveryavailabletechnicaltechniqueunder the sun, I amalsoof the opinion that people shoulduse onlythose techniqueswhich suit their style, insteadof trying to apply toomanyofthem.Making seriousmoney has no correlationwith the number of technicaltheoriesthatyoumayhavemastered.Thereareplentyofpeoplewhorundowntechnicalanalysis.Well,morethepeoplewhodoso,andmorethepeoplewhodisregardit,thehappierIambecauseitensuresthatthetechnicaltechniqueswillkeepworkingforalongerperiodoftime.

Thebasisoftechnicalanalysisisthetrendfollowingsystem.Trendscanbeidentifiedbyusingsimpleindicatorsinanytechnicalanalysissoftware.Alotofpeople have introducedmany complicated patterns andmethodologies to takeadvantageofveryshorttermmispricings.Personally,Ipreferpositionandswingtradingwhichincludesholdingpositionsfrom3-4daystoseveralweeks.

ComputersandTechnicalAnalysisThe advent of computers has revolutionised the use of technical analysis. Theavailability of huge computing power at an affordable cost has eliminated thegrind ofmanuallymaking technical analysis charts. Stockmarket data is nowavailableinbothintradayandendofdayformats.Computerisedanalysisallowsatradertotrackmanymarketssimultaneouslyandalsoallowshimtofocusonthe skills and judgement required in trading rather thangettingdrowned in itsmechanics. It also enables the technical analyst to look at charts inmore thanone time frames, allowinghim tomakebetter entries andmoneymanagementdecisions.

In my experience, a software that allows for charting of data and hasstandard indicators is good enough for beginner and intermediate technicalanalysts.Asyourskillsgrow,youcanstartbuildingcustomindicatorsandalsouseback-testingstrategies.

Imust however caution at this point that technical analysis ismore abouthowananalystusesthesoftware,ratherthanaboutthesoftwareitself.Thereisnosoftwarewhichcantakethehardworkoutofdetailedanalysis,orwhichcanbe a substitute for human judgement.Although there aremany softwares thatclaimalotofthings,thefactisthatnosoftwareortradingsystemcanadapttochanging market conditions as well as the human mind can. I would like toadviseall readersof thisbook togo throughat least twobasicbooks *on thissubjectinordertogainfulladvantageofthetechnicalanalysis-relatedchapters(chapters3and4)of thisbook.Also,all readersshouldhaveaccess toabasicchartingsoftwaresothattheycantestwhattheyreadinthisbook.

TypesofTrading

There are three types of trading, differentiated mainly by the time frameinvolved.Theseare:

1.SwingTradingSwing trading is themethodwhich allows trading of tradable swings, up anddown.Thelengthoftimethetradeisheldcouldbefrom3to4days,toacoupleofweeks.

2.PositionTrading

Positiontradingisusedbytraderswhotendtoholdtradesovermultipleswings,notendingtheirtradesonintermittentcorrections.Theycouldbeholdingtradesanywherefromacoupleofweekstomanymonths.

3.DayTradingDay traders trade within the course of a day. They generally do not carryovernightpositions.Daytrading,inparticular,remainsoneofthemostdifficultformsoftradingtomaster.

There are successful traders of all three types. Choosing the type of tradingapproachappropriateforyouisafunctionofmanythings,butmostsuccessfultraders tend to adopt, and try and master, any one of the three. The factorsaffectingyourchoicecouldbethesizeofyourtradingequity,yourpersonality,andprobablythedevelopmentofyourownnichewhichatraderdiscoversaftermanyyearsintrading.

Basedonmystyleoftrading,Iliketoconsidermyselfaswingtrader,andinextraordinarycircumstancesofastrongweeklytrend,apositiontrader.ThewayIusetechnicalanalysisis:

Identifythetrendofthemarket.Measurethestrengthofthattrend.Lookforalow-riskentryintothattrend.Usemoneymanagementtodeterminethesizeofanyposition.Useanappropriatestoploss.Keepfollowingthetrendtillthemarketprovesithasreversed.Keep out of the market when the market is not showing any significanttrendonewayortheother.

Ihopebythetimeyoufinishreadingthisbook,youwouldbeabletodoalloftheaboveeffectively.

TheAnatomyofaBar

Abar is themostbasiccomponentofachart justasanatomis themostbasiccomponent in all living and non-living matter. The bar contains very usefulinformationprovided the traderpicks itupearlyenough.Thenormalbaronachartconsistsoftheopen,high,lowandcloseprices.

Theopenbelongs to theamateurs; thehighofanybarbelongs to thebullsanddepictshowmuchforcetheyhad;thelowshowsthemaximumpowerofthebears;andtheclosingactionissetupbytheprofessionalinvestors.Sincemostmajormovements in themarketaredeterminedby theprofessionals, itpays tofollowthem.Iamnotatall suggesting that tradersshouldblindlyfollowwhattheyperceiveprofessionalstobedoing.Butjustwaitingtillthelastonehourcansometimeshelpyouavoidtakingfalsetradesthatyoumightotherwisegetinto.Duringthedaythemarketgyratesinbothdirections,i.e.upanddown,trappingplayers in both directions and then finally moves in one direction, eitherrewarding one set of players or closing in a narrow range. In either case,myexperienceisthatoutofthehundredtradesImighthavetakeninthebeginningofthetradingsession,IwouldhaveavoidedtakingatleastsixtyhadIwaitedforthe lasthalfhour.Thismakesahugedifference toyour tradingequity;younotonlyavoidovertrading,butthisalsoallowsyoutofollowthemarketinitstruestsensewithouthavingtobaseyourtradesonpredictions.

And,believeme,tradingisbothaboutreducinglossesandincreasingprofits.Thesameapplieseventoweeklybars.

Trends

Contrary to what a lot of people think, technical analysis is the art of trendfollowing rather than one of predicting prices and turning points. Trendfollowing remains the single most effective strategy for making big tradingprofitsinthestockmarkets:

Atrendisaseriesofrisingordecliningpricesoveranylengthoftime.Anuptrendisamarketwhichseeksconsistentlyhigherpricesovertime.Adowntrendisamarketwhichseeksconsistentlylowerpricesovertime.At any given time the market is comprised of three trends, namely theprimary,secondaryandminortrends.Primary trendcanbeeither a seriesof risingordecliningprices.Primarytrendscanlastfromonetoseveralyears.

Secondary trends are intermediate corrective trends to the primary trend.These reactions generally last from one to threemonths and retrace one-thirdtotwo-thirdsoftheprimarytrend.Minor trends are short term movements lasting from one day to threeweeks.

TheBigQuestion:IstheMarketTrendingorTrading?

Marketmovementscanbecharacterisedbytwodistincttypesofphases.Inonephase, the market shows trending movements either up or down. Trendingmovementshaveadirectionbiasoveraperiodoftime.

In the second phase, the market shows trading range movements orconsolidation,wherethemarketshowsnoconsistentdirectionalbiasandtradesbetweentwolevels.

Thesetwodifferentphasesofthemarketrequiretheuseofdifferenttypesoftechnicalindicators:

Trendingmarkets need the use of trend following indicators, such as themovingaverages,MACD,etc.Tradingrangemarkets,ontheotherhand,needtheuseofoscillators, liketheRSI,stochastic,etc.whichuseoverboughtandoversoldlevels.

So identifying thephaseof themarket is extremelycritical, for thatwoulddecidethemethodologyatraderneedstofollow.

ADX:AnsweringtheBigQuestion

The ADX, or the Average Directional Movement Index, fills this need foridentifyingwhethermarketisinthetrendingorthetradingphase.WellesWilderdevelopedtheADX,whichtomymindishismostusefulbut leastunderstoodinnovation.

Theconceptof trends iscentral to the ideaofADX.TheADXcantell thestrengthofthemovethatamarketmaybeinandthushelpyoukeepyououtofawhipsawingmarketandbykeepingyouinlongenoughduringatrendingmarkettomakehugeprofits.

ADXformsthecoreofmytradingstylesincemytradingisbasedontrendfollowing. TheADX is a standard indicator available in all technical analysis

software.TraderswoulddowelltoincorporatethekeyaspectsofADXintheirtradingstyle.

ADXdefinesthedegree—orstrength—ofthedirectionalmovementandnotitsdirection.

The directionalmovement system is a trading system based on the use ofADX, and gives timing information based on the strength of the underlyingtrend. We will now discuss the interpretations of ADX reading, and timingsignalsprovidedtothetraderbytheDirectionalMovementSystem.

DirectionalMovement

Directionalmovementisdefinedasthedifferencebetweenthehighandthelowof a particular bar on a chart that falls outside the range of a previous bar. Intermsofadailychart,priceactionaboveyesterday’shighispositivedirectionalmovement(+DM),whileanythingbelowyesterday’slowisnegativedirectionalmovement (-DM). This analysis can equally be applied to monthly, weekly,dailyorintradaydata.

Figures 2.1 to 2.4 show movements across two trading days highlightingpositive directional movement (+DM), negative directional movement (-DM),andzerodirectionalmovement.

InFigure2.1,theportionEAonthesecondday,whichliesabovetherangeofthefirstday,isdefinedaspositivedirectionalmovement(+DM).

In Figure 2.2, the part CE that lies below the range of the second day isknownasnegativedirectionalmovement(-DM).

Figure2.3showsanoutsideday,whichisadaywhoserangeencompassesallof themovementof thepreviousday. In thiscasebothCDandCEexceedAB so the greater of the two, namely CE, defines the directional movementindex,i.e.+DM.

Figure2.4showsaninsidedaywheretherangeofthefirstdayencompassestheentiremovementofthesecondday.Asthereisnodirectionalbiasachievedonthisday,thereiszeroDM.

TheDirectionalIndicator(DI)

As absolute difference in price movement fails to take into account theproportionof themovement,WellesWilderdevelopedthedirectional indicator(DI).Tomake theDMsconsistent across all stockprices,Wilderdecided thatprice movements are best described as ratios rather than absolute numbers.Accordingly,Wilderdecidedtodividethedirectionalmovements(+DM)and(-DM)by themarket’s true range.Sinceno trend isdetermined inaday, so theDIsarecalculatedoveranumberofdays.Wilderdecidedtouse14daysforthispurpose. The DIs provide the timing signals in the Directional MovementSystem,and theirunderstandingprovides thebackground for interpretationsofADXandeffectiveuseofitstimingsignals.

InterpretationofADXandDIs

ADXwasdevelopedfromtheDIs,andwewillmovestraighttotheuseofthisindicator without going into any more calculations. This indicator has beenprogrammedintomostpopulartechnicalanalysissoftware.

ThefirststepinusingADXistoidentifyasecuritywithahighADXsincethatwouldofferenoughdirectionalmovementtoallowtrendfollowingtrades:

AhighADXvaluedefinesastrong trend; the trendcouldbeeitherupor

down.AlowADXshowsaconsolidation,suchmarketsaregenerallydifficulttotrade.

Ingeneral, the following rulesmaybe followedwith regard to interpretingtheADX:

ADXInterpretations

1) ADX less than 20 isinterpretedasaweaktrendorconsolidation.

Indicatingtheuseofoscillators.

2) ADX rising from 15 to 25from lower levelsmeans thetrendisstrengthening.

Usetrendfollowingsystems.

3) ADXabove30isinterpretedasastrongtrend.

Usetrendfollowingsystems.

4) ADX at an extremely highlevel of 45 or above isinterpreted as a market in astrong trend with aconsolidation expectedanytime.

Startbookingprofits if theADXmakesatoporflattensout.

5) ADX declining below 30 isinterpretedasaconsolidationafteratrendingmove.

Use oscillators or credit spreads to tradethee consolidations. If bearish patternsdevelopandbreakdown,lookforADXtomove higher, this time indicating atrendingmoveonthedownside.

DITimingSignals

DIs,ontheotherhand,canbeusedastimingdevices:Longtradescanbeenteredwhen+DImovesover–DIs,andShorttradesareenteredwhen–DImovesbelow+DI.

ThesuccessofthistimingmethodologydependsonthestrengthofthetrenddeterminedbytheADX.Thegreaterthestrengthofthetrend,thegreateristhedirectionalmovement.Thestrongerthetrend,thefewerthewhipsawsgivenby

theDIs.WildernotedthatimportantturnsareindicatedwhenADXreversesdirection

after it hasmoved above both theDIs.Divergence between theADXand theprice is an important indicator of an impending reversal. Profits should bebookedateveryleveloncetheADXtopsout.DIsignalsmayoccurwithlaggingeffect. ADX should be used to filter the DI signals, taking only the onesoccurringwhenADXindicatestrending.

Conversely,whentheADXisatverylowlevels,Wilderrecommendednotusingtrendfollowingsystems.

Let’sgothroughsomeexamplesandseehowwecanbestusethiswonderfultradingsystem.

Figure2.5

Figure2.6

Figure2.7

As can be seen from Figures 2.5, 2.6 and 2.7, theADX keeps you in thetrendingmoves,whileindicatingconsolidations.ThewayIusetheADXisthatItrade lighter volumes during consolidations and substantially higher volumesduring trendingmoves.Thedrop in volumeduring consolidations could be ofthe order of two-thirds of the trending volume. This effectivelymeans takingsubstantialprofitsoffthetableasthetrendingmarketturnsintoatradingmarket.

ThemosteffectivesignalsfromADXarereceivedwhenitrisesfromaverylowleveltoabove15,andcontinuesonbeyond30.

ADXcanalsobeusedasfilterforvarioustrend-followingindicators,suchasMACDandmoving averageswhichotherwisegivewhipsaws in consolidatingmarkets.

Figures2.8and2.9illustrateexamplesoftradingmarketsandhowtheycanbe traded using oscillators. RSI (7) and Stochastics (7,10) should be used totrade consolidatingmarkets with a lowADX.Another option is to use creditspreadsorcoveredcallstotakeadvantageoftimedecay.

Figures2.8

Figure2.9

TheADXWorksonAllTimeFrames

TheADXindicatorandthedirectionalmovementsystemsarepossiblythemostusefultoolsintechnicalanalysis.ThemostimportantaspectoftheADXandtheDIs is that theykeepyou in the trend. I believe that technical analysis alwaysworksbestwhenthereisaconfluenceofindicatorsandpatterns.Iwouldadviseall traders to use ADX in conjunction with other technical patterns andindicators.

* TechnicalAnalysisofStockTrendsbyRobertD.EdwardsandMartinPringonMarketMomentumbyMartinPring,bothpublishedbyVisionBooks,aretwofinebooksyoucouldconsult.

Chapter3

TechnicalMethods

Indicators

As technical analysis has become more and more computerised, severalindicators have become fairly popular. Indicators like theMACD, stochastics,RSI,andmomentumarenowcommonlyused.Ifinditusefultodividetechnicalindicatorsintotwocategories,namely:

Trendfollowingindicators,andOscillators.

Also,more than the nuances of various indicators,what is important is tounderstandwhentousetheseindicators.

Trend following indicators are used in trendingmarkets— and oscillatorsareusedintradingmarkets.

MACD and moving averages form part of the trending indicators whilestochastics,RSI,momentum,etc.aresomeofthetradingindicators.Typically,IusetrendfollowingindicatorssuchastheMACDandmovingaverageswhentheADXisrisingover16to20whichindicatesatrendingmarket—andoscillatorswhentheADXisdeclining, thus indicatingconsolidation.Usingeither typeofindicatorinthewrongmarketcontextcanbelethalasdescribedinthepreviouschapteronADX.

MACD(MovingAverageConvergenceDivergence)

Traders should remember thatMACD is a trendingmarket indicator and thusgives the best signals only when the market is trending. MACD indicator,developedbyGeraldAppel,isamoreadvancedversionofthemovingaverages.

MACDconsistsof twolines, theMACDline(fast line)andthesignal line(smoothedaverage).BuyandsellsignalsaregivenwhentheMACDlinecrossesaboveorbelowthesignalline.TheMACDlineisthedifferenceofthe26-dayEMAandthe12-dayEMAwhichissmoothedbya9-dayEMAoftheMACDline.MypreferredMACDsettingsare3,10,16.Thisistheslowsignalline.

MostnovicetradersmakethemistakeofusingMACDinalltypesofmarketconditions.Whether themarket is trending or not can be ascertained by usingADXasdescribedearlier. In trading range-boundmarkets,MACD is likely togivemanywhipsawsandfrustratethetrader.

MACDTradingRules

Go long when the shorter termmoving averagemoves above the longertermmovingaverage.(SeeFigure3.1)Goshortwhenthelongertermmovingaveragegoesbelowtheshortertermmovingaverage.

Figure3.1

MACDHistogram

TheMACDhistogramoffersdeeperinsight intothebalanceofpowerbetweenthebullsandbearsthandoestheoriginalMACD.Itnotonly-showswhetheritisthebullsorbearswhoareincontrolbutalsowhethertheyaregrowingstrongerorweaker.

Ifthefastlineisabovetheslowline,theMACDhistogramispositiveandis

plottedabovethezeroline.Conversely,whenthefastlineisbelowtheslow,thehistogramisplottedbelowthezeroline(SeeFigure3.1).

[MACDHistogram=MACDLine—SignalLine]

TheMACDhistogrammeasuresthedifferencebetweentheMACDandthesignal lines, plotted as ahistogram.When the spreadbetween theMACDandthe signal line increases,MACDhistogrambecomes taller (deeper).When thetwolinesareclosertogether,MACDhistogrambecomessmaller(shallower).

The slope of the MACD identifies the dominant market group. A risingMACDshowsthatthebullsarebecomingstronger.AfallingMACDshowsthatthebearsarebecomingstronger.

The MACD histogram confirms a trend when, together with prices, itreachesnewhighsorlows.

MovingAveragesAmovingaverageistheaverageofapre-decidednumberofdatapoints,wherewitheachnewdatapointthefirstdatapointisrejected.Themovingaverageisan indicator that ismosteffective ina trendingmarket.Thereasonforusingamovingaverageintechnicalanalysisisthatiteliminatesnoiseandtendstoshowtheunderlyingtrendofpricesindicators.

Oneof themostcommoncomplaintsagainstmovingaverageis that itgetsyouintothetrendratherlate.Ihavealwaysfoundthischargefunny.Exceptinthecaseofbiggertimeframes,oraverylarge-periodmovingaverage,amovingaveragecanonlyshowa trendonce it is there; itcannotpredict trends, in factnothingcan.Theshorterthemovingaverage,theshorteristhetrendit’sabletoshow.

Thereisnoperfectnumbertouseforamovingaverage.Tradersusemovingaverages ranging from 10DMA to 200DMA and the samewithweekly andmonthlymovingaverages.Movingaveragesoftenprovide support toprices inan uptrend and resistance to prices in a downtrend. Themoving average thatworksbestforyoucanonlybediscoveredbytryingitoutoften;italsodependsonthetimeframeyouwanttotrade.It’slikebuyingashirt;thesameshirtdoesnotfiteveryone.

Iprefertousethe30-dayand200-daymovingaveragestogetafeelofthebroadlongtermtrend.Iftheshortermovingaverageisabovethelongermovingaverage,thetrendisup.Conversely,whenthelongermovingaverageisabove

the shorter moving average, the trend is down. These are two of the mostimportant moving averages, and a stock or the market closing below the 30DMAoftensignals thebeginningofa largercorrection inanuptrend.Closingbelowthe200DMAisthebeginningofadowntrend.Nolongpositionsshouldbeheldonceastockoramarketclosesbelowits200DMA.Conversely,closingabovethe200DMAsignifiesthebeginningofanuptrend.AnotherwayIusethe30-day and 200-day moving averages is using the turnings of the movingaverage—fromdowntoup,oruptodown—tobookprofitortochangemyview from bullish to sideways or bearish to sideways, respectively. I havealwaysfoundmovingaveragecrossoversleadingtolargemovesinthedirectionofthecrossover(Figure3.2).

Figure3.2

Shortertermtrendscanbedeterminedbyusingshortertermaveragessuchasthe 30 DMA or 50 DMA. The number used for the moving average is notimportanthere.Thatisbecauseitwouldnotmakeahugedifferencewhether35DMAor55DMAisusedasbothwouldgiveinformationsimilartothe30DMAor 50 DMA. Again, prices above the 30 and 50 DMA show an uptrend, andbelowthe30and50DMAshowadowntrend(Figure3.3).

Figure3.3

Sometimes two moving averages are used for the purpose of short termtrading, the averages selectedwoulddependon the time frameof trading.Forexample, for short term trading it couldbe10and50DMAs.For longer termtrading, itcouldbe30and200DMAs.Whentheshorter termmovingaveragemoves above the longer term one, traders can go long. Conversely, when thelonger term moving average goes below the shorter term moving average,traderscangoshort.Anothercombinationtoachievethesameresultcouldbe13and 30 DMAs. Again these combinations are not important, almost any twomovingaverageswilldo.

Movingaveragesdoanexcellentjobofprovidingsupportandresistancesothey shouldbeused to put stops.Anydecisive closebelowamoving averageshouldbetakenasabreachofthatsupport.Similarly,anydecisivecloseaboveacertainmovingaverageshouldbetakenasbreachofresistance.

Ialsoliketousea20-periodmovingaverageonalltimeframesthatIlookatbecause it provides the relative position of the market at that point. The 20-periodmovingaverageindicatestheprevailingbiasofthemarket,particularlyinshorter time frames, suchas the30-minute chart. It alsoprovidesgreat entriesinto existing trends in all time frames and buying options once the price goesbelow the20-periodmovingaverageand thencomesbackabove it, signifyingthat a reaction in an uptrendmay be over. This is one of my favourite entrymethods. Also, the number of bars above and below the 20-period movingaveragegiveafairindicationofboththeprevailingintradaytrendandalsowhenitstartschanging[Figure3.4(a&b)].

Figure3.4(a)

Figure3.4(b)

Oneoftheproblemswiththissystemisthatitgiveswhipsawsinasidewaysmarket.Thiscanbeaddressedusingthreemovingaverages,involving5,8and13-day moving averages. When the 5 and 8 DMA cross the 13-day movingaverage,golong.Whenthe5-dayaveragecrossesbackbelowthe8-dayaverage,yougetanexitsignal.However,youdon’tgetanewentrysignaluntilboththe5andthe8DMAareonthesamesideofthe13-dayaverage.Thesemethodsareavailableinmosttechnicalanalysisbooks(Figure3.5).

Figure3.5

Allofthesemethodscanbeusedonanytimeframe.Traders need to remember that both MACD and moving averages fail

miserably in trading sidewaysmarkets.These tools should only be usedwhenthere isadiscernable trend. If there isn’tone,more focusshouldbeplacedonoscillators.

UsingTrendLines

Trend lines, as the name suggests, are lines used to identify the presence of atrend.Inaddition,thebreakdownorbreakoutofthelinessuggestreversalofanexistingtrend.Therewouldbehardlyanytraderintheworldwhodoesnotusethetrendlineinoneformoranother.Itiscriticaltograsptheessenceofatrendline inorder touse it inmore innovativeways.This isaverysimpleandveryhandy toolwhich if applied correctlymakes a trader’s life very easy.A trendlinecanbeusedonanychartstartingfromyearly,quarterly,monthly,weekly,daily,60-minute,5-minute,etc.,andforanymarketthatischartable.

SupportLine

A line running under the prices and connecting three non-consecutive turningpointsonabarchart,andwhichiseitherhorizontalorslantingupward.

ResistanceLine

Alinerunningabovethepricesonabarchartconnectingthreenon-consecutive

turningpointsandwhichiseitherslopingdownwardsorishorizontal.

InterpretingTrendLines

Howevertherearecertainrulestobefollowedwhiledrawingtrendlinesandininterpretingthesignalstheythrowup:1. There should be at least three non-consecutive points joined by the trend

line and a trend line should not be “forced” upon a chart. There shouldactuallybealinewhichshowsatrend,thebreakdownorbreakoutofwhichshould show some kind of reversal. Remember, at least three non-consecutivepointsshouldbejoinedtoformavalidtrendline.

2. The longer a trend line, the more will be the consequences of itsbreakdown. In fact, the lengthofa trend line iscritical indetermining itssignificance.Forexample,a two-year trendlineismoresignificant thanatwo-monthtrendline,andatwo-monthtrendlinefarmoresignificantthanatwo-daytrendline.

3. Theflatterthetrendline,themoresignificantisitsbreakdown.Trendlineswith higher slopes are known to be broken easily. So a breakdown orbreakoutofa flatter trend line ismuchmoresignificantas itwouldshowhugesellingorbuyinghavingtakenplaceatthatlevel.

4. Themoretestedatrendlineis, thegreaterisitssignificance.Atrendlinewhichhasprovidedsupportorresistanceinthepastneedstoberespected.Not only is it likely to provide support again, its breakout or breakdownprovidesatradablemoveinthatdirection.

5. Another important application of the trend line is that it provides areference for placing stops. A stop should be placed at least 3% after abreakdownorbreakoutoccurs.

6. Traders should use only closing prices to assess if a trend line has beenbroken. Often the breakout or breakdown of trend lines are at well-advertisedlevels.Mediaanalystsrepeatthoselevelsoftenenough.Contrarytowhat they think, however, this is not a service to the trader; in fact, itworks to his detriment. This is because the large traders and institutionalinvestors create the particular intraday breakout or breakdown, leadingotherinvestorsandtraderstobelievethatasignificantchangehasoccurred.Whenindividualtraderstakepositions,themarketisconvenientlyreversedandsuchabreakdownorbreakoutiscalledfalse.Attheendofthedaythemarket closes at a levelhigher than the trend line, and the trend line stillremains valid. This ismost likely to happen in illiquid and small stocks.

Tradersshouldnotpre-emptabreakdownorbreakouttillitactuallyoccursandtheclosingpricesconfirmitforatleastacoupleofsessions.

7. Trend line breakdowns should occur with volume. A warning that aparticular breakdown or breakout is false is the kind of volume thataccompanies it because breakdowns generally occurwhen amuch higherthanaveragevolume is traded. Iwouldbeverycautiousonabreakoutorbreakdownthatoccursonlowvolumes.

8. Trend lines should be extended into the future.All trend lines should beextended into the future as they often continue to provide support andresistanceatthoselevelsevenatafuturedate.

Figure3.6

Nowsomepersonalnoteson trend line signals that Ihaveobserved inmyexperienceoftrading.

Trendlinesworkbeautifullyonintradaychartsforallthoseinterestedindaytrading,anditistheonetechniquewhichisconsistentlyproven.Inreallife,itisnotonlycriticalthatatrendlinebreakoccursandissupportedbyvolume,itisalso important for themarket to show strength in the direction of the break. Iidentifypivotsonachartandwouldliketoseethesetooviolatedalongwiththetrendlineviolationandvolumebreakout(SeeFigures3.6and3.7).Apivotisabaronanytimeframewhichisaturningpointonachart,alsocalledtheswinghighorswinglow.Forexample,anupwardpivotbarwillhavethetwoadjoiningbarswithhighsbelowthehighofthepivotbar.Adownwardpivotbar,willhavetwoadjoiningbarswithlowshigherthanthelowofthepivotbar(SeechartsinFigures 3.6, 3.7, 3.8 and 3.9). Generally, two of the above conditions aresufficienttoenterthetrade.Itisalsoadvisabletoenterthetradeinthedirectionof a trend identified in the higher time frame. This further increases the

probability of a successful trade. The procedure for entering a trend linebreakout trade is to take the tradeaspricesbreaka trendlineandcloseon theotherside.Sometimesthereisapullbacktothetrendline,andsomepeopleliketobuyorsell thepullback.Astopcanbeplacedonthevalidsideof the trendline.Once in the trade, traders should draw a fresh trend line and continue toholdthetradetill thenewtrendlineisbroken.Youwillbeamazedhowmanybig trends you can catch using this method. Trend lines can also be used bytraderstoscaletheirposition.Thismeansyoucankeepaddingacertainquantityofstockasmoredownwardslopingtrendlinesarebrokeninarallyorvice-versa(see, for example, the accompanying intraday SatyamCharts: Figures 3.8 and3.9).Scaling inwould furtherhelpmanage risk,aspositionswillgetaddedasthemarketgainsstrength.

Figure3.7

Figure3.8

Figure3.9

However good a trend line appears, I still like to look for additionalinformationthatwouldsubstantiatethebeginningofanewtrend.Itcouldbetheclassicalchartpatternson thecurrent timeframe. Itcouldbemarketactiononthe higher time frame. If the market action on the higher time frame issupporting market action on the current time frame, it suggests a very highprobabilityofprofitabletrade.Wewilldiscussthisaspectfurtherinlaterpages.

Oscillators(orMomentumOscillators)

Oscillators identify the emotional extremes of market crowds. They help in

determiningunsustainablelevelsofoptimismandpessimism.Professionalstradetheseextremesbybettingagainstthem,i.e.theybetonareturntonormalcy.Solong as oscillators keep making new highs, it is safe to hold long positions.Correspondingly,solongastheykeeptouchingnewlows,itissafetoholdshortpositions.When an oscillator reaches a new high, it shows that an uptrend isgainingspeedandislikelytocontinue.Whenanoscillatortracesalowerpeak,itmeans that the trend has stopped accelerating and a reversal can be expectedfromthere,muchlikeacarslowingdowntomakeaU-turn.Thetwooscillatorswhich I use most extensively, and which work well, are the RSI and thestochastics.Thereareother indicatorsavailablebut those tooprovidethesameinformation.

OverboughtandOversold

Anoscillatorbecomesoverboughtwhen it reachesahigh levelassociatedwithtopsinthepast.Anoscillatorbecomesoversoldwhenitreachesalowlevelassociatedwithbottomsinthepast.

Whenanoscillatorrisesorfallsbeyonditsreferenceline,ithelpsatradertopickatopandabottom.Oscillatorsworksplendidlyinatradingrange,buttheygivepremature anddangerous trading signalswhenanew trenderupts fromarange.

Anoscillator can stayoverbought forweeks at a timewhen a new, stronguptrendbegins,givingbuysignals.Itcanalsostayoversoldforweeksinasteepdowntrend,givingprematurebuysignals.

TypesofDivergences

There are three typesofdivergences asdefinedbyDr.AlexanderElder inhisbook,TradingforaLiving.

Class A divergences identify important turning points and are the besttrading opportunities. Class B divergences are less strong, and Class Cdivergencesaretheleastimportant.(See:Figures3.10,3.11and3.12).

Figure3.10:ClassADivergence

Figure3.11:ClassBDivergence

Figure3.12:ClassCDivergence

Myexperiencewithdivergencesisthattheyworkverywellinretrospectbuttrades should be taken based on price action. Divergences can take weeks toworkout,andsometimestheydonotworkoutatall;remember,thereisnoholygrailintechnicalanalysis.Thesedivergencesserveasexcellentpointstotightenstopsandtakesomeprofitsoffthetable.Divergencesshouldnotbeusedasbuyor sell signalsbut, instead, as a “get ready” signal—butyoumustholdyourshottillyouseethetarget.Remember,momentummeasurestrendacceleration,i.e.anygainorlossofspeed.

ClassABearishDivergence:Pricesreachanewpeakwhileanindicatorreachesalowerbottom.Thisisthestrongestsellsignal.

Class A Bullish Divergence:Prices fall to a new lowwhile an indicator is correctedabovetheearlierlow.Thisisthestrongestbuysignal.

ClassBBearishDivergence:Pricestraceadoubletopwhileanindicatorreachesonlyalowerpeak.Thisisthesecondstrongestsellsignal.

Class B Bullish Divergence:Prices trace a double bottomwhile an indicator traces ahigherbottom.Thisisthesecondstrongestbuysignal.

ClassCBearingDivergence:Pricesreachanewpeakwhileanindicatortracesadoubletop.Thisistheweakestbearishdivergence.

ClassCBullishDivergence:Pricesfalltoanewlowwhileanindicatormakesadoublebottom.Thisistheweakestbullishdivergence.

ClassAdivergencesoftenidentifygoodtrades.ClassBandCdivergencesleadtowhipsaws,andarebestignored.

TripleBullishorBearishDivergences

Theseconsistofthreepricetopsandthreeoscillatortops,orthreepricebottomsand three oscillator bottoms. They are even stronger than the regulardivergences.Butagain,donotbuybasedondivergencealone.

RelativeStrengthIndicatorn(RSI)

TherearesomemythsaboutRSIwhichIwouldfirstliketodispel.Myth:BullishandBearishDivergencesGivetheStrongestBuySignals:DivergencesbetweenRSIandpricesdonotgivethestrongestbuyandsellsignalsalthoughthesetendtooccur at major tops and bottoms. They show up when the trend is weak andreadytoreverse.Whilethisistheoreticallytrue,inactualfactitisverydifficulttotradedivergences.Thereasonforthisisthatthemarketcontinuestomoveuplongafterthebearishdivergenceisvisibleonthecharts.So,too,isthecasewitha bullish divergence. What these divergences help in is providing a warningsignal that the trendisweakening.Accordingly,atsuchtimesstopsneedtobetightenedandprofitsprotected.Myth:OverboughtandOversoldLevelsCanbeUsed toBuyandSell:Overboughtandoversoldlevels cannot be used to buy and sell under all circumstances. In trendingmarkets,RSItendstobecomeoverboughtandoversoldforlongperiodsoftime.Using itmake buy and sell decisions can be disastrous in suchmarkets.Evenwhen tradingrange-boundmarkets,RSIcanbeprone towhipsawsand tradingvolumesshouldbereducedwhileusingitinsuchmarkets.Theselevelsshouldbeusedfortherange-boundmarketandforre-testingtrades.

Nevertheless, RSI remains one of themost popular indicators in technicalanalysisandcanbeusedinavarietyofusefulwaysasdescribedbelow.

ChartingPatterns

Chart patterns like head and shoulders breakouts, trendline breakouts, supportand resistances work well with RSI which often completes these patterns inadvanceofprices,thusprovidinghintsoflikelytrendchanges.

ZoneShift

SinceRSI indicator is based on closing prices of a security or an indicator, it

tendstotravelbetweenthebullishandthebearishzones.Itcanbeusedtoassessthetrendofthemarketasthiszoneshifttakesplace.NoticehowtheRSIholdsthe50levelinthemainuptrendandatthesametimefindsresistanceatthe50levelduringtheintermediatedowntrend(Figure3.13).

Figure3.13

RSIisalsousedasacontraindicator.Thismeansthatoncetheweeklytrendis identified,whether up or down, the dailyRSI is used to enter trades in thedirectionoftheweeklytrend.Whentheweeklytrendisup,anoversoldlevelofdaily RSI is used to enter long trades. When the weekly trend is down, anoverboughtlevelofdailyRSIisusedtoentershorttrades.Profitscanbetakenwhen the daily RSI moves to the other extreme, i.e. when RSI moves fromoversoldtooverbought—oroverboughttooversold.Thistechniqueisusedinconjunction with either the Fibonacci levels, stochastics, and/or the 20-periodmovingaverage.Perfect levelsofentryare impossible topredictbutgenerallyan oversold or overbought region can be identified.Actual trading signals aretakenwhenasignificantpivotisbroken.Iliketousethe7-dayRSIasshowninFigure3.14,whichdoesagoodjobofidentifyingdecententrypoints.

Figure3.14

StochasticsStochastics is the other popular oscillator which can either be used orindependently in conjunction with RSI. It consists of two lines, the%K (fastline)andthe%D(slowline).Theslow%Dlineisasmoothedversionofthefastline.Mypreferredsettingfor%Kis7andthatfor%Dis10.%Kcrossesover%Dwhenabuysignalisgivenand%Dcrossesover%Kwhenasellsignalisgiven.

Therearetwovarietiesofstochastics,thefastandtheslowversion.Thefastversion isaverysensitiveoscillatorandhas the tendencyofgivingwhipsaws.Sometradersprefertousetheslowstochasticwhichisconstructedbyusing%Dofthefaststochasticas%Koftheslowstochastic.Thisisthensmoothedoveragivenperiod to find the%Dof theslowstochastic.ThisoscillatorcanalsobeusedasacontraindicatorsimilartotheRSI.Stochasticshasthetendencytostayoverboughtandoversoldinhighlytrendingmarkets(Figure3.15).

Figure3.15

FibonacciMethods

Oneoftheenduringgoalsoftradersistofindameaninginthemazethatisthestockmarket. They have used astrology, rocket science, fundamental analysis,andtechnicalanalysis,etc.totryandachievethisgoal.Fibonaccimethodsisonesuch attempt at unravelling the mysteries of the stock market by relating itsmovementstotheFibonacciSeries.FibonacciSerieswasdiscoveredlongbeforetherewere stockmarkets and but, amazingly, it works verywell in the stockmarketsasitdoeswithmanyothernaturalphenomena.

Leonardo Fibonacci is credited with the creation of Fibonacci Series. Theserieshasitsfirst twonumberas0and1.Theothernumbersarearrivedatbyaddingtheprevioustwonumbers.Forexample:0+1=11+1=21+2=32+3=53+5=85+8=138+13=2113+21=3421+34=5534+55=89,andsoon.

Thuswearriveataseriesofnumbers0,1,2,3,5,8,13,21,34,55,89....

Nowthesenumbersarerelatedtoeachotherbyaratio.Alotofphenomenainnature, science and astrology is explained by this property of the FibonacciNumbers.Forexample:21+34=.61834+55=.61855+89=.618

Similarly,34+21=1.618,55+34=1.618,89+55=1.618

ThisratioisknownastheGoldenRatioandformsthebasisoftheFibonacciMethodsintechnicalanalysis.

Theothertwofractionsmostcommonlyusedintechnicalanalysis—0.382and0.5—arecalculatedasfollows:(1-0.618)=0.382,and0.5isthemeanof0.382and0.618

FibonacciRetracements

Figure3.16(a) showsFibonacci retracements in anuptrend andFigure3.16(b)showsFibonacciretracementsinadowntrend.

Figure3.16(a):FibonacciRetracementsinanuptrend

Figure3.16(b):FibonacciRetracementsinadowntrend

HerearetherulesforusingtheFibonacciretracementtool:

Identifyaswinghighandaswinglowinthepriceaction;Generally38.2%,50%and61.8%valuesareused;25%and75%canalsobeusedincasetheabovevaluesdonothold.In very strong bull and bearmarkets, prices usually do not retracemorethan 25% to 38.2%. Inmoderately bullish and bearishmarkets, they canretraceupto50%to61.8%.If theprices startbreaking the61.8% to75%retracement, themain trendmaybeunderthreat.Always look for supporting evidence along with Fibonacci retracements,suchas extremevalues in short termRSIor stochastics, or confluenceofFibonaccilevelsacrosstimeframes.Focusonregionsofsupportandresistanceinsteadofactualvalues.

Figures3.17and3.18showexamplesofFibonacciretracementlevelsinanupswingandadownswing,respectively.

Figure3.17:FibonacciRetracementlevelsinanupswing

Figure3.18:FibonacciRetracementlevelsinadownswing

ConfluenceofFibonacciLevelsWith almost five Fibonacci levels to contend with, traders can often be leftwonderingwhichoneofthelevelsismostlikelytohold.Insuchcases:

Confluence of two Fibonacci levels measured from two different swinglows to the same swing high in an upswing is considered the mostsignificantsupportlevel.Ontheotherhand,confluenceoftwoFibonaccilevelsmeasuredfromtwo

different swinghighs to the sameswing low isconsidered tobe themostsignificantresistancelevel.Whenthestockgetsclosetoaconfluencelevel,tradersneedtobeontheirtoesandlookforsupportingevidenceinordertoact.Fibonaccilevelslikeotherindicatorscannotbeacteduponinisolation.

ExamplesofconfluencesofFibonacci levelsare illustrated inFigures3.19and3.20.

Figure3.19

Figure3.20

CandlestickCharting

Originallydevelopedin17thcenturyJapanforricetrading,candlestickchartingconsistsofdepictingprice informationin termsofholloworwhitebodies,andfilled or black bodies, with wicks at both ends. A white body indicates theopeningpriceof thesessionbeingbelowtheclosingprice;andtheblackbodyshows the opening price of the session being above the closing price of thesession.Thewicksatthetopandbottomoftherealbodiesdepictthehighandlowoftheday.

The major difference between the Western technical charts and thecandlestickmethodisthatthecandlesticksgiveaclearviewofmarketbehaviourbothintermsofbuyingandsellingactivityinthemarket,andwhetherthetrendisindecisivenessorclear.Candlestickpatternsoftenprovidethetriggerforabuyor sell decision once the Western technical indicators move to extremeoverbought and oversold conditions. Candlesticks is nowadays a standardformatting option in most technical analysis software. A brief overview ispresented here to give you its flavour. Excellent books on the subject areavailablewhichgointothedetails.*

Thedojioccurswhentheopenandthecloseforthedayarethesame. It depicts indecision and can often mean impendingweaknessinanuptrend.

Therealbodyissmallandattheupperendoftherange;the color is not important. The lower wick should belongerthantheupperbody;generallybullish.

Thehangingmanisconsideredbullishbecauseoftheuptrend.Thecolor isnot important;couldbebearishifthebodyisblackandthenextdayopenslower.

Theshootingstarindicatesanendtotheupmove.Thebody of the shooting star does gap up over thepreviousday.

Inanuptrend,ononedayasmallwhitebodyoccurs.Thenextdaypricesopenatnewhighsandquicklyselloff,closingbelowtheopenofthepreviousday.

In a downtrend, a small black body occurs. Thenextdaypricesopenatnewlowsandthenquicklyrallytocloseabovethecloseofthepreviousday.

Themorning star is a bullish reversal pattern. Idealmorning stars havegapsbefore and after themiddleday'sbody.

Evening star is a bearish reversal pattern. It occursafteranuptrendandshouldhavegapsbeforeandafterthemiddleday’sbody.

Therealbodyissmallandattheupperendofthe

range; the colour is not important. The lower wickshould be longer than the upper body; generally

bullish.In anuptrend, ononeday a smallwhite bodyoccurs.Thenext dayprices

openatnewhighsandquicklyselloff,closingbelowtheopenof thepreviousday.

Inadowntrend,asmallblackbodyoccurs.Thenextdaypricesopenatnewlowsandthenquicklyrallytocloseabovethecloseofthepreviousday.

* How toMakeMoney Trading with Candlestick Charts by Balkrishna Sadekar, published by VisionBooksisabookyoucouldconsult.

Chapter4

ApplyingTechnicalstoTrading

Ed Sekyota, amillionaire trader, once said at a seminar that if the trend of amarketwasup,hewould takeachartof themarketandhang itonawallandwalktotheothersideoftheroomandthenturnback.Ifthetrendofthemarketstillappearedup,hewouldconsiderthemarket.

Thefoundationofthetradingprocessstartswithdeterminingthemaintrendof themarket. To profitably trade futures or options, or even a stock for thatmatter, it is important that we establish the trend of the underlying security.Usingacricketinganalogy,youngstersarealwaystaughtnevertohitacrossthelineofaball,ornevertohittheballagainstthespin.Totakeaboatagainstthetide ismuchmoredifficult thanrowingdownstream.Thehumanegoseems toget extreme satisfaction from trying to predict future events, particularly so inIndia. Also, people generally like to be thought of as trendsetters rather thantrend followers. It is thiskindofbehaviour that themarket seeks topunish. Ifthereisnothingelseyougainfromthisbookandjustrememberthat“thetrendisyourfriend”,thisbookwouldhavedoneitsjob.

In the Indian bull market of 2003, for example, far too many individualinvestors andexperts actuallymissed thebigupwardmovebecause theyweretoobusypredictingcorrections.

Whenamarkettakesaparticulardirection,youdon’taskquestions—yousimplyenterinthedirectionofthetrendatthefirstopportunity.Youdonottrytofigureoutthereasons,orthegrowthrateofthecompanies,orthehealthoftheIndianeconomy,etc.Thetruthreallyisthatthemarketneedspeoplewhoarefarless sophisticated and smart than thosewho come to it. Themoremechanicalyoumaketheprocessoffindingthetrend,thefewermistakesyouwillmake.

SwingTrading

Swingtradingisthemostconsistentlyprofitablestrategythatyoucanuseinthefuturesmarket. It involves taking positions for about 3-4 trading sessions andcapitalising on short term up and down swings in the market. Swing tradingbanksoncatchingthelargestpartoftheswingbythreemainmethods:

1. Enteringtrendsonreaction;2. Successfulretestsofhighsorlows;and3. Buyingorsellingbreakoutsorbreakdownsfromflagpatterns.

EnteringTrendsonReaction

Themosteffectivefuturesswingtradingstrategyisdeterminingthetrendinthehigher time frame, and then looking for low risk overbought or oversoldconditionswithinthattrend.

For example, if the time frame to be traded is daily, then the trend of theweekly charts needs first to be determined. If the time frame to be traded isintraday,thenthetrendofthedailychartneedstobedetermined,andsoon.

There are several different ways of determining trends. Traders shouldrememberthattheycanonlydetermineatrendifthereisone.Theyshouldnot“force”atrendwherethereisnone.

Obviously,enteringtrendsonreactionisamethodologywhichcanonlybeused in trendingmarkets.Foreaseofexplanation,wewilluse theweeklyanddailytimeframes.Thetechniques,though,areapplicableforalltimeframes.

1. The trendon the larger time frame canbe determinedbyusing either themovingaveragesortheMACD.

2. The strength of the trend should be determined by usingADXas alreadydescribedinChapter2.

3. Now,onthesmallertimeframeentriescanbemadeusing:Ͱ20DMA;ͰRSI;orͰStochastics

4. Also on the smaller time frame traders should draw lines at significantsupportandresistanceareas,sothataroadmapforatradeisdrawn.

5. Usetrailingstoplossesoncethemarketmovesintheappropriatedirection.I generally advise against strict adherence to predetermined target for

moves,asmarketstendtoovershootsuchtargets.Tradersshouldholdontopositionssolongthemarketisactingasanticipated.

WhatisaTrend?A trend is a seriesof risingordecliningpricesoverany lengthof time.Thus,uptrendisamarketwhichseesconsistentlyhigherpricesoveraperiodoftime.A downtrend, on the other hand, is a market, which sees consistently lowerpricesoveraperiodoftime.

Trendscouldbeclassifiedasshortterm,mediumtermandlongterm.Ashorttermtrendcouldlastfor1to2weeks,amediumtermtrendfrom10

to12weeks,andalongtermtrendcouldbeonelasting12to15months.Atrend isassumedtobe inforce till there isevidence that ithasreversed.

Traders should avoid the temptation of assuming trend reversals before theyactuallyhappen.Oncea traderdiscoversabias in themarket,hecan thenuseentry setups to find thosewith the lowest risk for trading futures or applyingoptionstrategies.

TheEdSekyotaincidentcitedatthestartofthischaptershowsthattherearenohiddenformulastofindingthemarkettrend.Inthischapterwewillconsiderthemethodsfordeterminingthemaintrendofthemarketanddeterminewhetherit’satradingoratrendingmarket.Oncewehaveestablishedthemarket’strend,wecanthenlookatentrysetupsinthedirectionofthemaintrend.Lookingforentry setups in the direction of the trend enhances the chances of successfultrades.

MethodsofTrendDeterminationTherearethreemethodsoftrenddeterminationwhichareeasiestandthatIusemost.Therearelotsofothermethodsofdoingsoaswellandthesecanbefoundin books on technical analysis. Since this is a book on derivatives, I amdiscussingonlyalimitednumberofmethodsoftechnicalanalysis.

Thus,threeoftheeasiestmethodsare:

1. Visualinspection.2. Movingaverages.3. MACD.

VisualInspectionofCharts

Avisualinspectionofthemarketchartisusuallyenoughtodetermineitstrend.Inthemarket,asinlife,ifsomethingisvisuallyclear,itisgenerallypure.Asfaras Iamconcerned if it takesmore thanaminute to tell the trendofanystockchart,thenitprobablyisnotworthtradingbecauseit’snotlikelytobeatrendingmarket.

Onedrawbackofthismethodisthatitmightnothelpinidentifyingsmallertrends.Nonetheless,itisveryusefulinfilteringchartsforbeginnerusers.Let’sgo over some examples of visual inspection from the Indian stock market.Skepticsmight call these “well chosenexamples”butmy response iswhynottrade the “well chosen”examples?Whygo looking for trendswhere there arenone?Whenatrendisthere,oneglanceissufficient,asinFigures4.1and4.2.

Figure4.1

Figure4.2

MovingAverages

Whenlookingatachart,Iwouldliketoknowifit’sinalongtermupordowntrend.Thisisdonebyusingthe200DMAtodevelopabiasonthestockorthemarket.Apricechartoverits200DMAisinanuptrend,andwhenbelowits200DMAitisinadowntrend(Figure4.3).

Figure4.3MACD

Ontheweeklychart:

LookforastrongupordowntrendbasedontheADX.Onthedailychart:

WhenthefastMACDlinecrossesovertheslowsignalline,itgivesabuysignal.Golongandplaceaprotectivestopbelowthelatestminorlow.When the fast line crosses below the slow line, it gives a sell signal.Goshortandplaceastopabovethelatestminorhigh.Intheabsenceofastrongweeklytrend,thissametechniquewillgivemanywhipsawstotraders.ThedefaultspecificationsfortheMACDare12,26,9althoughIprefertouse3,10,16.AsexplainedinChapter3,theMACDsignalmaybealittledelayed.Usingthe upward slopingMACD histogram as the market rallies again after acorrection isa leadingsignal.Similarly thedecliningslopeof theMACDhistogramcanindicateresumptionofadowntrendafteranupwardreaction(Figure4.4).

Figure4.4

LowRiskEntriesOncethetrendhasbeendetermined,thenextstepistogetlowriskentriesintothe trend. The best entries are ones which occur after a contra trend reactionsinceenteringafteracorrectionallowsforastrongermoveandreducestheriskofcorrection.Thereareseveraltechniquestoaccomplishthis:

Useofa20DMAinthecaseofadailychart;Useofa7dayRSI;Useofstochastics(7,10).

Useof20DMA

The 20 DMA is the most effective tool for entering the weekly trend oncorrection in the daily chart. Once the price corrects below the 20DMA andmoves back over it, the correction is deemed to be over and the market isexpectedtoresumeitsuptrendagain.Thusasthemarketmovesbackoverthe20DMA,traderscangolong.Iftheweeklytrendisdown,apricemoveoverthe20DMAsignifiesapullbackrallyinadowntrend(Figure4.5).Thisdowntrendisresumed as prices again move below the 20 DMA. The 20-period movingaveragecanbeusedasaveryeffectivetoolinalltimeframes.

Figure4.5Useof7DayRSI

ThedailyRSI(7)identifiesentrypointsasitmovesbelowthe40levelandthenturns back upwards. These points are marked with the dotted arrows on thechart.TradersneedtonotethatthereareothertimesaswellwhentheRSIgoesbelow40buttheweeklytrendisnotupinthosecases.

AsimilarprocedurecanbeusedindowntrendswhereanRSIlevelof60canbe chosen as the benchmark. In this case a downtrend can be taken to haveresumedastheRSIdeclinesaftergoingoverthe60level(Figure4.6).

Figure4.6UseofStochastics(7,10)

Thedailystochastics (7,10)canalso identify lowriskentries intoa trend.Thestochasticsgoingbelowthe20levelduringaweeklyuptrend,andthenturningupward,signifiestheresumptionofthedailyuptrend.Similarly,thestochasticsgoing above the 80 level and then turning down during a weekly downtrendsignifiesresumptionofthedailydowntrend(Figure4.7).

Figure4.7UsingAllThreeTechniquesTogether

Using the RSI, stochastics and the 20 DMA together as a confluence ofindicators, entries can be timed nearly to perfection. When all these threeindicatorsare inagreement, traderscan take thatasaconfirmedsignal (Figure4.8).

Figure4.8

SuccessfulRetest

It ishumannaturetorespectthingsthatarecomplicated.Aschildren,weweretaughtthatmakingmoneyisdifficult—“nopain,nogain”,etc.Iwouldliketosaythatinmytenyearsoftrading,theeasiestaspecthasbeenlookingforentrysetups.Themoredifficultpartismanagementofatrade,andaprofitableexit.Atthis point I would categorically state that simplemethods work best. Anyonewhobelievesthatchartingortradingcanbeprofitablebymakingitcomplicatedisdestinedforfailure.Beginnertradersoftenmakethemistakeoftryingtolookfor the magical key that will open the door to tremendous riches, and keepbuyingallkindsofhypedandexpensivesoftwareandbooks.

Letusnowturntoavisualtechniquewhichcanbeusedfordetermininganentry setup for both cash andderivativesmarket. It has been around since thetime stock markets were invented but is often forgotten because it is notcomplicated enough to be respected. Any market which makes a higher topduringthecourseofarally,pullsback,andisthenunabletocrosstheprevioustopissaidtohavesuccessfullyretestedtheprevioustop.Conversely,anymarketin a downtrendwhichmakes a new low, pulls back up, and then is unable to

piercethepreviouslowissaidtohavesuccessfullyretestedthebottom.Thesedaysastechnicalanalysisbecomesmorepopular,pricesmomentarily

gopastprevioussignificanthighsorlows,andthenthereisasharpdeclineorarally, respectively, after getting the retail investors to go long or short on themarket. In fact, up to 70% of the time these highs or lows are tested and themarket comesbackwithoutbeingable topierce them.So,generally speaking,wheneverasignificanthighorlowisgettingtested,it’susefultotakealongorashort position with a small stop loss and this often turns out to be a highpercentagetrade.Incasethemarketsuccessfullytakesthehighout,theoppositepositioncanbetakenoncethepreviousstopishit.Tradersshouldpracticethesetradesbecausetheseareveryeffectivetradesinarange-boundmarket,whichiswhatthemarketismostofthetime.

The failure to pierce previous extreme levels is a signal that the trend isreversing.Evenifthetrendisnotreversing,theseconditionsprovidepotentiallypowerfulmovesaslotsofparticipantsneedtoreversepositions.Thesepatternshaveahigherthan90%probabilityofsuccess.Incalculatingthispercentage,Iamincludingallthethreefollowingscenarios:

1. Thepricemakesahigherbottom,oralowertop,afteradeclineorarally,respectively.

2. The price touches the exact same bottom, or top, and then rallies ordeclines,respectively.

3. The price momentarily pierces previous top or bottom, only to reversecourseagain.

Thethirdsituationgivesthemostpowerfulmoves.Butjustahigherbottomoralowertopbyitselfwouldbeaprematuresignalfortakingpositionsintheoppositedirection. Iprefer touse thesesigns to lightenup longs inanuptrendandshortsinadowntrend.Breakingofapreviouspivotintheoppositedirectioncan conclude the confirmation of a reversal. Breaking of a down pivot in anuptrendandupwardpivotindowntrendshouldbetakenasanentrysignalintheoppositedirection.These tradesareveryhighprobability tradesandareworthwaiting for.Oversoldandoverbought levelsof theRSIand stochastics canbeusedtotradetheseranges.Thesuccessfullyretestedbottomortopcouldbeusedasastop.Thissetupcanbeappliedinanytimeframeandyoucancapitaliseonthe big trends by using this technique. This is because all big uptrends ordowntrends generally startwith a successful retest. (See Figures 4.9, 4.10 and

4.11)

Figure4.9

Figure4.10

Figure4.11

BullandBearFlags

Bullandbear flagsarecontinuationpatterns foundmidwayduringa rallyoramarketdecline.Theseare theeasiestand thesurest setups forenteringa trend(Figure4.12).

Figure4.12

Duringamarketrallypricesmoveupacertaindistancewithgoodvolumes,

and the market then stalls a bit for a few days, a phase which is calledconsolidation. This creates a flag-like formation shown in Figure 4.12 and iseasilyrecognisable.Thissetupinvolvesenteringthetradeinthedirectionofthemain trend when the flag pattern is broken. The advantage here is that thedirectionandsizeofthebreakoutisknown.Thesizeofthefirstandthesecondmovesarethesame,sotraderscanhaveaprofitobjectiveofthesizeofthefirstmove.A flag is generally foundmidway during an up or a downmove. Thispatternhasover90%accuracy.

ThewayIuseitinreallifeisthatifIseeastockrisingordeclining,Ikeepfollowingitcloselytillitstallsandformssomekindofaconsolidatorysidewayspattern.Theimportantthingfortraderstokeepinmindisnottogettooinvolvedintheshapeorthesemanticsofthesidewaysconsolidation.Instead,thecriticalaspect is to look for a temporary stalling of the trend and to get inwhen themarketbreaksoutintheoriginaldirection.OnceIfindalowvolumesidewaysconsolidationsubsequenttoarally—oradecline—onadailychart,Iliketofollowthestockontheintradaychart,lookingforatrendlinebreakoutorsomeotherclassicalbreakoutpatterninthedirectionofthetrendwhichthenprovidesmewith a low risk entry. Stops can be placed at the lower end of the flag asshown in the accompanying charts (Figures 4.13 and 4.14). Traders shouldrememberatalltimesthatourjobisnotanalysisbutmakingmoney.

Figure4.13

Figure4.14

SupportandResistanceDiagramsfortheSwingTraderSinceswingtradingislargelydependentontradingsuccessfulretestsoflowandhighs,allswingtradersshouldcarrysupportandresistancechartsofatleasttwotimeframes(seeFigure4.15).

Figure4.15

These charts, which should be updated daily, are helpful in entering high

probabilitytrades.Tradersshouldbealertassignificantresistancesandsupportsarereached,particularlyinarange-boundscenario,totaketheretesttrades.

Somepracticaladvice:whilethesesignalsarequitereliable,marketsdonotmove according to anygiven script.Try to go long at least above an intradaypivoton theupside,or short at leastunder an intradaypivoton thedownside.Sometimesmarketsgiveswhipsawsbeforetakingaparticulardirection.Atothertimes,themarketstartsmovinginanarrowrangebeforerevealingitsdirection.Everytraderhasseenthemarketapparentlyinadowntrendinthemorning,thensuddenlyturncourseandendupwithahealthygain.Thisisoneofthereasonstradersshouldneverhavestrongopinions;because themarketaswellasothertraders do not care about your opinion. If the market goes contrary to youranalysis,changeyouranalysisandyourtrade.Lookata tradingdayasakintofindingyourway througha thick forest.Youneed tomake this journeydaily,andeveryeveningyouneedtopreparemapsaccordingtowhatyouexpect theroutethenextdaymaybe.Butifyourmapdoesnotwork,andyoufindyouareheadingthewrongway,youmustquicklychangeyourcourse.Whenthemarketdoesnotbehaveasyouexpectitto,doasthemarkettellsyoutodo.Keeplossessmalltillyoufigureoutwhatthemarketisdoing,butdonotovertrade.

Istartoutwiththemap.IfIbelievethemarketisinadowntrend,Iwaitforthemarkettomakesomesortofanintradayhigh.Thiscanbeachievedby:

1. Havingallthesupportsandresistancemarkedontheintradaychart,and2. Using the slow stochastic, the fast stochastic and the 20-period moving

averagetotrytosellanintradayhigh.

You sellwhenboth the stochastics reachoverbought and thenyou sell thefirstblackcandlefromthetop.Sometimesthatisnotthetop,soIuseatleastaoneper cent stop tomake sure that I differentiate anynoise fromanupmove.Also,youneed tobewatching the intradaychart all the time if thedaily timeframeisyourcanvas, likeit isformost traders.Forawhile theindexorstockmightbehaveasyouanticipated,butyouneedtochangestanceassoonasyouseethingschanging.

Onewayofkeepingatabistokeepwatchingtheintradayadvancedeclineratio:thisisavailableontheYahooIndiaFinancesection.Generally,itissafetotradeinthedirectionoftheadvancedeclineratio.Ifthenumberofdeclinersaremoreonacertainday,thenyouarefinebeingshort;ifthenumberofadvancersaremore,youaresafebeinglong.Whenthisratiostartschangingfrom5:1andheadstowards1:1,themarketischangingdirection.Also,learntodifferentiatebetween intraday bounces and genuine upmoves.One rule of doing so is that

afteranintradaybounce,themarketshouldcomedownwithvelocity.If,ontheother hand, themarket starts consolidating at higher levels, youneed tomoveout of shorts. If breadth also stalls at that point, then something is certainlychanging.Soyouneedtokeeplookingforevidencetomakesurethatyouareinsync with the market. Will you always be successful? No. If you are notsuccessful,keepastopinplaceandre-evaluateifyouarewrong.Youneedtobeonyourtoesinanymarket.Expectthepunchcomingfromthelefthookorrighthook.Donotbesurprisedorshockedbyanymarketmove.Actquicklytofallinlinewiththemarket.Donotexpectorhopethemarketwillmoveinsyncwithyou.

Thesame thingholdswhenbuying the intraday low.DoIalwayscatch it?Of course not; some days I have to reversemy positionmidway and take theoppositepositionasIseethemarketmovingcontrarytomyexpectation.Thereare somedayswhen Ihave todo this twice,oreven thrice.Thoseare thebaddayswhenthemarketiswhipsawingmeallovertheplace.AtsuchtimesIquitforthedayandletthemarketfirstdecideonwhereitwantstogo.Youcannotbestubbornwiththemarket.Youneedtodanceinstepwithitsmovements.

Onceyour trademovesat leastonepercent intoprofitby theday’sclose,youshoulddecidetocarryittothenextday.Thereasonforthisisthatovernightgainscanbesubstantialifthemarketopenswithagapinfavourofyourtrade.If,ontheotherhand,thegainshavebeenlessthanonepercentandthemarketdilly-dalliestowardstheclose,it’sagoodideatoclosethetradeandcomebackfresh for the next trading session. If you are long at close of trade, youmustwatch for excellentmarket breadth (at least 2:1 in favour of advances) and aclosing rate near the high. If you are short, the market should close weak,preferablynearthelowofthedayandwithpoormarketbreadth(atleast2:1infavour of declines). The trade should be carried so long as the market keepsactingright.

Fora long trade,keepwatching thebreadthof themarket after themarkethasmovedinyourdirection;ifitstartstodeterioraterapidly,bookpartialprofit,then wait to see the breadth of the market as it bounces. If it seems just anintradaycorrection, rebuildpositionabove intradayhigh. If themarket fails totakeouttheintradayhigh,booktherestoftheprofit.Ifthereisasuddenselloff,wait for a bounce and look at the strength of the bounce; if the bounce looksweakandsodoesthebreadth,bookallyourprofits.Asaruleofthumb,ifyouare unsure about what is happening, book your profits entirely and stay out.Profitsearnedonceshouldnotbeallowedtoerode.Waitforthemarkettoshow

itshand.Moreopportunities tobuyorsellwillalwayscomeagain.RememberthetwoDalalStreetadages:

Inbullmarkets,buyallcorrections.Sameisthecasewithshortpositions.Donotshortadullmarket.

Remember these two. In later chapters, we will discuss the concept oftrailingstop.

Chapter5

DayTradingRulesandSetups

I often think of day trading as being similar to a military operation, wherepulling the trigger is probably the easiest part.Day trading is about disciplineand training of the mind. It is about waiting in the trenches till the rightopportunity(setup)appears.It isaboutquantifyingtheriskineverytrade.It isknowing when to hit and when to run. Yes, it’s about guerrilla warfare. It’sabout recognising temporary de-mand-supply mismatches and capitalising onthem. It’s not about standing in the way of large trends and letting theinstitutionsmaul you. It’s like the Vietcong fighting the US army, where theVietsgotthebetteroftheAmericansbyusingguerrillatactics.Collectively,theAmericanscouldmaulthembutinguerrillawarfaretheAmericansgotabloodynose.Aguerrillaisjustthat,andheshouldneverthinkofhimselfasageneral.Similarly, the day trader should always remember that he is in the trade for aday,maximumtwo.Heshouldnottrytobeapositiontrader.Ifatradertriestoweartoomanyhatsatthesametime,hewillendupfailingateverything.Justasallwarsarefirstwonontheplanningtable,itiscriticalthatadaytraderhaveaplanbeforestartingtotrade.Atradingplanisessentialforsuccess.Itisutterlyimpossible to succeed at trading without a concrete plan. The following aresuggestions, some general, others specific, that I believewill help day tradersachievetheirgoals.

DoYourHomework

Thestudyof specific stocksorderivativesand their relationship to theoverallmarket isanabsoluteessential. It issuggestedthat thetraderworkat leastonehouroutsideofmarkethoursonfamiliarisinghimselfwithstocksthatcouldbetradedthenextday.Asthisbookisfocusedonderivatives,thenumberoffuturesandoptions tobescannedbecomes limited.For Indianderivatives, thiscanbe

doneontheInternetonthefollowingsites:www.moneycontrol.comwww.capitalmarket.comwww.equitymaster.comhttp://in.biz.yahoo.com/commentary/www.sify.comwww.walletwatch.comwww.nseindia.com

And,manymore.Daytradersinparticularandtradersingeneralshouldrememberthattrading

isaglobalprofessionandtheyshouldthusbereceptivetoideasfromtradersofother countries. Also, traders should study global currency and commoditycharts, not only because it will enhance their knowledge of charting but alsobecause these derivatives are also likely to be launched in India in the future.GoldandsilverfuturesarealreadyavailablefortradingwithmostIndianstockbrokers.

With experience, a trader will have greater understanding of the widelytraded stocks and will be able to better judge information for potentialopportunities.Inaddition,atradershouldspendsometimeeverydayinhoninghis craft; studying trading techniques, refining trading ideas, etc. Weekendsrequireatleasttwotothreehoursofstudylookingforsetupsforthefollowingweek.Atradershouldbepreparedtospendaminimumoftwelvehoursaweekoutsidemarkethourson suchplanningand study.A seriousday trader shouldacquireagoodchartingsoftwareandtrytogetholdofasmanytradingbooksasareavailable.Youneedtounderstandthatsuccessfultradingisapassionandtherewardsareenormous.Also,itiscriticaltotakeyourmindofftradingwithsomeotheractivityaswell.I,forone,playtenniseverymorningtokeepmyselffreshforthedayahead.

SticktoaSchedule

Astandardscheduleisessential.Atradershouldarriveathistradingcentrehalf-an-hourormorebeforethemarketopensandplanonbeingthereallday.Beforethe market opens, the trader should have a list of potential trading stocks orderivativesbasedonhishomeworkofthepreviousevening.

Heshouldreviewhowthesestocksandderivativesbehavedthedaybefore,anddrawconclusionsastowhetherornothewillfollowthemwhenthemarketopens.Thetradershouldhavehisattentiononthemarket,andonnothingelse;he should also be rested and ready to attack the market. If there is some

distraction that threatens to take his attention off themarket, he should ceasetrading until the situation is addressed and until he can trade again with fullconcentration.Ifyougetupinthemorning,fightwithyourwife,andthenyourneighbour over parking space, your chances of winning at trading are greatlyreduced.

LearnHowtoManageYourLosses

Not being able tomanage your losses, or letting them run, is the number onereason why traders lose money. Losses are inevitable. Nobody makes moneyeveryday.Thekey towinningoverall is to limitone’s lossesand tobeable tooffset themwithprofitable trades.Allbig lossesstartbybeingasmall loss. Ifthemarket isnotactingaccordingtoyourexpectation, justgetout.Alsomakesureyoudon’tovertrade,andbeextremelycarefulonentries. It’smucheasiergetting intoa trade thangettingoutofone.The tradershouldnever takemorethanasetlimitofpoints.Itismypersonalexperiencethatit’sextremelydifficulttosetanumberlimitonpoints,suchasone-halfapoint,etc.Aneasierwaytotackle the problem is in terms of limiting the rupee value loss on a trade, forexample, '10,000.The per trade figure you set should be nomore than 2%ofyourtotaltradingcapital,youcanthenfigureouthowmanysharesthatmeans.Thus,ifyouaretrading1,000sharesofanystockorfutures,thenyourstoplosscannot bemore than '10. You should also be aware of the range amarket istradinginduringthedayinordertomakeanassessmentofthestoplossintermsofpoints.Inadaytradingscenario,andunlessthereissomeunexpectednews,eight timesoutof ten themarket formsa range in the firstcoupleofhoursbyestablishingahighandlow,andthentowardstheendof thedaybreaksoutordownfromthatrangeandestablishesadirection.

Another strategy is to look for amove in one direction and then look forsome intraday consolidation or continuation patterns to be able to tradebreakoutsorbreakdowns.Asagooddaytrader,youshouldhaveaviewonthetrendandtrytotradeinthedirectionofthattrend.Traderscanmakeexceptionsinspecialcircumstanceswherethereisnodailytrend,namelywhenthemarketis choppy or you are able to short at the top or bottom of the range and anintradaycountertrendmove;thesearelowpercentagetrades.

MoneyManagement

AnotherthingmostIndiantraderstendtooverlookistheproperuseofleverage.Most unsuccessful traders feel that if they have enough money to pay themargin, they are ready to play.Or, thatwhatever capital they have should beused in taking themaximumpossible position.Both these are very dangerousmethodsoftrading.

Basedonhistradingcapital,atraderneedstocarefullyworkouttheamountofleveragehewillemploysothatevenastringoflossesdonotputhimoutofbusiness. Drawdowns are a part of every trader’s life. A streak of losses caneasilyreduceyourequityby15-20%.Atradershouldtradeonlyagivennumberof contracts against his entire capital based on whether he employs aconservativeoranaggressiveapproachtotrading.

Forexample,atthetimeofwritingoneNiftyfuturescontractat1500NiftylevelwasworthͲ 3 lakh.Accordingly, a conservative investor should have aminimumof66%ofthetotalcontractvalueashisaccountequity,i.e.Ͳ2lakh.SoifsuchatraderhasanaccountequityofͲ30lakh,heshouldbetradingnomorethan15Niftycontractsatanytime.Bytakingthisapproachatraderwouldbeabletoabsorba15-20%drawdownandstillrecover.Hewillneverbethrownoutofthegame.Amoreaggressivetradermighthave33%ofthetotalcontractvalueashisaccountequity.Thus,forasimilarNiftycontractworthͲ3lakh,heshouldhaveatleast'1lakhashisaccountequity.Thistraderwouldbeingreatertroubleifhehasa15-20%drawdown.

One’s position size should be increased only when one’s trading capitaldoubles.MoneymanagementwillbediscussedingreaterdetaillaterinChapter12whichisexclusivelydedicatedtothesubject.Leverageproducessomeveryexcitingreturnsbutcaneasilywipeoutatraderifusedexcessively.

MaximumSharesperTrade

Traders with little experience get wiped out in short order by trading largenumbersofshares.Untilthetraderisconsistentlymakingmoney,i.e.tentradingdays ina rowwithno losingdays, thenumberof shares shouldbe limited. Inchoppysidewaysmarkets,youshouldalsoreduceyourvolume.Remember,bullmarketsshouldnotbeconfusedwithbrilliance.Conversely,choppymarketswillnotallowyoutobebrilliant.Whenthemarketsareslow,reduceyourexposuresize.

NumberofTradesperDay

Trading too much in a day is the third reason why traders consistently losemoney.Thereisabsolutelynoreasontotrademorethanfivetradesperday.Themaximum number of trades should be limited to five per day. And even fivetradesarejustifiedonlyifatraderistradingmorethanonestockatatime.Iliketo look at a successful day when I make one entry and one exit or position.Successfultradingisaboutmakingentriesextremelycarefulandthenaperiodofinactivitywhilethemarketdoeswhatyouwantitto,followedbyanexitwhenyouhavemadeprofits several times the risk.Overtrading is the singlebiggestpitfallatraderhastocombateveryday.Andovertradinghappensbecausetradershave no plans. The intraday gyrations of a market need to be viewed in thecontextof a larger time frame,only thencana traderdevelopadirectionbiasandtakeahighprobabilitytrade.So,haveyourplanreadyeverydaybeforethemarketopens.

AvoidTradingDuringtheSlowPeriodoftheDay

Trades are consistentlymore successful before 11.00 a.m. and after 2.00 p.m.Thisisbecausebefore11.00a.m.youtendtocatchthehighsorthelowsoftheday and after 2.00 p.m. you catch the breakout or breakdowns. Trades areconsistentlylesssuccessfulbetween11.00a.m.and2.00p.m.Thereisonlyoneexception;ifaparticularstockisinplay(beingtradedheavilyduetosomefactorsuchasabignewsannouncement),thisrulecanbebrokenwithrelativesafety.

Buttryingtofindatradebetween11.00a.m.and2.00p.m.isalmostalwaysabadmoveandshouldbeavoided.Itissafertomissafewopportunitiesthantoconsistentlylosemoneywhenthemarketisslow.Personallyspeaking,Iliketoobservethemarketactioninthefirstcoupleofhoursbeforetakinganypositions.Technicalanalysisisahypothesis,themarkettellsyouwhereitactuallygoing.

WaitFortheBestEntrySetups

It is worth waiting for the best entry setups to initiate trades, particularly infutures.Alotofheartburnandlossescanbeavoidedifdaytraderswaitfortherightsetupsbeforeenteringtrades.Alotofsetupsarediscussedinthischapter.Itisalsoimportanttokeepaviewoftheoverallmarketandtakeatradeinthedirection of the larger trend. Themarket often gyrates up and down before it

breaksoutinthedesireddirection.Sobettertheentry,thehighertheprobabilityof a winning trade. A day trader should desist from what I call compulsivegambling. Compulsive gambling iswhen a day trader comes to tradewithoutpreparation,andenters tradeswithoutanyregard tosetups.All tradersneed tofind the bias of the market in order to increase their probability of winningtrades. Day traders should remember that each trade contributes to, or takesaway,fromtheiroverallbottomline.Thisisabusinessthattheyarerunninganditshouldnotbemistakenasanadventureorathrill.

When you tradewithout knowledge or preparation, the stockmarket turnsinto a casino. I cannot stress enough that the day trader needs to developenormous amounts of self control before he can win in the market. A verysimple technique of reducing risk in day trading, and even in a swing tradingsituation, is to buy oversold and sell overbought. Sounds simple, doesn’t it?Well,hereishowyoucanaccomplishit.IusetheYahooIndia’sintradaychartsto identify a low risk buy or sell by putting on the slow as well as the faststochasticindicators.

ConsidertheintradaychartinFigure5.1whichwastakenfromYahooIndiaFinance site (link: http://in.finance.yahoo.com/). On this chart put the slowstochasticsandfaststochasticsindicatorsandalsoa20-periodmovingaverage.These two indicators show the relativeoverboughtpositionof themarketoverthe 80 level and oversold positions of the market under that level. The chartfurtherhasa20-periodmovingaverageonit.Now,let’sconsidertwoscenarios:

Figure5.1

1. Themarketisinastrongdailyup(down)trend.Insuchacase,daytraders

should try to buywhen both slow and fast stochastics on the daily chartreachtheoversold(overbought)levelsbelow(above)20(80),andthepricechartrises(falls)above(below)the20minutemovingaverage.

2. Whenthereisnoapparentdailytrend.Inthiscase,daytradersshouldmakesure that theymake trades when only both the indicators are in extremeterritories.

This increase the chances of a successful trade since a trendless marketusually tends to swing from overbought to oversold levels during the day.Overall,as themarginoferror isverysmall inday trading,day tradersshouldtradeonlywhenthemarketsareoverstretchedineitherdirection,whichcanbeascertainedbyindicatorssuchasstochastics.

UseStopsandTargets

Itiscriticalfordaytraderstousestopsandtargetsas,indeed,itisforalltraders.Butitisallthemoreimportantfordaytraderssincemosttimestheysquareuptheirpositionsbytheendoftheday.Daytradersshouldhaveaclearplanbeforetheycometothetradingcentre.Theyshouldalsobookprofitsonaregularbasisso as not to lose profits on the table; they need these profits to cover theinevitablelosses.Itisverycriticalthatthedaytradershouldhavearisk/rewardratio of at least 1:2. Also, day traders should be alert and open to reversingposition if the patterns are not working out because failed patterns lead toextremely strongmoves in the opposite direction.As a rule of thumb, I keepstopsatthepreviouspivotinthedirectionoppositetothetrendthatIamtryingtotradeinalltimeframes.

Timestopsisanothereffectivetechniquewhichworkswellfordaytraders;for example, they can keep a stop loss of three hours, and at the end of threehours into the trade they can squareup,whether theyhavemade aprofit or aloss. There are other traders, however,who prefer stop losses based on rupeevalueorpercentages.

LimittheNumberofPositionsatOneTime

A trader should try and limit himself to one open position at a time. Two

positions are acceptable, but three are not. A trader should understand thebenefitsofanarrowfocus.Eachtraderneedstofindhisownniche.Ifatraderisgoodattradingtechnologystocks,heshouldkeepdoingthat.IfsomeoneisgoodatNiftyfuturesandindexoptions,asIbelieveIam,thereisnoreasontomovetostockfuturesoroptions.Adaytradershouldrememberthatattheendofthedaythecolourofthemoneyisthesame,nomatterwhichstocks,orhowmanystocks, you are trading. I agree with the school of thought that after a pointdiversificationisahedgeforignorance.

Whiletheaboveisgenerallytrue,obviouslyitwon’tapplyifyouaredoingbasket trades — but most people don’t trade a basket of stocks. Holding apositionovernightisdoneonlyifthemarketclosesstrongandthetraderexpectssome follow through action the following day. The maximum number ofpositionsneedstobeseeninthelightoftheworstpossiblesituationbecausetheworstcan,anddoes,occur.Theworst,ofcourse,isthatallpositionsstartlosing.At that point a trader should not lose more than a certain percentage of histradingequity.Youalwaysneedtolivetobeabletofightanotherday.

All rules can be safely broken under certain circumstances. But in myexperience breaking more than one rule is a grave mistake, and reduces thepossibilityofsuccesstolessthan25%.Itshouldnotbedone.

EachTraderShouldHaveHisownTradingRegimen

Everybatsmanincrickethashisownstyle—SachinTendulkarcannotbatlikeRahul Dravid, and Dravid should not try to be a Tendulkar. Similarly, everytraderhasa regimen,a styleor setof rules thathe follows inchoosing trades.Forexample,mostdaytradersusetechnicalanalysisasapartoftheirpersonalregimentoformconclusions.

Atradermusthaveapersonalregimen,aspecificsetofrulesorguidelinesthathefollows.Atrader’spersonalregimenwouldincludethespecificsofwhatindicators he uses and why. The regimen should be constantly refined andpolishedowingtothefactthatthemarketchangesallthetime,andwhatworkedsix months ago may not work now. Traders in Indian markets should avoidstocks with questionable fundamentals which show high volume as these canattract manipulation and are sooner or later confined by the exchange to thetrade-to-trade category where each transaction must result in delivery. Oftenthese stocks then loseall their liquidityanddropsharply inpriceaswell.Thechances of this happening in the derivatives market is lower as derivates are

allowedonlyinlargecapandwidelyheldstocks.Your tradingguidelinesmustbe inwriting.Theseguidelinesmustbeyour

own.Youmust not rely on another trader’s recommendation as a buy signal,some “hot tip”, or a computer program, or anything else to make your finaldecisions.Personally,Ithinkthebestwaytolosemoneyinthemarketistositata broker’s terminal. In India, often day traders are bunched up in a broker’soffice,sometimesasmanyasfivetosixtraderstoeveryterminal.Therearelotsofrecommendationsflyingaround.Theremaywellbesuccessfultradersamongthem—buthowdoyoutell?

Also, the software available at a broker’s office may not always be goodenoughfordecentintradaytechnicalanalysis.And,ofcourse,youropinionsarelikelytogetcolouredbyallkindsofrumours.

Iconsidertradingtobealoner’sjobandatradershouldtrustonlyhisownanalysis.Tradingisnotaboutreachingaconsensus.Atradermustmakehisfinaldecisions himself, and he can’t do so without a personal regimen. Lack of apersonalregimenmeansatraderisopentothevagariesofwhoeverorwhateverismakingthedecisionsaroundhim.Thetraderhimselfmustmakethecall,notsomethingor someoneelse.Apersonal trading regimenhelps the trader refinehis skillsand learnwhatworks forhimandwhatdoesnot.Hecanchangehisregimenatanytime,ofcourse,buthemusthavesomethingtochange.

ImportanceofIntradayChartsforaPositionTrader

Alotofpositiontraders,peoplewhokeeptheirpositionsfromafewdaystoacouplemonths,may be tempted to ignore this chapter. But I have found thatintradaychartsarecriticaltoapositiontraderformakinglowriskentriesclosetoone’s stop losspivot. If amarket is inanuptrendand theposition trader iswaiting for a retracement in order to enter a position, it is often difficult todecide whether the market has reversed or is in a relief rally. At that pointintradaycharts,andreversalpatternstheyexhibit,canbeextremelyusefultothepositiontrader.Whentradingahighertimeframe,it’susefultokeeptabsonallthelowertimeframespossible.Anexampleofthisisgivenlaterinthischapterinthe1-2-3continuationsetup.

TheDayTrader’sGuidetoPriceandVolume

There is a close connection between price and volume and it is important for

everydaytradertounderstandatleastthebasicsofthisrelationship.Generallyspeaking,increasingvolumeindicatesthecontinuationofatrendanddecreasingvolumeindicatestheendofatrend,orareversal.Youneedtobefamiliarwiththiswhenyouaredaytrading.

Let’shavealookatsomescenariosfromdaytradingperspective:

1.APriceAdvancewithSteadilyIncreasingVolume

Agoodwayofimplementingthisstrategyistolookformarket’svolumeleadersaround 11 a.m. These volume leaders can be seen on both theNSE andBSEterminals and on the Yahoo India Finance site, which I have found containshighlyusefulinformationintermsofprice,volumeandcharting.Onceyouhaveidentifiedtheheavyvolumestocks,whether thosemovinghigheror lower, it’softenprofitabletotaketradesinthedirectionofthemarketinsuchstocks.Thisshouldhoweverbedoneonlywiththatparticularday’sperspective.

Oftenabasketofthreeorfoursharescanbeboughtwhichhavetheheaviestvolumes and aremoving in the direction of themarket.While this is notmypreferredstyleoftrading,buttherearepeoplemakingalivingoutofit.

In general, higher prices need to be supported by higher volumes. Highervolume is the fuel which sustains an upmove and which indicates continuingupwardmomentum.Asthepricerises,moreandmorebuyersgetattracteduntilthepricereachesastageofeuphoria thatusually indicates theendof thepriceadvance.

2.ASlowingPaceofBuyingwithDecreasingVolume

RememberinganOldDalalStreets adagemightbe inorderhere:Don’tbuyaquietmarketatthetop,anddon’tsellaquietmarketatthebottom.

Aquietmarket at the top indicates that the top is near, and that buying isdryingup.Ithastwopossibleoutcomes:

Sellersrealisethatthetopmightbenearandstartselling,causingthepricetoreverselower.The stock starts consolidating and gets supported by strong bids, whichindicatesthatanup-moveislikelylater.

In such a case, traderswhoare long shouldbookprofits andwait for newpatternsandre-enterlaterincasethetrendcontinues.

3.HigherVolumeDuringPriceAdvanceswithLowerVolumesonPullbackThis indicates a continuinguptrend.A lowervolumeduring thepullback indicates that therearenotenoughsellers in themarket todrivethestockdown,althoughlowvolumeisseenasevidenceofacountertrendmove.Daytraderscanusea 5-period RSI under 40 to identify oversold areas in an uptrend, and overbought areas over 60 in adowntrend,andaccordinglyenteralowrisktrade.

4.BigBuyingVolumeWithoutthePriceGoingHigher

This indicates distribution which, in turn, means resistance. A big seller maywellbe in themarket.There isnoway to tell at thispointwhether thebuyerswouldwinthisbattleanddrivethepricehigher,orwhethertheywouldgiveupandthestockwilleventuallyreverse.Insuchcases,tradersshouldwaitfornewpatternsbeforeinitiatingfurthertrades.

5. A Slow and SteadyMovement Upward with Consistent Volume This indicates a continuing upwardmomentum.Theremightbeabuyerinthemarketwhoissteadilybuyingsharesandtryingtonotattracttoomuchattentionwhiledoingso.

6.AnExtremeAccelerationintheAdvancingPriceWhichisNotSustainedThisindicatestheendoftheeuphoric stage of the upward move. This is a very common scenario. When everyone is getting intosomething, I like to avoid it altogether andpreferwaiting for themarket to changedirection. Insteadofstampedingonthewayin,it’softenmorebeneficialtowaitforthemarkettoreverseandenterontheshortside,orviceversa,whenthepanicoreuphoriadiesdown.Forme,thosestagesofeuphoriaandpanicareveryimportantexitsignals.Theycanalsopresentveryinterestingentrypoints,especiallyafterastockhashadapanicselloff.

DayTradingSetups

1-2-3ContinuationPatternCriteria

1. Widerangebarbreakingoutofsupport.2. Narrowrangebarnearoratthehighsofthepreviouswiderangebar.Often

thisnarrowrangebarisalsoaninsiderangebar.

Entry

Switchtoasmallertimeframeandtakeabreakoutfromthebaseoruseabovethehighsofthenarrowrangebarofbar2.Stop

Under the lowsof thebaseor lastmajorpivot lowon the smaller time frame,underthelowsofthenarrowrangebar,orunderthelowsofthethirdbaratthe

timeofthesetup.TargetBar1=Bar3

Now that you see the setup on the daily chart (Figure 5.2), get ready tocapitaliseon the lower time frame.Let’snowconsider the30-minutechart, asthesetupappears(Figure5.3).

Figure5.2

Figure5.3

WhenIwasabouttoentertheabovetrade,mybrokertoldmethattherewasa lot of uncertainty; therewas a futures andoptions expiry thenext day, stateelectionresultsweredueinthesameweek,andtheFIIswereexpectedtobookprofitsbecauseoftheiryear-endconsiderations.Inotherwords,hetriedhisbesttogivemeall the reasons fornot taking the trade.But thebeautyof technicalanalysisisthatwhenyouseeasetup,andseesupportingevidenceonothertimeframesandindicators,youneedtopullthetrigger.Theabovetradegaveme50points in three trading sessions,which onmy volumes of 3,000 shares of theNiftyisͲ1,50,000—andthatisnotbadforthreedaysofwork.Thekeyherewaswaitingforthebreakoutsincethemarketwaschoppy.Thingscanneverbetotallycertaininthemarket,sothereisnopointwaitingoncethechartssuggest

abuy.

The2BSetupCriteria

Ahighfollowedbyaslightlyhigherhigh.Entry

Whenthehighofthefirsthigh(Point1inFigure5.4)breaksonapullbackfromthesecondhigh(Point2inFigure5.4).

Figure5.4

AlternateEntry

Under the prior bar’s lows after the second high ismade. For instance, if thelowsofthebarmakingthesecondhighisͲ510,entryisunderͲ510.Theonlytimeitisnotunderthebarthatmadethesecondhighisifthathighisfollowedbyaninsiderangebar,inwhichcaseyouwoulduseabreakinthelowsoftheinsiderangebar.

Stop

Overthesecondhigh.

Target

Target should be thewidth of the trading range from the point of breakout orbreakdown.

AscendingTriangleCriteria

Equalornearlyequalhighsandhigherlowsonreducingvolume.Entry

Breakoutfromthetrendlinesonhigherthanaveragevolumeasthetrendlinesconverge.Stop

Underthelowsofthebase,orlastmajorpivotlowonthesmallertimeframe,orunderthelowsofthesetupbar.Target

Equaldistanceonabreakoutcomparabletothedistancebetweenthefirsthighandfirstlowinthetriangle.Ascendingtrianglestendtobreakouthigher(Figures5.5and5.6).

Figure5.5

Figure5.6

TradingRange/Congestion

TradingRangeCongestionBasing/Consolidation

BreakoutCriteria

Abase/tradingrangeathighsorlows.Entry

Abreakout in themost recent sectionof the trading rangeor trend line in thedirectionofthetrendpriortothetradingrange(Figures5.7and5.8).

Figure5.7

Figure5.8

Stop

Thestopwouldbeunderthelastpivotlowwithinthetradingrange.Target

Anequalmoveto thatbefore the tradingrangeon themoveoutof the tradingrange.

HeadandShouldersCriteria

High (left shoulder) followed by a higher high (head) and then a lower high(rightshoulder)whichiscomparabletotheleftshoulder.Entry

Breakdownfromtheneckline.Thenecklineconnectsthelowsoneithersideofthehead.Alternativeandpreferredentryisusingabearflagbreakdowntoenteraftertherightshoulderhasformed(Figures5.9and5.10).

Figure5.9

Figure5.10

Stop

Overthepastpivothigh.

Target

Theheightoftheheadfromthenecklineisthetargetfromthenecklineafterthebreakdown.

Pennants/Wedges

Flags,PennantsandWedges

Flags,pennantsandwedgesareextremelyimportantforadaytrader.Thesearelittlestallingpatternsinanongoingtrendwhichprovidethedaytraderbothwithalowriskentryandastoploss.Thesepatternsoftenoccurinthemiddleofanuporadownmove inall timeframes (Figures5.11and5.12).Soa targeton theupside or downside of a move preceding these patterns is good bet. I knowtraderswhomakea living trading just thesepatterns.As Iwould like tostressagain, we are here to make money and not be right in predicting tops andbottoms.

Figure5.11

Figure5.11

Figure5.12

Infact,IamoftenaskedifweareatthetoporbottomofamarketandIamalwayshesitantaboutansweringthequestion.Thisisbecauseknowingwhetherthemarkethastoppedoutorbottomedoutisnotthekeytomakingmoney.Thekeytomakingmoneyinanytimeframeisenteringtrendswithalowriskentryandthenusingpropermoneymanagementtechniques.

ReverseHeadandShouldersCriteria

Low(leftshoulder)followedbyalowerlow(head)andthenahigherlow(rightshoulder)whichiscomparabletotheleftshoulder(Figures5.13and5.14).

Figure5.13

Figure5.14

Entry

Breakhigherfromtheneckline.Thenecklineconnectsthehighsoneithersideofthehead.

Stop

Underthepastpivotlow.

TradingNews-BasedGaps

Tradinggapsisprobablyatparwithtradingflags,pennantsandwedgesintermsof easebut far superior in termsof the returnsoffered in the shortest possibletime. In India, bad news often occurs overnight, such as a terrorist strike,political parties withdrawing support to bring down governments, companiesannouncingresultseitherafterthemarketclosesorbeforeitopens.Andnotonlybadnews; sometimes there is goodnews aswell that comes after themarketsclose. The good news could be companies announcing spectacular results,government announcing divestment, companies announcing acquisitions, etc.The reaction to such news is often in the shape of a gap up or a gap downopening — a logical reaction to such news. The trouble is, the discountingmechanismofthemarketoftenquicklyover-reacts.Thetechnicalreasonforthisisthatthemarketbecomesoversolduntilstronghandsthenpickitupfromthelowerlevel.Inmyexperience,95%ofthetimethereactiondoesnotseefollowthroughinthedirectionofthegapandcanbesuccessfullytradedintheoppositedirection.

Let us consider an actual event to understand the market’s discounting

mechanism.When the late Mr. Dhirubhai Ambani was critically ill in hospital, the

Reliancesharemovedlowereverytimetherewasnewsoffurtherdeteriorationinhishealth.Nowtragicas itwas, therewasnodoubt thathissonswere thenablyrunning thecompanyand, inabusinesssense,hisdeathwasnotgoing tomakeadramaticchangetothecompany’soperations.YettheReliancesharelostgrounddayafterdayforabouttwoweeksandwentdownfromͲ285toaboutͲ260. Traderswouldwatch television thewhole day for updates fromAmbanibrothers. The news that Mr. Ambani had finally passed away came after themarkets closed. Investors and traders were jittery about the market reactionconsidering Reliance’s heavyweight status. The next day the Reliance sharegappeddownͲ5butrecoveredalmostimmediatelyandfinallyclosedhigherbyaboutͲ10.Thisincidentshowsthatthemarketwasdiscountingtheeventwellinadvanceofwhenithappened,andactuallymovedtolookaheadonceitdid.Itis such events that a trader needs to look for to get into great setups andpotentiallyveryrewardingtrades(Figure5.15).

Figure5.15

Another situation that easily comes to mind were the quarterly results ofIndianITcompaniesannouncedinJuly2003.Marketveteranswouldrememberthatintheearlierquarterofthatyear,Infosysreduceditsguidancetoabout10-15%growthinnetprofitfortheyearandtheshareimmediatelytanked30%inaday.Subsequently,therewasaJulybloodbathinalltheITstocks.SowhenthenextquarterresultswereabouttobedeclaredITstocksstarteddeclininginvalueand the sentiment was such that as each IT result approached, the particularstockwouldstartdeclining.IparticularlyrememberSatyamasitfellfromͲ175

to aboutͲ 150 in a matter of a week, with wild rumours of extremely poorresults floating all over the place. Satyam results were declared before themarkets opened and were lukewarm. Satyam gapped down Ͳ 5 but thenimmediatelywent upͲ 15 and closed strong for the day. This incident againshowshowthemarketanticipatesnewsandoftenthereactioniscontrarytothenewsdeclared(Figure5.16).

Figure5.16

Thereareothertypesofnews,suchastheGujaratearthquakeoranovernightterroriststrike,whichthemarketcannotforesee.Tragicassucheventsare,theyprovide some very useful opportunities to the day trader. At the time of theGujarat earthquake, for instance, the Sensex gapped down 80 points at theopeningandwentdownbya totalof160points.Butasnewscamein that theindustrieslocatedinGujaratweresafe,themarketsrecoveredandclosedthedayonly35pointsdown.Thecementstocksevenclosedpositivebecauseofpeoplebettingontheensuingreconstruction.

StrategyforTradingonNews

1. Identify the previous day’s high and low for the market index, or the

particularstock;2. Ifthenewsmakesthemarketorthestockgapupabovethepreviousday’s

highbyatleast10Niftypoints—or2%ontheparticularstock—waitfor

thefirsthalf-hourandidentifythehighandlowofthehalf-hour;3. Placeasellstop5pointsbelowthepreviousday’shigh.Ifthemarketgaps

downpreviousday’slowby10points,placeabuystop5pointsabovethepreviousday’slow.

4. Ifthegapisfilled,placeaninitialprotectivestoponepointabovetoday’shigh (for buys, one tick below today’s low). As the position becomesprofitable,movethestoptobreakeven.

Chapter6

CashandFuturesArbitrage

As I began writing this chapter in January 2004, Indian batsmen were

thrashingtheAustralianbowlersallovertheparkDownUnder.ImentionthisasIseeanimportantanalogybetweencricketandtradinginthestockmarkets.Inbatting, they say, the job of the openers is to see off the new ball so that afoundationislaidforthemiddleorderbatsmentogettoabigtotal.Similarly,intrading it’s important to see off some of the choppy sessions, overboughtperiods, or periods of uncertainty so that when the market again resumestrending,traderscangetbackintothemarket.

Knowing when not to trade is perhaps as important as knowing when totrade.

All experienced traders would recall the expensivemistakes theymade attimes when it would have been better to have kept out instead of takingunacceptable risks. It is perhaps thepressureof “idle cash” thatmakes traderstake risks that they should not. This pressure can be eliminated by takingadvantageof thearbitragereturnsofferedbetweenthecashandthederivativesmarket.Thereturnscanbeof theorderof15-22%annualizedriskfree,hardlysomethingtobesneezedatwhenyourcashisidlinganyway.

The cash and futures arbitrage is a strategy which often offers risk freereturns at rates better than savings accounts deposits andmost other risk freeliquidassetclasses.

The futures price of any security, or the index, is a combination of twofactors;thecashpriceoftheasset,andthecostofcarryfortheperiodremainingtoexpiryofthefuturesinstrument.Forexample:

TheonemonthfuturespriceofRelianceIndustries=CashpriceoftheReliancestock+thecostofcarryforaperiodofonemonth.

In the Indianmarkets thecostofcarrycurrentlyvariesbetweenanegative35%per annum to a positive 35%per annum. It can even be higher or lower

than the 35% figure but thatwould be an extraordinary event. Themethod ofcapturingthisriskfreereturnissimple.

FuturesPriceHigherthantheCashPrice

We all know that at expiry the futures price closes at the cash price of thesecurity or index. So in the above Reliance example, if the futures price ofRelianceishigherthanitscashprice,youcanbuytheReliancestockandsellasimilarquantityofReliancefutures.ThiswillallowyoutoearnthecostofcarryoftheReliancefutures.

Forexample, if thepriceofReliance isͲ400onthedayofexecutionandtheReliancefuturesistradingatͲ406,itispossibletobuytheReliancestockforͲ400andselltheReliancefuturesatͲ406.Onexpiry,assumingRelianceclosesatͲ450,youmakeͲ50bysellingtheReliancestockandloseͲ44bybuyingbackthefutures,whichisͲ6inamonth,or18%annualized,riskfree.Thisis,ofcourse,beforecommissions.Thestockitselfisacceptedasmarginforthefuturesposition.

Futures prices are generally higher than the cash prices in an overboughtmarket.

CashPriceHigherthantheFuturesPrice

Intuitively, the cost of carry should always be a positive figure. In the Indianmarkets,however,weoftenseefuturespricesbeinglowerthanthecashprices,generally in an oversold market. This may be due to the fact that the Indianmarket is cash settled and not delivery settled, so the futures price is more areflectionofsentiment,ratherthanthatofthefinancingcost.

Let us assume that the cash price of theReliance share is greater than itsfuturesprice.SupposethecashpriceisͲ406andthefuturespriceisͲ400.Theobvious thing todowouldbe to sell the stock in thecashmarket andbuy thefutures.SoatexpiryifRelianceclosesatͲ450,youwillbuybackthestockatalossofͲ44andmakeͲ50onthesettlementofthefuturesposition.Butsincethereisaninteresttobepaidforborrowingthestock,ithastobedeductedfromthecostofcarryearnedfromthisstrategy.Assuminganinterestof12%ispaidonthestockborrowed,andtherewasa20%marginonthefuturespositionanda50%marginontheborrowedstock,itwillleadtoareturnof8.5%,whichmightnotamounttomuchaftercommissions.So,thisstrategyshouldbeappliedonly

whenthecostofcarryisabnormallyhigh.Also,sincetheIndianmarketsfollowtheT+1settlement,thestockhastobe

deliveredthenextmorning.AndwhilemostlargebrokerslikeKotakSecurities,etc.dosomestocklendingwhichwouldmakeitpossibletocapturethisreturn,themechanismisnotyetwelldevelopedandthesmallerbrokersusuallydonothavethisfacility.Withthelargebrokerswecouldhaveborrowedthestockfromthedepositoryandsolditinthemarket,payinganinterestwhichwouldbelowerthan thecostofcarryof the futures.Whenusingborrowedstock,youneed tomake sure that you are making money after paying the interest on borrowedstockandcommissions.

Sebi has put in place margin trading and stock lending system from 1February2004.Thissystemisprovidedtoinvestorsonlybycorporatebrokers.Thisfacilitywilltaketimetodevelopanditwillbeinterestingtoseeifitcanbeemployedforsellingthestockshortintheabovecase.

ReturnsPossiblewithCashandFuturesArbitrage

Table6.1 shows thekindof returns that arepossible throughcashand futuresarbitrage. Traders should remember that these are risk free returns. These arereturnsthroughcashandfuturesarbitragefromJanuary2004whichwasawildlybullishmarket;suchcostsofcarrymaynotbeavailableatother times.Sothisstrategy cannot and should not be applied at all times, typically much betterreturnsarepossibleinbullmarkets.

Personally,Iliketolockinextraordinarymispricingsinthefuturespriceandanythingnear3.5%perannumwouldexciteme.

WhytheCostofCarryVariesAccordingtotheMarketSentiment

IthinkIndiantraderscanunderstandthisbetterthantradersfromanywhereelse.

Rememberthegoodolddaysofthebadla?Nowbadlatoowasafinancingcost and itvariedwildly, from12-13% toashighas48%at times.Thebadlarates depended on the market conditions. Higher badla rates meant a highdemandformoneywhich, in turn,meant that themarketswerebullish.Lowerbadlaratesprevailedwhenthedemandformoneywaslowbecausethemarketswereeitherflatorbearish.

Bykeepingthisfinancingcostprincipleinmind,traderscanmakemoneybycashandfuturesarbitrage,andalsogetasenseof themarket’sdirectionwhenthecostof carry is at its extremes.Typically,when thecostsof carryofmostNiftystocks isupwardsof35%perannum, it’sagood time to takeprofitsonyourlongpositionsandusethearbitragestrategytoearnafurther35%onthoseprofits.Costsofcarryabove35-40%areunsustainableover the long termandwouldsooneror later lead toacorrection in themarket,orat leastasidewaysmovement. Conversely, when the cost of carry is negative, something whichshould not theoretically happen but does in the Indian market — a similar

extreme value would signify an oversold market and one which should beboughtinto.

AdvantagesofUsingCashandFuturesArbitrage

ReasonableReturnsWhenNoOtherTradeisVisibleThis strategy can offer 18-22% returns annually for traderswhen there are notrades visible on the horizon. This is amuch better option than keeping yourfunds at no interest with the broker, or even keeping them in your savingsaccount.Goodtradesarelikemusic;theyflowverysimplyandnaturally.Oftenthestressesof runningahousehold,peerpressure,etc,can leada trader intoafalse trade. Inmy years of trading, I have found that the best trading is donewhen these is no pressure. Which is why I spend a lot of time looking foropportunitieswhich can helpmemakemoney from activities other than pureswing trading. Cash futures arbitrage is one such; writing covered calls isanother.Returnsof18-22%annuallymaynotexcite stockmarketpunters,butstockmarkettradingisasmuchaboutstabilityandconsistencyofreturnsasitisabout the quantumof returns on every trade.These are all issues professionaltradersneedtothinkabout.Theseextrareturnstakesomepressureofftheneedtotradeallthetime,thusenablingthetradertowaitforthebestsetups,confidentthatheismakingmoneysomewhereelse.

Waitingforgoodtradesinmycasecouldmeanthefollowingtwoscenarios.

WaitingForaMarketCorrectiontoTakeaSwingTrade

Wehavediscussedearlierthelowriskentrytechniqueofbuyinginanoversoldcondition ina lower time frame in thedirectionof the trendestablished in thehigher time frame.Nowduring strong bull trends, sometimes themarket doesnotcorrectforalongtimeandjustkeepsgoingup.Thishappened,forinstance,betweenDecember2003andJanuary2004.Iwashavingmycompleteexposurethrough most of the trend; I then booked profits when the market turnedsideways and my targets were achieved. But the market rallied some morewithoutfirstcorrectingsubstantially.Nowattheriskofnotparticipatinginthesubsequentmoveand,again,notgettingthebestentryintothetrend,IdecidedIwouldgoinformycompleteexposure.

Generally, based on my money management methods I am long or short3,000 shares, or 15 contractsofNifty,.So I decided to let themarket run andtookaone-thirdpositionof1,000Nifty,whichkeptmecomfortablyinthetrend

while waiting for the perfect set up, which inmy case would havemeant anoversoldlevelinthedailychartplusareversal.SomecouldarguethatIletgoofprofits thatmighthavebeenmine.Butamature trader realizes thatnomarketgoes up forever and corrections are inevitable. A trader can hold a positionconfidently if he thinks that he entered the best setup possible. Chasingmomentum can be a dangerous game and one that can leave you withdrawdownsof15-20% if your run into a correction as soon asyou enter.Thecashfuturesarbitragestrategymakesmoneyevenwhenyouarewaitingforgoodasetup.

WaitingForCoveredCallSetups

Oneofthebigdangersincoveredcallwriting,asweshallseelaterinthebook,islookingatdownsidesbiggerthanthecallpremiumsyouearn.Thiscanhappenifcallsarewritteninamarketthathasbeenmovingupwardforawhileandissusceptibletoacorrection.Ihaveoftenbeeninsuchasituation.Andeverytimethewaithasbeenworthwhilesinceeachtimethemarketcorrects,it’seasiertomake money on the covered call. Again, nobody knows when the correctionmight take place. So there is need for a strategy which gives liquidity andreasonablereturnsonidlecash.Cashfuturesarbitragefulfilsthatspace.

PerfectforCashWhichYouCannotRisk

Alltradershavecashwhichtheydon’twanttodirectlyriskinthestockmarket.Cash futures arbitrages canbea technique to earnadecent risk free returnoncash that cannot be risked. All traders keep some reserve cash or an accountwhere they keep their profits for times when the market stop being helpful.Thesefundscanbedeployedinriskfreestrategiessuchascashfuturesarbitrage.

PerfectforChoppySidewaysMarkets

Markets go through periods of consolidation and up and down action whentradingbecomesverydifficult.Thecostsofcarryof futuresare reasonable tillaboutthe15thofeverymonth.Soit’salwayspossibletowaitafewdaysifonehas to till some extraordinarymispricings appear. Thesemispricings are veryquickly taken care of by smart arbitrageurs, sowaitingonceyou spot such anopportunityisnotthesmartestthingtodo.

ReducestheMarketRiskofaPortfolio

Alotofhighnetworthinvestorsandmutualfundshaveveryhighweightageinindexstocks.Therearetimeswhenthemarketmightlookoverheatedandtheseinvestorsmaywant to reduce the riskofpossiblemarketdeclines for thenextfewweeks.Atsuchtimestheycansellindexfuturesworththeentire,orapartof,themarketvalueoftheirportfoliotohedgeagainstmarketdeclinesandalsoearn the cost of carry in the bargain. Index futures arbitrage may not beprofitable for individual traderbecauseof the inefficiencies inbuying thecashNiftyortheSensexportfolio.

Although it is possible to buy the Nifty cash portfolio through the Niftybasket,which is a portfolio ofNifty stocks bought by shooting bids at all thestocks in the weightages that they represent in the Nifty. But the overallacquisitionpriceoftheNiftybeesmayturnouttobehigherthantheNiftycashatthesamepointsincesomeoftheNiftyconstituentsarenotliquidatalltimes.Insuchacase,ifthetraderwantstoinvestͲ10lakhinindexarbitrage,hecanbuyͲ10lakhworthofNiftybeesandsellanequivalentamountofNiftyindexfutures.ButtraderspurelyinthearbitragegameforthecostofcarryreturnswillnotfindtheNiftypremiumstooexciting.

TheotheroptionisbuyingtheNiftybees,whichisaproductbyacompanywhichcloselytrackstheNifty.Thebeestradesatone-tenththevalueofthecashNifty.Forexample,iftheNiftyisat1,900,theNiftybeeswouldbearound189-190.Buttheliquidityissopoorthatserioustraderscannottradealargequantity.Asofwritingthisbook,theliquiditywassomethinglike3,000sharestradedinaday.Sothisalsodoesnotseemtobeaveryviableoptionthoughthingsmightchangeasthemarketsdevelopsomemore.

PossibleOutcomesoftheCashFuturesArbitrage

Likemost things in life, if executedproperly the returns from thecash futuresarbitrage strategycanbe juicedup.Thehighest costsof carryare foundwhenthemarketisgreatlyoverboughtwhichmakestheshiftingofprofitsfromswingtradingorcoveredcallwritingtothisstrategyveryconvenient.

Therearetwopossibleoutcomesoncesuchastrategyisimplemented.

Ifthefuturesmaintainapremiumtillexpiry,letthefuturesexpireandsell

the stock.For example, I hadbought6,900 sharesofNalco forͲ 201.50andsold6,900NalcofuturesforͲ204.50with25days left forexpiry. Itturned out to be 24% annualized return, and I pocketed approximatelyͲ21,000inprofit.Sometimes if the market corrects in the interim, the cost of carry canbecome negative during themonth because of temporary demand supplymismatch. This opportunity should be used to unwind both legs of thestrategyandthusenhanceyourprofitsevenfurther.Forexample,if intheaboveNalco case a correction had occurred before expiry and theNalcostockfallentoͲ195andthefuturestoͲ193,IwouldhaveunwoundbothlegsandmadeapproximatelyͲ35,000intheprocess.

Itisnotpossibletotradefull-tiltinthestockmarketeveryminuteortargetmaximum possible returns all the time. There are times when you need tooperateinalowergear,alsotimeswhenyouneedtopressonthegaspedal,sothat overall your returns are above average. The goal has to be protection ofcapital, alongwith generation of returnswhile taking the lowest risk possible.Cashfuturesarbitrageisagreatwaytomanagevolatilityinreturnsoveraperiodof time and also deploy idle cash at a decent rate of returnwhilewaiting forbetter trading opportunities. As good as the cash futures arbitrage strategysounds,tradersshouldrememberthatcapturingextraordinarymispricingsisnotpossibleallthetime.Youneedtoassesswhetherthecostofcarryishighenoughtodeliverworthwhilereturns.

Chapter7

GettingtoGripswithOptions

Before the introduction of derivatives in India, you could either buy or sellstocks.Thesmarterinvestorsandtraderswouldeitherearnbadlaonthesharestheyheldorearnedbadlabymargin lendingactivity to theexchange.I like tothinkofoptionsasthebass,trebleandvolumecontrolsofamusicsystemthatisthestockmarket. If therewerenobass, trebleandvolumecontrols,youcouldeitherswitchtheradioonoroff,andbeforcedtolistentothesongsandnewsatthesamevolumeandtone.Withtheadventofderivatives,alotmoreflexibilityhascomeavailable to traders.Theycanadjustandmassage their stockmarketexposure with the various derivative instruments, particularly options and acombinationofoptions,futuresandstocks.

Anoptionscontract involves thepayment,or receipt,ofapremiumfor theright tobuyorsell theunderlyingassetataparticularprice,withinaspecifiedperiod. Each transaction in the options market involves either opening a newpositionorclosinganexistingone.

Letusnowdiscussoptionsfromatrader’spointofviewandwithoutgettinglostintoomuchmathematics.

Stocksandfuturesarelinearproductswherethedownsidecouldbeasmuchas the upside.The huge benefit of options, on the other hand, is that they arenon-linear products with only limited downside but unlimited upside for thebuyer.

Theoptionseller,converselyhaslimitedupsidebutunlimiteddownsiderisk.But this asymmetry comeswith certain risks and rewards for both options

buyersandsellers.Thenakedoptionsbuyerdoesnotlosemorethantheoptionpremium he pays. An option position is called naked if it is not hedged byanother options or futures position, or a spread strategy. Accordingly, simplybuying a call or a put is called buying naked options. In order to enjoy thebenefit of limiting the loss only to the premium, a trader needs to takemany

otherkindsofrisks,namely:

Theriskofsidewaysmovementofthemarket;Theriskofadversemovementofthemarket;andTheriskoftimetoexpiry.

A little laterwewill comparewhether it is the buyer or the sellerwho isactuallyabletoreduceriskintheoptionsmarket.

Generally speaking, options are spoken of in terms of hedging andspeculation.

Speculation(Trading)withOptions

Byspeculation,Imeanbuyingnakedputsorcallsandthevariousstrategiesthatmakeuseofacombinationoffutures,optionsand/orstocks,withtheintentionofmaking aprofit insteadof hedging anotherposition.Profitable tradingwithanyinstrumentinanymarketrequiresstrongtrendingmovesbecauseoftheriskslistedabove, though theoptionsmarketdoeshavesomestrategies fora range-boundmarket on the option selling side. Also, it is critical to remember thatbecause of fixed contract sizes, the minimum position a trader can take isdefinedbythestockexchange.

Personally,Iuseoptionsforspeculationonlyinastronglytrendingmarket.One of the reasons for this is that Indian options are liquid only for the nearmonthexpiration.

Also, IneverbuyoptionsforhedgingpurposesbecauseIdonot think it isworthpayingextratohedge,exceptinthecaseofcoveredcalls(whichissellingcalls against stock positions). The covered call actually putsmoney into youraccount.Thecoveredcallisdealtwith,inexclusivedetail,inChapter9.

HedgingwithOptions

Hedgingisdefinedastakingapositioninconjunctionwithastockorafuturesposition to reduce the risk of adversemovement.Hedging in the above senserequirespaymentofapremium,muchasaninsurancepolicydoesand,inturn,putsthereturnbarhigherforachievingprofittargets.BothareworthycausesinthemselvesbutIwouldliketofocusinthisbookontheenhancementofreturns

andmanagement of risk through options. Still, wewill discuss some hedgingstrategiesaswellinlaterchapters.

Buyingoptionsforpurposeofhedgingreducesreturnsandactuallyincreasesriskexcept,maybe, in thecaseofvery longterminvesting.Iwouldrathersellthanbuyanoptionanyday,sinceat-the-moneyputscanbepricedupto4%oftheunderlyingcontract.Inextraordinarycircumstanceswhereaportfolioneedstobeprotected,out-of-moneyputscanbebought.Orsometimeswhenthenextmonth’s futures contracts become active in the middle of the current month,traderscanhedgeforatmostone-and-a-halfmonthbysellingindividualstockorNifty futures. Another goodway of hedging is to keep selling calls against aportfolio (covered calls) and over a period of time earn enough premia tocushion any fall in themarket. In general, for traders the bestway to protectprofitsistobringthemhome.Positionscanalwaysbere-enteredlateronafteracorrection.

Butifoptionsareusedaccordingtoone’sviewofthemarketandvolatility,etc., they can be effective inmost situations.Generally speaking, options canand shouldbeused inconjunctionwithotherproducts like futuresand stocks.Optionscanthusreducethedownsideduringadversemarketmovementandalsooffersteadyreturnsinasidewaysortrendingmarket.Allthesestrategieswillbediscussedinthisandlaterchaptersofthisbook.

Options:SomeImportantConceptsMarketLotsThe stock exchanges in their wisdom decided to limit the Indian derivativesmarket to the relatively larger players and thus introducedmarket lots with aminimum contract size of Ͳ 2 lakh. As the derivatives market was firstimplemented at a Nifty level of about 1,000 (or Sensex 3,300), the averagecontractsizesinsomecasesrosetooverͲ10lakhwhenthemarketrallied.Asofwriting thisbook, the lotshavebeenre-sized inorder tobring theexposurebackdowntoͲ2lakhpercontract.Butsincestockskeeprisingandfalling,thisproblemwillexisttillastablepolicyisputinplace*.Theoptiontraderneedstounderstandtheoverallriskheistaking,bothintermsofhistotalexposuretothederivatives market, as also for each individual derivative contract. This isdiscussed in detail in the chapter on money management later in the book(Chapter 12). If the exposure of a particular options contract is more than atrader’s pre-determined exposure to the derivatives market because of the lot

size,heshoulddesistfromtakingpositionsinsuchoptions.

StrikePrice

Thepriceatwhichtheunderlyingstockofanoptioncanbepurchasedorsoldbythecontractbuyeriscalledthestrikeprice.ThestrikesinoptionsofmostIndiansharesare inmultiplesofͲ5andͲ10.Generallyspeaking,fivetosixoptionprices are available on both sides of the current price of the underlying. Ofcourse, thisdependsonwhether thepriceshavebeenmovingupordownatagivenpointof time.Forexample, theACCstock tradingatͲ200mighthaveoptionslistedwithstrikesofͲ150,Ͳ160,Ͳ170,Ͳ180,Ͳ190,Ͳ200,Ͳ210,Ͳ220,Ͳ230,Ͳ240andͲ250.

But sometimes theremaynotbe somany strikes available in real life.Forexample, ifNiftymovesupfrom,say,900 to1500, itmayhaveoptionsofallstrikesbetween1,300and1,500butonlytwostrikesof1,510and1,520ontheupper sideonanygivenday. It is important for traders to factor in the time ittakes exchanges to list new strikes. In fast moving markets, sometimes theexchangescanbealittleslowandthereisnothingwecandoaboutit.

Another problem is that strikes which are closer to the price of theunderlying aremore liquid than are the others.As explained later under “TheGreeks”section,I liketobuythehigherdeltaoption.Ahigherdeltaoption,ingeneral,isanoptionwhichisdeepin-the-money;inotherwordsonewhichisonthe profitable side of the strike price by quite a margin. Sometimes that isdifficultwiththeliquiditybeinglowfordeepin-the-moneyoptions.Soyouneedto strike a balance by buying sufficient in-the-money strike and one that hasreasonableliquidityinproportiontothevolumesthatyouareexpectingtotrade.Checkwithyourbrokerifyoucaneasilybuyandsellthequantityyouwanttotradeandwhatquantitiesareotherbuyersandsellersputtingtheirbidsfor.

In-the-money

A call option whose strike price is below the current price of theunderlying;orAputwithastrikeabovethecurrentprice.

Forexample,iftheACCstockistradingatͲ200,theACCcalloptionswith

strikes190,180,170andbelowareallin-the-money.

Out-of-the-money

AcalloptionwhosestrikepriceisabovethecurrentpriceoftheunderlyingstockorAputwithastrikebelowthecurrentprice.WhenACCistradingatͲ200,theACCcalloptionswithstrikes210,220,230andupwardsareout-of-the-money.

At-the-money[ATM]

This is an option that has a strike price equal to the current price of theunderlyingstock.

TheACCoptionwith a strikeofͲ 200 is at-the-moneywhen the stock istradingatornearthestrikeprice.

ExpirationDate

Thedatewhenthetermofanoptionscontractterminatesiscalleditsexpirationdate.TheexpiryofIndianoptionsmandatedby thestockexchanges is the lastThursdayofeverymonth.Technicallyspeaking,optionscontractsareavailablefor the nearmonth (current),midmonth (next) and farmonth (themonth afternext). Currently, however, only the near month options usually have tradableliquidity and only towards the last week of the nearmonth do options of themidmonthgatherenoughliquiditytobetradedcomfortably.

Presently in India, therefore, the number of days to expiration has morerelevance than is apparent. Options for the subsequent month (midmonth)becomeactiveinthelastweekofthecurrentmonth.Asarule,tradersshouldtrytobuyasmuchtimevalueaspossiblesothattheirpositionshaveenoughtimetoworkout.Unless themarket is inastrong trendingmode, longoptionsshouldnotbeheldafter the15thor20thof theexpirationmonth.This isbecause thetimecomponentoftheoptionexpiresveryfast,andusuallyduringthelastfewdaysof themonththelossduetotimevalueisequal toorevenmorethanthegain on the underlying stock. The decay of the time value is known as timedecayand the rateof timedecay isavailableas theta (see thesectionon“The

Greeks”laterinthischapter)onmostoptioncalculators.

UnderlyingStockorIndex

Thestockorindexthatanoptiongivesitsbuyerorsellertherighttobuyorsellis known as the underlying. For example, in the case ofACC call option, theunderlying stock is ACC and the behaviour of the option depends on themovementoftheACCstock.

OptionHolders(OptionBuyers)

Theybuyersofoptionsareoftendesignatedasoptionholders.This isalso thesameascreatingalongpositionintheoptionsmarket.Theoptionbuyerneedstopayjusttheoptionpremiumandhisriskislimitedtothepremiumhepayssincethatisthemaximumhecanlose.

OptionWriters(OptionSellers)

Writers receive money (premium) for writing, i.e. selling, options. They areconsideredtohaveshortpositionsontheparticularoptionofthestockorindex.The optionwriter has to pay an upfrontmargin to the brokerwhich can varyfrom20%to70%.Theshortpositioninoptionshasunlimitedriskandlimitedreturn,andashortpositionintheoptionsmarketistreatedasashortpositioninthe futures market. This means that a naked short options position attractsmarginsandmarktomarketrulesofashortfuturescontractbecause,intheory,the loss on anoptions contract could be unlimited,much like in the case of ashortfuturescontract.

TypesofOptions

There are two types of options contracts — the call and the put. Then, too,optionscanbeeitherEuropeanorAmerican.Europeanoptionscanbeexercisedonly on the exercise date, whereasAmerican options can be exercised at anytime.

InIndia,asinmostpartsoftheworld,onlytheindexoptionsaretradedasEuropeanoptionswhilethestockoptionsaretradedasAmericanoptions.

Therearealsotwokindsofinstrumentsavailableunderoptions:

Call is the right to buy the underlying asset at a particular pricewithin aspecifiedperiod.Put is the right to sell the underlying asset at a particular price,within aspecifiedperiod.

OptionValue

Theoptionvalueiscomposedoftwoparts:

Intrinsicvalue,andTimevalue.

Intrinsic value is the amount by which an option is in-the-money. Forexample,letussupposetheACCstockistradingatͲ220andthe200ACCcalloption is tradingat apremiumofͲ32.Of thepremiumofͲ32, the intrinsicvalueisͲ20.

Timevalueisthepartofanoptionpremiumthatexceedsitsintrinsicvalue.Intheaboveexample,therefore,thetimevalueisͲ8.

Justtoclarifyintermsofwhichoptionstobuy;ifIambullishonACCandtheshareistradingatͲ200,Iwouldtakethequotesof200,210,220ACCcalloptionsandcompare the intrinsicvalueswith the timevaluesandbuy theonewiththemaximumintrinsicvalue.

Out-of-the-money(OTM)optionscostlessthanin-the-money(ITM)optionsbecausethechancesofappreciationarehigherinITMoptions.Personally,Ibuyonlyin-the-moneyoptionswiththeleastamountoftimevalueinthem.Thus,intheaboveACCexample,ifthe200callissellingforͲ30and210callissellingforͲ25,Iwouldbuythe200callevenifthismeanspayingͲ5more.Thisisbecausethelesstimevaluethereisinanoption,theloweristhevaluethatislostbecause of time. Currently, in India only the near month (or current month)optionsareactuallyliquidenoughtotrade.Accordingly,unlesstherearestrongtrendingmoves,theoption’stimevaluecanevaporateinahurry.

Optionswithmoretimetillexpirationcostmorethanthosewithlesstime.

FactorsThatDeterminethePriceofanOptionTherearefourmajorandtwominorfactorsthatdeterminethepriceofanoption:

Themajorfactorsare:

Priceoftheunderlying.Volatilityoftheunderlying.Strikepriceoftheoption.Timeremaininguntiltheoptionexpires.

Theminorfactorsare:

Prevalentriskfreeinterestrate.Dividendrateoftheunderlyingstock.

Volatility

Volatilityisameasureofthefluctuationinastock’s(orindex’s)priceandoftenplaysthemostimportantroleinoptionstrading.

Knowingvolatilitycanhelpyou:

Chooseandimplementanappropriateoptionsstrategy.Improveyourtiminginenteringorexitingpositions.Identifyoverpricedandunderpricedoptions.

UnderstandingVolatility

Volatility isameasureof theamountbywhichanasset’sprice fluctuates inagiventime.Mathematically,volatilityistheannualizedstandarddeviationofanasset’sdailypricechanges.

Therearetwotypesofvolatility:

Historicalvolatility,and

Impliedvolatility.

Historical volatility is a measure of the actual changes in an asset’s priceovera specificperiodof time.Historicalvolatility is available inmost tradingsoftware,suchasTrade-station,Supercharts,EI2000,etc.It’salsoprovidedbymanytechnicalanalystsanddataproviders.

Implied volatility is a measure of how much the “market” expects anoption’spricetomove.Thus,itisthevolatilitythatthemarketitselfisimplying,rather than that indicated by the pastmovements of the stock’s price. Impliedvolatility can be calculated on the options calculator or obtained from severalfinancial websites (see Appendix II). The moment you decide to buy or selloptionsor implementanystrategyusingoptions, it iscritical toremember thatimpliedvolatility(IV)isanimportantpartofthepuzzle.

Let’s go through an example as a step-by-step guide to buying or sellingoptions.

Table7.1ImpliedVolatilityCalculator

RiskFreeInterestRate: 6.00%UnderlyingAsset:Marketprice(Ͳ): 322.00Dividends: 322.00

ExdateAmountOrContinuousrate 20%

Option:Optiontype:Optionmarketprice(Ͳ): 25Strikeprice(Ͳ): 320.00ValueDate 11/18/03Expirationdate: 11/27/03Daystoexpiration: 9Pricing:Pricingmodel: BlackScholesNumber of steps for binomialmodel:

100

ImpliedVolatility: 118.33%

SupposeyouwanttotakealongpositionintheSatyam320calloptionatͲ25, and the currentpriceofSatyamstock isͲ 322.Letus assume the current

datetobe18November2003andtheexpiryisonthe27November2003.Youhave to include either the 18th or the 27th in your calculation of impliedvolatility,notboth.Nowletuscalculatetheimpliedvolatility(Table7.1).

Asyoucanobserve,theinputsyouneededtocalculateimpliedvolatilityareverysimple.Youneedthecurrentdateandthedateofexpiry,theoptionsstrikeprice, thecurrentpriceof theunderlying, risk free interest rate (whichwewilltakeas6%),andhistoricalvolatility.Giventhese,youwillautomaticallygettheimplied volatility in the option. At the time of writing this book, the Satyamsharehadahistoricalvolatilityof50%andtheimpliedvolatilityintheparticularoptionexamplewehavechosenis118.33%,whichmeansthisoptionhasalotofvolatility premium— or time value— in it. Traders should avoid strategieswhichconsistofbuyingsuchanoption.Instead,one’sstrategyshouldbetosellahighvolatilityoption.

Table7.2ImpliedVolatilityCalculator

RiskFreeInterestRate: 6.00%UnderlyingAsset:Marketprice(Ͳ): 322.00Dividends:

ExdateAmountOrContinuousrate 20%

Option:Optiontype:Optionmarketprice(Ͳ): 10Strikeprice(Ͳ): 320.00ValueDate 11/18/03Expirationdate: 11/27/03Daystoexpiration: 9Pricing:Pricingmodel: BlackScholesNumber of steps for binomialmodel:

100

ImpliedVolatility: 143.29%

Now, let’sconsider thesameSatyam320optionwith theotherparametersremainingthesameexceptfortheoptionpremium,whichisassumedtobeͲ10,andagaincalculatetheimpliedvolatility(Table7.2)

Thesame320Satyamcall,havingthesamenumberofdays toexpiry,and

with obviously the same price of the underlying and other inputs but with apremium of Ͳ 10 has an implied volatility of 43.29% which is lower thanSatyam’shistoricalvolatilityof50%.Withallotherthings,suchasone’sviewon the market and the stock being equal, the lower implied volatilityimmediatelymakesthisSatyamcalloptionappropriateforbuying.

Itisimportanttounderstandwhyit’snotagoodideatobuyoptionswhichhavehighimpliedvolatility.

The stockmarket goes through alternatephasesof high and lowvolatility.Periodsofhigharefollowedbyperiodsoflowvolatility,andviceversa.Letussupposeatraderbuysahighvolatilityoption,andthevolatilityofthestockorthemarket—andhencetheimpliedvolatilityoftheoption—goesdown.Evenif the underlying subsequently moves in a favourable direction, the optionpremiummaynotappreciatebeyondtheoption’spurchaseprice,andmayevendepreciate as the days to expiry reduce. This kind of option buying will beconsidered a high risk buy.On the other hand, if a trader buys a low impliedvolatility option, and both the volatility of the underlying and the impliedvolatility of the option go up, even if the movement of the underlying ismarginallyunfavourable,theoptionwillatleastholditsvalue.

The implied volatility can be high or low compared to the historicalvolatility. The important point is that one should buy a low implied volatilityoptionwhichwillbecheaperthanahighvolatilityoneofthesamestrike,expiryandunderlying instrument.Youshouldchoosestrategieswhich involvesellingof options when the implied volatilities are high, and buy options when theimpliedvolatilityislow.

Wewilldiscussthebuyingandsellingofvolatilityfurtherinthechapteronoptionsstrategies(Chapter8).

TheGreeksThe Greeks help the trader to understand the rate of change of the optionpremiumwithchangesinthepriceoftheunderlying, timetoexpiry,volatility,etc.

OurdiscussionoftheGreekswillincludedelta,gamma,vega,thetaandrho.Thesegreek letters denote the sensitivityof theoptionpremium to changes inthe above criteria. It is useful to understand the Greeks because they are anaspectofthebuyingorsellingdecisionintheoptionsmarket.Whileitishelpfultounderstandthatcallvaluesriseandputvaluesfallwhentheunderlyingindex

orstockrisesandotherfactorsremainconstant,itismuchmorehelpfultohaveaspecificestimateofsuchchangesinvalue.Suchanestimatemakesitpossibletochoosefromamonganumberofstrategiesthatareappropriateforaspecificmarketforecast.

Delta

Deltadealswiththemostimportantdeterminantofanoptionprice,namelytheprice of the underlying. Personally, I consider delta to be themost importantGreekofall.AswewouldallrememberfromClassXIIMaths(yes,thedreadedcalculus),deltaofanoptionisthefirstderivativeofoptionvaluewithrespecttochangeinthepriceoftheunderlying.

We will not delve into the mathematics of delta but instead focus on itsconceptandutility.Deltaisanestimateofthelikelychangeinanoption’svaluegiven a one-unit change in price of the underlying instrument, assumingotherfactorsremainconstant.Deltascanvarybetween+1and–1.

In simple language, in the case of a higher delta option, the change in theoptionpremiumwouldbemoreforeachrupeeofchangeintheunderlyingstockorindex,whetherupwardordownward.

In the case of a lower delta option, on the other hand, for each rupee ofchange in the underlying, the change in option premium would be lesser. Inotherwords,thecorrelationofanoption’spremiumtoitsdeltaispositive.AsatradingstrategyIalways trade thehigherdeltaoptionbecause foreachunitofmoveintheunderlying,thehigherdeltaoptionpremiummovesmorerelativetoalowerdelta

Table7.3PriceoftheUnderlying(?) CalculatedOptionPremium(?) Delta(?)280 5.75 +.29285 7.32 +.343290 9.15 +.397295 11.26 +.452300 13.64 +.508305 16.30 +.562310 19.22 +.614315 22.39 +.664320 25.81 +.71

Now,what isahighdeltaoption?Themorein-the-moneyanoptionis, the

higher is its delta. The less in-the-money an option is, the lower is its delta,everythingelsebeingconstant.

Let’snowlookatanexampletoputtotestwhatwehavesaidabove.Let’sconsider the Satyam 300November Call, where the date of valuationwas 14November 2003, the expiry date of the option was 27 November 2003, thehistoricalvolatility64%,riskfreeinterestrateof6%anddividedrateof20%.

We now examine how the option premium of this Satyam 300NovemberCallchanges,as theoptionmoves fromdeepout-of-the-money todeep in-the-money(Table7.3).

Theabovetablebringsouttheprocedureforbuyingoptions.Asyoucansee,there are benefits of buying higher delta andmore in-the-money options. Thedelta ismoving towards +1 as the option becomesmore in-the-money,whichmeans that for each rupee of upward movement in the underlying stock, theoptionpremiumincreasinglymovescloser to+1.Allelsebeingequal,Iwouldalwaysbuythehigherdeltaoption.Thehigherdeltaoptionbehavesmorelikeafutureasitsdeltaapproaches+1.Hencebybuyingadeepin-the-moneyoption,atradergetstheupsideofafuturewhilelimitingthedownside.

TheotherwayIlookatitisthatthemorein-the-moneyoptionyoubuy,thehigheristheintrinsicvalueinitspremium.Asweknowbynow,thetimevaluepart of the option can evaporate very fast. So the option which has greaterintrinsic value is the one that I like to buy, since Iwant to pay as lowa timepremium as possible. Such an option behaves more like a future and mydownsideremainslimited.CallsHavePositiveDeltas

Theplussign(+)associatedwiththedeltaoftheSatyam300CallinTable7.3indicates apositive,ordirect, relationshipbetweenchanges in thepriceof theunderlying instrument and change in the theoretical value of the call. As thetable illustrates,when the underlying stock level rises, so does the theoreticalvalueofthe300Call.

Itshouldbenotedthataplusorminussignassociatedwithanoptionvaluemay be different from the sign of an option position. The subject of positiondeltaswillbediscussedlater.PutsHaveNegativeDeltas

Let’s now examine the Satyam 300 Put option, keeping all other parametersexactlythesame(Table7.4).

It’squiteapparentthateveninthecaseofputsbuyingahigherdelta,in-the-moneyputismuchbetterthanalowerdeltaput,at-the-moneyput,oranout-of-

moneyput.The minus sign (–) associated with the delta of the 300 Put indicates a

negative, or inverse, relationship between the change in the underlyinginstrumentpriceandchangeinput’svalue.AsindicatedinTable7.4,arise intheindexlevelcausedtheputvaluetodecline.

The other Greeks are more important from a theoretical and a conceptualpointofviewandwewilldiscusstheseonlybriefly.

Table7.4PriceoftheUnderlying(Ͳ)

CalculatedOptionPremium(Ͳ)

Delta

320 7.44 -.29315 8.99 -.336310 10.78 -.386305 12.82 -.438300 15.13 -.492295 17.71 -.548290 20.57 -.603285 23.70 -.657280 27.10 -.71

Gamma

Refer back to the delta tables (Tables 7.3 and 7.4) and note that the delta of+0.29 does not exactly predict the 300 Satyam Call value after a one-pointincrease in the underlying index. This is because the difference between theestimated changes in value and the actual change in value occurs because thedeltachangeswhenthepriceoftheunderlyingchanges.Gammaisanestimateofthechangeindeltaforaoneunitchangeinpriceoftheunderlyinginstrument,assuming other factors remain constant.Mathematically, gamma is the secondderivativeof theoptionpricing formulawith respect to change inpriceof theunderlying.Theimportanceofthisfactoriscapturedbydelta.

Vega

Vega is the change in option value that results froma one per cent change involatility,assumingotherfactorsremainconstant.Vegaanswersthequestion:ifthevolatilitychangesbyonepercent,howmuchdoestheoptionvaluechange.

Mathematically, vega is the first derivative of option pricewith respect to

changeinvolatility.Sincefirstderivativesaretheoretically“instantaneousratesofchange,”andsincevegaestimatestheimpactofaonepercentchange,therewillbefrequentroundingerrors.

Let’slookatourSatyamexampleagain(Table7.5).Strike:Ͳ300Priceofunderlying:Ͳ295Daystoexpiry:13Volatility:64%

Table7.5ChangeofVolatility Vega OptionPremium(Ͳ)54% 0.16 4.0059% 0.17 4.8664% 0.18 5.7569% 0.185 6.6674% 0.189 7.596

AsTable7.5 show,optionpremiums riseas thevolatility increasesand sodoes vega. This is the reason we have been stressing that you buy only lowvolatilityoptions.

Theta

Theta is an estimate of the change in optionvaluegiven a oneunit change intimetoexpiration,assumingotherfactorsremainconstant.Now,thisistheall-important time factor that we have been discussing. Time factor is currentlycriticalinIndiabecausewearereallytalkingonlyaboutthenearmonthoptionsastheothersdonothavesufficientliquiditytoberelevant.

Going back to our example of the Satyam300Call, let’s look at the timedecayofthisoption.(Table7.6)Strike:Ͳ300Priceofunderlying:Ͳ295Volatility:64%

Table7.6Timetoexpiry Theta(7daytheta) OptionPremium('25 -2.3 9.9620 -2.6 8.3615 -3.026 6.5510 -3.53 4.465 -.536(1daytheta) 1.99

Withoutgettingtoodeeplyinvolvedinthemathematicaldetails,Iwouldliketopointout thata tradershouldnote the increasingnegativevaluesof thetaasthe option nears expiry. The theta values are negative because the longer anoptionisheld,thegreateristhetimedecayeffectonit.

We should clearly understand that in India, where there are about twentytradingsessionsinagivenmonth,theoddsarestackedheavilyagainstanoptionbuyer.PersonallyIwouldbeveryhesitant tobuyanyoptionsafter the15thofanymonthforthesamemonth’sexpiry.Pleaserememberthatunlessthemarketistrending,thelossintimevaluecouldexceedeventhegainsfromafavourablemovementintheunderlying.

Rho

Rhoisanestimateofthechangeinoptionvaluegivenaonepercentchangeininterestrates,assumingotherfactorsremainconstant.Rhoisnotimportantfromashorttermtradingperspectiveasinterestratesdonotchangeveryoften.

FactorstoKeepinMindWhenBuyingOptionsDoNotUseOptionsSolelyasaTimingToolIt is important to understand that options have a limited time horizon andpersonally Idonotknowofany timecycleanalysiswhichworksconsistently.This isbecauseevenobvious-looking trends take time todevelopbut the timeclockisalwayswindingdownintheoptionsmarket.It’sthereforeimportanttobuyoptionswithlowvolatilitysothatthereisnopossibilityoflossbecauseofvolatility.

BuyDeepIn-the-MoneyOptions

Aswehave seen in this chapter, it is always better to buy deep in-the-moneyoptionsbecauseeachunitgainintheunderlyingstockorindexleadstoahighergain in the option premium.Also, deep in-the-money options suffer less fromtimedecayastheintrinsicvalueinsuchoptionsishigh.

AlwaysBeReadytoAdjustPositions

If themarket isnotactingasyouanticipated itwould,getoutofyouroptionsposition.The last thingyoushoulddo in theoptionsmarket ishopeandpray.

Quicklyreadjustyourpositionwithregardtothenewmarketrealitybutdonotover hedge as that raises your investment— remember, there is no risk-freetrade.

TrytoReduceYourNetInvestmentbySellingCallsWhereverPossible

Wewillbediscussingtheuseofspreadsinlaterchapters.ThisiscriticalinIndiabecausetheoptionhasverylittletimetowork.Iwouldgototheextentofsayingthatitisalwayspreferabletobuyastockorafutureandsellcallsagainstthembecause they do not have any attached time value.Covered call strategies arediscussedinChapter9.

KeepaReasonableProfitTarget

I generally believe anything over 50% is a reasonable return in the optionsmarket.Unlessthemarketisreallytrendinginonedirection,itisworthbookingprofitsasandwhenmorethan50%profitsareachievedandmoveontothenexttrade. This 50% is the absolute return in amonth because that is the time toexpiryofIndianoptions.

DoNotBuyMoreNakedOptionsThanIsJustifiedbyYourTradingAccount

Itisveryimportanttounderstandthattheoptionsmarketprovidesthekickertoyourportfolio,andthiscannotbe100%ofyouraccount.Personallyspeaking,Ineverkeepmyaccountexposedmorethan10%tonakedoptionbuying.

InIndia,thecultureofserviceinthebrokerageindustryisjustaboutstarting.Beforethemid-nineties,therewerefewbrokersandthesepeopledidnotbothera lot about customer service. At that point, just getting an honest broker wasconsidered being lucky. Now though things are improving,most of the smallbrokersstillliketoputtheonusofresponsibilityontheclient.Asreaders,mustbeaware,inthederivativesmarket,ineachmonthlysettlementeachbuyshouldcorrespondtoasell,whichthebrokerhastomarkastheclosureoftheposition.Butthishastoberemindedtohimthatalongorashortpositionalreadyexistsandthesecondtransactionistheclosingtransaction.

* (Please seeAppendix I for the information on lot sizes for derivatives contracts on all stocks andindices)

Chapter8

StrategiesforTradingOptions

Introduction

Different option strategies are used for taking advantage of the expectedmovement in a particular stock or index. An options strategy may involvebuyingandsellingputsorcalls,orbothatthesame,ordifferentstrikesofstocksortheindex.Thisisdoneinordertotakeadvantageofallkindsofviewsontheunderlyingstockorindex,suchas:

Bullish TrendingupmoveexpectedMildlybullish MildupmoveexpectedNeutral RangeboundmovementexpectedBearish TrendingdownmoveexpectedMildlybearish Milddownmoveexpected

HowtoDevelopaViewontheMarketoraParticularStock

Views on a stock or index are developed on the basis of technical analysis,fundamentalanalysis,orexpectednews.

Inmyexperienceaviewonthebasisoftechnicalanalysisworksbestinthecase of trading options. Am I biased? Maybe. Making money in the equitymarketischallengingenoughmostofthetime,itgetsevenmorechallengingifthereisatimeelementattachedtoit.

Chartsandcurrentpricesoftenhaveallthefundamentalsandnewsbuiltin,moreso inIndiabecauseheresomepeoplearemore informedthanothersandinsider trading is rampant. This is proven by the fact that stocks movespectacularlydaysbeforeannouncementofanyimportantrelevantnews.Sotheonlywaytobeattheseinsidersistoknowwhattheyaredoing,andthatcanbediscovered on the charts. There is no question that over the long term stocksmovebecauseoffundamentals,butwhethertheydosoforthesamereasonsovertheshort termisopentoquestion.Optiontradinghasnothingtodowithlong-term fundamentals because such trades last only onemonth. This leads us toimportanttime-relatedissueswhichweshallnowdiscuss.

WhyTimetoExpiryissoImportantinChoosingOptionsStrategiesinIndia

InIndia,themostimportantpointtorememberisthatpresentlythemostliquidoptions are those of the currentmonth. So nomatter how sure one is about astock’smovement,iftheexpectedmovementdoesnottakeplacebythetimetoexpiry,theoptionsexpireworthless.

Strategies thatworkinIndiaare thusa littledifferentfromthose thatworkworldwidemainlybecause the Indianoptionsbuyerneeds todealwith time toexpiry issues.Worldwide farmonthoptionswhichexpireseveralmonths fromnow, or even years later, are quite liquid. Accordingly, we will discuss onlythose strategies in this chapterwhichareparticularlyuseful for Indian traders.Traders interested in other strategies will find a lot of excellent literatureavailable on the topic on the Net. Also, we will discuss the practical tradingissues and conceptswithout going intodetailed theories, as this book seeks tohelpyoubecomeabettertraderandnotPhDsinderivatives.Ifyouwishyoucanconsultstandardtextbooksonoptionswhichreallygetintopay-offdiagramsforatheoreticalexplanationofstrategies.

The time factor discussed above thus calls for codifying some certainunwrittenrules(beingwrittenforthefirsttimeinthisbook)thatIndiantradersshould follow. Following these rules would greatly improve your chances ofmaking in the Indian optionsmarket. These are ruleswhich experience in theIndianequityoptionsmarkethastaughtthesavvyamongtheIndiantraders.

UseOptionStrategiesWhichInvolveSellingofOptionsasWell

Most successful strategies in the Indian context involve the selling of options.Tradersdosoinordertoreducetheirnetinvestment.Tradersandinvestorsneedtoremember thatevenif thenewstheyhaveiscorrect, itcan take timebeforethe price moves in the expected direction. But if they run out of time on anoption, they are in any case going to make a loss. Option buyers shouldremember that option sellers are very smart people and the chances of theirhavingpriced in fundamentals and expected news is very high. In some casessoldoptionscanevenbe twice thenumberofboughtoptions.Wewilldiscussthisfurtherunderthestrategiessection.

NetInvestmentShouldbeKepttotheMinimumPossibleandReturnsShouldbeCalculatedonNetInvestmentBasis

Investorsand tradersneed toremember,particularlywhenusingstrategies thatinvolve buying options, that they can lose even if the stock moves in theirexpecteddirection.Thiscanhappenifaveryexpensivestrategyisusedandthefavourablemovement is not dramatic enough to offset the high cost.This canalsohappenifveryexpensiveoptionshavebeenboughtandthesellerhaspricedintheexpectedmovementofthestock.

Tradersneedtoalwaysrememberthattheoptionsgameisloadedinfavouroftheoptionsellerwholikestopriceineveryconceivableeventandmovementin themarket or a given stock.All strategies discussed in this chapter seek tominimizethenetinvestment.

High ImpliedVolatility Should beConsistently Sold either as a Straddle or aCoveredCall

TheimpliedvolatilityconceptwasdiscussedindetailinChapter7.Asdiscussedthere, and also in the later chapter on special situations (Chapter 10), sellingoptions offers the best odds for making money. Again, it’s important toremembernottosellunhedged(naked)optionsandtotakeprotectiveactionincaseofunhedgedoptionsoncetheynearbreakdown.

Sellinghighvolatilityoptionsmakesthetaskoftheoptionbuyerevenmoredifficult as it raises the bar above which he can make money. Also, highvolatilityperiodsarefollowedbyperiodsoflowvolatility.Thus,notonlydoestheoptionbuyerlosevolatilitypremium,healsolosesvaluabletimevalue.

TradersMustAlwaysRememberthatMarketsTrendonly30%oftheTime,soStrategiestoCaptureRangeBoundMovementareaMust

Withoptionsitisnotpossibletocapturerangeboundmovementeitherinstocksor themarket.Theimportantpoint tobear inmindhereis that trendingmovesare followed by consolidations, which are again followed by trendingmoves.70% of the time the market moves in a trading range, making no significantmoveseitherupordown.Itisonly30%ofthetimethatmarketsactuallytrend.Sotheoptionsmarketnowgivesatradertheopportunitytotakeaviewontherangeboundmarket.

Aswediscussed inanearlierexample, tradersmust remember that it’snotimportant for your view to be completely right;what is important is that you

keep changing your strategy as the view changes. Often when you positionyourself fora rangeboundmarket, themarketmaywell start trending,orviceversa.Thiscanhappentothebestoftradersintheworld.Whatisimportantisfor a trader to realize this quickly and make the appropriate changes to hisstrategy.Of course, at such times it is helpful to havebought cheaper optionsandsoldthemoreexpensiveones.

BeCarefulofWell-advertisedStrategies,TheyareMoreExpensivetoExecute;ItisSometimesWorthwhiletoPursuetheOppositeStrategy

Financialmediaoftentryto“help”retailtradersbysuggestingoptionstrategies.I wish it were that simple. For example, often during the budget period theyrecommend a strategy calledbuying the straddlewhich involves buying a calland a put of the same strike price. Since everyone tries to get on to thissupposedly money making bandwagon, the straddle ends up being veryexpensive and it becomes impossible to make any money by going in for it.There are other times when buying calls or puts is highly recommended forreducingrisk.Atthesetimesitisworthwhiletodotheoppositesincethemarketwould have alreadydiscounted the entire expected pricemove; of course, thismustbedonewithappropriatehedging.

Don’tGet intoOptions Tradingwithout a ThoroughKnowledge of TechnicalAnalysisandAccesstoChartingInformation

Asdiscussedearlier,itismyopinionthatconsistentmoneyinoptionscanonlybemadebyusing technicalcharts.This isparticularly true in Indiabecauseofthe lack of liquidity involved in the longer-termoptions. I believe only chartscangiveareasonableviewofthepricemovementexpectedinaone-monthtimeframe.

MarketTimingisNottheKeytoMakingMoneyinOptions

Iwouldlikestressthatoptionstradingisnotabouttimingthemarket.Whileitisimportant tohaveaviewonthemarket,buyingorsellingoptionsorstrategiesjust because you believe themarket is going up or down is a little simplistic.Onceyouhaveaviewon themarket, it is critical todetermine the amountoftime in which the expected movement might take place. Thereafter it isimportanttodeterminetheimpliedvolatilitiesoftheoptionsinvolved.Atrader

should thenconsider the implicationsofhis tradenotworkingout,andhaveacontingency strategy to keep one’s loss to theminimum. In otherwords, youneed to clearlyworkout the risk reward ratio.Options trading is rather like agameofchesswherethewinnermaynothavethebestanalysisbuthewouldbetwhenmostparametersareinhisfavour.

GatheringPreliminaryInformation

Thefollowingdrillcanbefollowedinmakingagoodoptionstradingdecision:

Developaviewonthemarket,ortheparticularstock.Trytoassessthenumberofdaysitwilltakefortheviewtomaterialize.As far a possible, use a credit strategy (one that puts money into youraccount) instead of a debit strategy (one that takes money from youraccount).Acreditstrategyworksevenif thestockor themarketdoesnotmoveasmuchasyouexpectitto.Calculatetheimpliedvolatilitiesoftheoptionsinvolved.Thinkabouttheadversescenarioincasethestrategywerenottoworkout.Workoutthebreakevenpointofyourtradeand,ifpossible,trytomakethetrade risk-freeonce the trademoves inyour favourbybookingprofitsoncertainoptionsandbuyingorwritingnewoptionswithdifferentstrikes.

Armedwiththeabovetechniquesandaviewofthemarket,wearenowpreparedto enter the exciting world of option strategies. In each case, we will firstdescribeastrategyand thenshowhow it is implemented in the IndiancontextTheuseofPeterHoadleysoftwareforevaluatingoptionstrategiesisexplainedinAppendixIII.

VerticalSpreads

Averticalspreadalwaysconsistsofonelongoptionandoneshortoption,wherebothoptionsareof thesame type (bothcallsorbothputs),andhave thesameexpiration,butdifferintheirexerciseorstrikeprices.Traderswhoalreadyhaveaviewastothedirectionofthemarketusethesespreads.Consequently,weseethat vertical spreads are of two varieties, the bull spread and the bear spread.What determines whether a spread is bullish or bearish is not whether it iscomposedofputsorcalls.Rather,ifthetrader/investorbuystheoptionwiththelower exercise price and sells the option with the higher exercise price, thespread isbullish.Conversely, ifhebuys thehigherexercisepriceandsells theloweronethespreadisbearish.

CreditSpreads

Acredit spread is, simplyput,one inwhich the receiptofcash from theshortoption exceeds the amount of cash paid out for the long option, inclusive oftransactioncosts.Thus,thefollowingwouldbeconsideredascreditspreads:

Bearcallspreads;Bullputspreads.

DebitSpreads

Conversely,adebitspreadisoneinwhichtheamountofcashpaidoutfor thelong option exceeds the amount received for the short option, inclusive oftransactioncosts.Thus,thefollowingaredebitspreads:

Bullcallspreads;Bearputspreads.

Thereisnobetterwaytointroducethebenefitsofspreadingthanbydirectlycomparing a spread’s risk reward profile with that of purchasing of theunderlying or a “naked” option. This will highlight why spreading can be sovaluable.

NakedOptions

Assumeweweredealingwith thepurchaseof1SatyamComputersApril200call@Ͳ 15and theunderlyingwas tradingatͲ 205.The risk rewardprofilewouldlookasfollows:1.Breakeven:SinceIpaidͲ15forit,IwouldbreakevenontheApril200calliftheSatyamstockwastradingatͲ215.Why?BecauseIhavetorecouptheͲ15IpaidaspremiumͲ200+15=Ͳ215.

2. Profit: I would make money on this April 200 call when the underlyingSatyam share moves above the breakeven point. Since theoretically the stockpricecouldgoupinfinitely,mypotentialprofitisunlimited.3.Loss:IftheSatyamshareweretoclosebelowͲ215upontheoption’sexpiry.Istandtolosemoney.Now,hereisthegreatthingaboutoptions;Idon’thavetoworry about how far belowͲ 215 the stock closes.Unlike in the case ofmyowning the stock, themost I can lose is the total premium I paid for the calloption,Ͳ15inthiscase.Notabaddeal.(Figure8.1)

Figure8.1(a)

Figure8.1(b)

TheBullCallSpread

Thebullcallspreadcomesintoplaywhenatraderisbullishinhisviewoftheunderlyingshare,butperhapsnotsobullishastosimplybuytheshareitself,orbuy naked calls. He wants to gain from the anticipated increase in theunderlying’sprice, but believes that abreakevenofͲ 15mightbedifficult toachieveinthemildlybullishscenario.Ahedgedposition,then,isthebestbetforhim.Sohe settles on a bull call spreadwhich enables him tobet on a bullishpositionbutwithabitofaninsurancebuiltin,ifyouwill,foralowercostthananakedcallandalotlessriskthanowningthestockitself.Weshallseewhythisissoinamoment.

Rememberwe said that a bull call spread is simply a combination of twooptions,alongonewithalowerstrikepriceandashortonewithahigherstrikeprice,wherebothoptionsareofthesametypeandexpirationbuthavedifferentstrikeprices.

Let’slookatanexample:Buy1SatyamApril200call@Ͳ15Sell1SatyamApril220call@Ͳ7NetCostofAprilSatyamBullSpread=Ͳ8Let us now seewhat the possible risk, reward and breakevenpoint of this

bullcallspreadwouldbeandhowitcompareswiththeriskandrewardprofileofanoutrightcall.1.Loss: The most this bull call spread can lose isͲ 8 (orͲ 9,600 per lot),becausewe incurredadebitofͲ15 foroneApril200call,butoneApril220call soldgeneratedͲ7credit.Considering theworstcasescenario—becauseoptionsaretherightbutnottheobligationtoengageinatransaction—traderscanjustletthembothexpireworthlessiftheysowish.

Thus,theloss=Ͳ15–Ͳ7=Ͳ8.

That’salotbetterthanlosingͲ15onthestraightcallpurchase.2.Profit:Thebigcompromiseinspreadingisthatatraderlosesthepotentialforunlimitedgainthathehaswiththenakedlongcall,orinowningtheunderlyingstockoutright.

This is because profit in a bull call spread is limited to the differencebetweenthestrikeprices(higherminuslower),minusthedifferencebetweenthepremiums(premium1minuspremium2),ifandonlyiftheunderlyingisabovethesecondstrikeatexpiration.

Accordinglyintheaboveexampletheprofitwouldbe:Ͳ(220-200)-(15.7)=Ͳ(20)-(8)=Ͳ12.

3.Breakeven:Thebreakevenpoint is equal to the lower strike priceplus thedifferenceinpremiums.

Inourexample:Ͳ(200)+(15-7)=Ͳ(200)+(8)=Ͳ208

So,thebreakevenonourverticalspreadisapriceofͲ208fortheSatyamshare.

Asdescribed in the introductorysectionof thischapter, spreadscanhelpatrader calibrate the risks he takes in line with his degree of bullishness orbearishness.Forexample,ifatraderisfeelingmorebullish,hecanenterintoaspread that offers a greater possibility of reward on the upside; theaccompanyingtrade-offbeingahighercostonthedownside.[Figures8.2(a)&(b)].

TheBullPutSpread

Nowlet’stakealookatthebullputspread.Intheputmarket,thebullputspreadisthefunctionalequivalentofthebullcallspreadinthecallmarketinthatthetraderopting for this spreadhasabullishviewof themarket, andhe sells thehigherstrikeputwhilepurchasing the lowerstrikeput.This scenariocreatesanet credit on the position as awhole because the premiumof the short put isgreaterthanthepremiumofthelongput.

Let’s look at the maximum profit we can make, the maximum loss, andbreakevenpoint:

Figure8.2(a)

Figure8.2(b)Figure8.2(a&b):Payoffdiagramforthebullcallspread

Profit:Thesaleof thisSatyam180/200put spreadgivesan inflowofͲ8.Thiscreditisthemaximumprofitonecanachieve.Ifatexpiration,theunderlyinghasa price above the exercise price of the short put, then both options expireworthless,becausethesearebothputs,andaput is in-the-moneyonlyif ithasintrinsicvalue.Sell1SatyamApril200put@Ͳ15Buy1SatyamApril180put@Ͳ7CreditͲ8

Loss:Theworst-casescenarioforthebullputspreadwouldbeiftheunderlyingexpiresbelow thehigher strikeprice, less thepremiumcollectedatexpiration.Accordingly,thesellerofthisspreadcanlosethedifferenceinthestrikeprices,minustheinitialcredit.Thus:

MaximumLoss=(Ͳ200-180)—8=Ͳ12

Figure8.3(a)

Figure8.3(b)

Figure8.3(a&b):Payoffdiagramforbullputspread

BelowͲ180,the200putisalwaysworth20pointsmorethanthe180put.The20-pointmaximumvalueof thespreadminus thecreditwereceivedgivesusthemaximumloss[Figures8.3(a&b)].

TheBearCallSpreadThebearcallspreadisahedgedstrategythatcanbecomposedwitheitherputsor calls. Like the bull call spread, the bear call spread offers the trader acompromise:limitedrewardforlimitedrisk.Thetraderusingabearcallspreadhasanopiniononthepricedirectionoftheunderlyingshareorindex;heexpectsittodecline.

Therearevariousreasonswhyatradermayuseabearcallspread:hemightwant to enter into a position immediately to take advantage of an anticipateddecline,buthasdecidedthatthecostofentryofanakedlongputpositionistoohigh;or,thetradermighthaveaspecificpricetargetontheunderlying.

You would recall that, by definition, if a trader buys the option with thelowerexercisepriceand sellsonewith thehigherexerciseprice, the spread isbullish;conversely,ifhebuysthehigherexercisepriceandsellstheloweronethespreadisbearish.

It follows, then, that ifwe aregoing in for a bearish spread, andonewithcalls,itwouldlooksomethinglikethis:

Buy1SatyamApril220Call @Ͳ7debitSell1SatyamApril200Call @Ͳ15creditNet Ͳ8credit

Note that if Satyam were belowͲ 200 at expiration, both options wouldexpireworthlessbecausecallshaveintrinsicvalueonlywhentheunderlyingistradingabovetheoption’sstrikeprice.ThetwostrikepricesbeingͲ200andͲ220,anythingunderͲ200meansnointrinsicvaluesforthecalls.

Thisisabearspreadwehaveoptedfor,soclearlyweexpectthemarkettogodown.Remember,wehavealreadycollectedͲ8whenweputonthespread.Soifbothoptionsexpireworthless,thenwesimplypocketthecreditofͲ8.

IfSatyamwere toexpireaboveͲ220, then the spreadwouldbeworth itsmaximum of Ͳ 20. Above Ͳ 220, both options have intrinsic value. Themaximumaspreadcanbeworthisthedifferencebetweenthestrikepricesofitslegs.

Now in this case, we don’t actually collect Ͳ 20. Remember, we havealreadyreceivedaͲ8credit.Sinceweareshortthespread,wereceivedacreditofͲ8foraspreadthatendedupbeingworthͲ20.WejustlostͲ7onthedeal.Notsogreat,butpossiblybetterthanbeingshortthestockornakedcalls.

Tosummarize:

Maximumprofitforabearcallspreadisthecreditreceived;inthiscase,Ͳ8.Maximum loss for a bear call spread, is equal to themaximum possiblevalueofthespread,minusthecreditreceived.Intheabovecase,

Ͳ(220-200)-(8)=Ͳ20-Ͳ8=Ͳ12

Thebreakevenistheshortstrikeplustheamountreceivedforthespread.Inthiscase:Ͳ200+Ͳ8=Ͳ208

Figure8.4(a)

Figure8.4(b)

Thecallweareshortwilllosemoneywhenthestockrises.Itwillcontinueto

losetilltheupperstrikestopsthelosses,thusthemaximumofͲ20inthiscase.SincewecollectedͲ8 tobeginwith, theworstwecando is loseͲ7andthepoint where we start losing (the breakeven) is that the lower strike plus theamountwetookin,namelyͲ208[Figure8.4(a&b)].

TheBearPutSpreadThebearput spread iscomposedofbotha longputandashortputwhere thelongputhas thehigher strikeand the shortputhas the lower strikeprice.Forexample:

Buy1SatyamApril200put@Ͳ15paidSell1SatyamApril180put@Ͳ7receivedCost=Ͳ8debitThe cost of the spread is the difference between the premiumpaid for the

longoption,andthecreditreceivedfromtheshortoption.Let’strytofigureoutwhatthemaximumriskandrewardwouldbeforour

hypotheticalSatyamspread.Theworst-casescenarioisifSatyamclosesaboveͲ200atexpirationinwhichcasebothlegswouldexpireout-of-themoney.

Sincebothoptionsexpireworthless,thetraderwouldlosetheͲ8hepaidforthespread.Thus:MaximumLoss:Thebearputspreadisadebitspread.Themaximumamountoflossinadebitspread(onethathasbeenpurchased)istheamountpaidforit.Inthiscase,Ͳ8.Ͳ15debitlessͲ7credit

Maximum Profit: Figuring out the profit (reward) is a bit more complicated, butshouldstillpresentuswithonlyalittledifficulty.NotethatinourhypotheticalSatyamspread, theshortSatyamͲ180puthasvalue ifSatyamwerebelowͲ180.Inwhichcase,thevalueoftheshortputwouldmatch,rupeeforrupee,thevaluereceivedforthein-the-moneyͲ200put.

Whentheunderlyingisbelowstrike1atexpiration,themaximumprofitinabearputspreadis limitedtothedifferenceinstrikeprices(strike2–strike1),minusthedifferenceinthepremiums(option2–option1).

(AssumingunderlyingbelowͲ180)Long1SatyamAprilͲ200put@Ͳ15Short1SatyamAprilͲ180put@(-)Ͳ7Themaximumprofitequalsthedifferencebetweenthetwostrikes(Ͳ200-

Ͳ180)lessthemoneyspent/received(Ͳ15-Ͳ7)(Ͳ20)-(Ͳ8)=Ͳ12Thus,themostwecanmakeonthisspreadisͲ12

Breakeven:Finally,thebreakeveninthisspreadisthehigherstrikepriceminusthenetpremiumpaid:Ͳ200-Ͳ8=Ͳ192Itisimportanttonotethatthedegreeofbearishnessofthebearputspreadis

determinedbythestrikepriceoftheshortput.Again,thismakesintuitivesense.Thefartheraway,orout-of-themoneythe

short put is, further the underlying has to drop for the spread to reach itsmaximumvalue[Figure8.5(a&b)].

Figure8.5(a)

Figure8.5(b)

Thissectionconcludesouroverviewofthevarioustypesofverticalspreads.

VerticalSpreads:ASummaryofKeyPointsIn this section,wewill summarize some essential points thatmust be kept inmindinordertobecomeamoreproficientdirectionalspreader:

1. Staying spread is staying alive: Putting on a spread means trading thepossibilityofunlimitedrewardforthebenefitoflimitedrisk.

2. Vertical spreads are combinations that are used by a trader who has anopinion on the direction of the underlying. A bear spreader believes theunderlyingwouldgodown,whileabullspreaderfeelsitshouldgoup.

3. Averticalspreadconsistsofat leastonelongoptionandoneshortoptionwhere both options are of the same type (whether puts or calls) andexpiration,buthavedifferentstrikeprices.One-to-oneverticalsaretypical,havelimitedriskrewardprofilesandhavebeendiscussedabove.Butratiovertical spreads are also strategies that are popular amongst advancedoptionstradersandcarryverydifferentriskcharacteristics.

4. Aspread’smaximumvalueisdefinedasthedifferencebetweenthestrikepricesofthetwolegsthatcompriseit.

5. The maximum profit possible in a debit spread (one that has been

purchased)isthemaximumvalueofspread,minusthenetamountpaid.6. Themaximumlossinadebitspreadistheamountpaidforit.7. Themaximum profit potential of a credit spread (one that is sold) is the

amountofcashreceived.8. Themaximumlosspossibleinacreditspreadisthemaximumvalueofthe

spreadminustheamountreceivedfromsellingit.9. Atexpiration,theverticalspreadwillbeworthzeroifbothoptionsareout-

of-themoney.10. patient—andneverovertrade.

Now, letus turn tosomepoints thatneed tobekept inmindwhen tradingoptionsinIndia.

I would again remind traders and investors that options sellers can makemoney inmoreways than can option buyers. Somypersonal preference is totakeoncreditspreads,wherethetradermakesmoneybothwhentheunderlyingmakesamoveintheexpecteddirectionorsimplyhoversjustaboveorbelowthesold put or call. Also, time is in favour of the credit spread. Buying nakedoptions should be ruled out even in a hugely trending market because thebreakeveniswaytoohigh.

OnlyinaclearlytrendingmarketdoItakeondebitspreadsandthen,too,Idon’t focus on the absolute amount of money I make but on the percentagereturnonmynetinvestment.Theotherthingtokeepinmindisthatit’salwayspossible for the underlying to first move in the expected direction and thenretrace theentiremove.Sobookingprofitsalong theway isalwaysadvisable.Profitscanbebookedeitherbyunwindingbothlegsofthespreadorbyrollingoptionsup,downorout.

RollingOptionsUp,DownandOut

Rolling of options is a strategy used to book profits on profitable optionspositionsandstrategies,andonewhichIhighlyrecommend:

Rollingofoptionsconsistsofsellingoptionsofastrikewhich isdeep in-the-money and buying a comparatively out-of-themoney option so thatsomeamountofprofitsarebooked.Rolling up is booking profits on the lower strike option and buying the

higherstrikeoption.Rollingdownisbookingprofitsonthehigherstrikeoptionandbuyingthelowerstrikeoption.Rollingoutmeanswindinguptheoptionspositionalltogether.

Forexample,ifIaminprofitinthe200/220Satyambullcallspread,assoonasthestockreachesaroundͲ220,Iwouldsellthe200callandbuythe210call,thusreducingtheinvestedamount,sometimesevenmakingthespreadriskfree.Or, I would roll out the entire spread, which means selling the 200 call andbuying back the 220 call. This sometimes does not make sense if your shortoptionisnotdepreciatingbecauseoftimevalue,orinotherwordsifthereislotsoftimelefttoexpirythenthedeeperin-the-moneycallappreciatesmoreslowlythan does the comparatively more out-of-money call, so rolling up to bookprofitsistheonlysolution.Tradersandinvestorsneedtorememberthatspreadsshouldgenerallynotbeheldtillexpiry.Wheneverprofitsareavailable, tradersshould take them. If a spread is not working out, it should bewound up andsomethingelseconsideredinstead.

RatioSpreading

Aratiospreadinvolvesbuyinganat-the-money(ATM)ornear-themoneyoptionand selling multiple out-of-themoney (OTM) options with all of the optionshaving the same expiration date. Ratio spreads can be constructedwith eitherputsorcalls.Theratioisusuallytwooptionssoldforeveryoneoptionbought.Thoughyoucancertainlyhaveotherratios,justdon’tgooverboard.Well,thisisastrategywhereinyouputup littleornomoneyupfrontandprofit ifyouarerightbutdon’tlosemuch—orevengainasmallprofit—ifyouarewrong.

RatioCallSpread

Let’sconsidertheexampleofanactualbullishtradeonReliance.ThestockwasthentradingatͲ500.WebelievedthatitcouldappreciatebutwasunlikelytogooverͲ530andthat,therefore,wecoulddoaratiocallspread.Asnotedabove,aratiocallspreadisconstructedbybuyinganATMcallandsellingtwoormoreOTMcalls.Consequently,weboughtoneRelianceApril500call atͲ18andsoldtwoApril530callsatͲ6each.Inessence,wewouldbepayingͲ18fortheApril500callandreceivingͲ12forsellingthetwoApril530calls.AtmosttimesͲ30isenoughinabigsharesuchasReliancebutperhapsnotinthekindofroaringbullmarketwewerethenin.Ontheotherhand,Ididnotwanttoloseif therewereasharpcorrection.Sometimesif thepremiumsreceivedaremorethanthepremiumpaid,thespreadmightbedoneatacreditbutIdonotliketomake the spread so risky that both the short calls get exercised againstme. Ifratiocallspreadsaredoneatacredit,youcaneliminateallofyourdownsideriskandget to keep the credit even if the underlying goes to zero.Two importantthings thatoption traders shouldalwaysbeawareofare theirmaximumprofitpotential and the breakeven point. They should know howmuchmoney theystandtomake,andatwhatpricewouldtheybreakeven.

I can use a complex formula to explain this but I would rather use thisexample. Equally, I’d advise traders to also work out the maximum profitpotentialandbreakevenwithoutgettingintoformulas.

NowsincethenetdebitinthistradewasͲ6,thebreakevenpointwasͲ506.ThemaximumprofitwouldbemadeatͲ530whereonewouldmakeͲ12onthelongcallandgettokeepͲ12creditoftheshortcalls.SothetotalmaximumprofitwouldbeͲ12+Ͳ12=Ͳ24,whichwasfourtimestheinvestmentandagoodpercentagetradeconsideringourviewonthestockandthelowbreakeven.

Ontheotherhand,onewouldstartlosingonthistradeifthestockmovedupmuchhigher thanͲ 530because theone longcall is hedgedby theone shortcall;andyouhaveanextrashortcallwhichcomesintoplaybeyondͲ530.AtͲ530 one would have madeͲ 12 on the long call (which provided a kind ofprotectionoverͲ530),plusͲ12thatwasreceivedaspremium.So,onnetbasisontheupside,onewouldmakealosstillthepricewentaboveͲ554.ThisisthewayIlookatratiospreads.

Wehadinitiatedthistradeon4April2004.ReliancetookitstimegettingtoͲ 530 during the month and the expiry was around the 27th. On the 23rdReliancewasquotingatͲ526,sosincemylongcallwastradingatͲ24andthe

shortcallstradingatͲ4each,IdecidedtorolloutofmypositionsentirelyandmadeͲ16onaninvestmentofͲ6.

A similar analysis is possible for ratio put spreads.An examplewould bebuying1Reliance500Putandselling2Reliance570Puts.Tradersshouldtrytofigureouttheabovevaluesfortheputratiospreadsaswell.

There are however certain caveats that traders and investors need toremember:

Earlieronwesawhowimportantitwastoestablishthespreadatacredit,sinceiteliminatedthedownsideriskinthecaseofaratiocallspread—orupsideriskonaratioputspread.Manytimesit isnotpossibletoobtainacredit when initiating a ratio spread. Only when there is a disparity inoption premiums, and implied volatilities of OTM options are highcomparedtoATMoptions,aretheregoodopportunitiesforratiospreads.Traders should sell options that have a low probability of going in-the-money. Don’t sell strikes that have a good chance of becoming in-the-money.Focusonsellingstrikeswhichareasfarfromthecurrentpriceaspossible.

Theratiospreadisanexcellentstrategyfromarisk-and-rewardstandpoint.Itisaneutraltomildlydirectionalstrategywithlittleornoupfrontcosts.Youcanprofitwhenyou’rerightandevenprofitwhenyou’rewrong.Theonlytimeyourunintotroubleiswhenyou’reprovedtooright.Goodratiospreadopportunitiesare not available every day. But when conditions are right, you should startlookingforthem.

Straddles

BuyingaStraddle

Strategy

Buy anATM call and anATMputwith the same strike price and expirationdate.TimeDecayEffect:Detrimental.Situations: Look for a market with low volatility about to experience a sharpincreaseinvolatility.Profit:Unlimited.Profitrequiressufficientmarketmovementbutdoesnotdependonmarketdirection.Risk:Limitedtothenetdebitpaid.Marginisnotrequired.UpsideBreakeven:Strikepriceplusnetdebitpaid.DownsideBreakeven:Strikepriceminusnetdebitpaid.

Buying a straddle consists of buying a call and a put of the same strike,whetheroftheindexorastock,whenasharpupwardordownwardmovementisexpected. It is a very expensive strategy as the net debit can be large and isjustifiedonlywhenamovecommensuratewiththatkindofdebitisexpected.InIndiasincethereisonlyamonthforthisstrategytoworkout,it’simportanttowind it up once the particular news is announced, or equally if the expectedmovedoesnothappenbecausethetimevaluecaneatawaythepremiumsveryfast.Also,sincethisstrategyhasbecomepopular—becausepeopletendtobuystraddles around the budget or around result announcements — the impliedvolatilitiesoftheconcernedoptionsrisetoveryhighlevelscausingstraddlestolose some of their sheen. It still remains viable at high market levels and instrong trending markets where the markets move more than the entire debitbeingpaid.Itcanalsobeusedifthevolatilityofthemarketdiminishes,andthemarket is about tobreakout ineitherdirection.Butbecauseof the time factor,tradersshouldbeverycarefulofpayingthehighpremiumsinvolved.

As it is a riskyproposition atmost times, traders have foundvariations ofstraddles to trade sharp moves. For example, if a trader feels there is a 60%chanceofabigsharpupmoveand40%chanceofasharpdownmove,hecanbuyfuturesandat-the-moneyputs.Thiswayhepays thepremiumofonlyone legandgetsexposureinbothdirections.Asthemarketmovesinonedirection,onelegofthisstrategycanbecoveredwhileretainingtheother.

Let’srunthroughanexampleofaNiftystraddle[Figures8.6(a)&(b)].AssumetheNiftyistradingat1,500,andasharpmoveisexpectedineither

direction.

The1500CallisboughtforͲ52andthe1500PutisboughtforͲ48,sothebreakevenforthisstraddleis100pointsupordown,i.e.above1,600orbelow1,400.Insuchacase,IwouldbookprofitsifIamgetting150pointsoneitherside. If the Nifty ends between 1,400 and 1,600 there will be loss, with themaximumlossoccurringat1,500.

If the Nifty ends between 1,400 to 1,600, the loss would be 100 (TheabsolutedifferenceoftheNiftyatexpiryandstrikepriceofthestraddle,whichwas1500.IftheNiftyatexpiryisat1,464,thelosswouldbeͲ64.

IftheNiftyendsupat1,640,theprofitwouldbe:Ͳ(1,640-1,500)-100=Ͳ40.

Figure8.6(a)

Figure8.6(b)

Figure8.6(A&b):Pay-offDiagramsforBuyingaStraddle

Idonotbelievethatastraddleshouldbeheldtillexpiry;anystraddlewhichis going to be profitable will work out soon after it’s been put on. Holdingstraddles which are not profitable till expiry can lead to huge losses as thepremiumsgeteatenaway.

Traders should avoid buying straddles at very high implied volatilitiesbecause in such cases the sharp move might already be built in the optionpremiums and after the expected event or news if the markets become rangebound,premiumscanfalltoevenhalfifthepricehasnotmoved.Forexample,in theabovecase thepremiumscould fallbyabout50%and the total straddlecouldbeavailableforonlyͲ50,eventhoughtheNiftymaystayat1,500—andthiscouldbebeforeanytimedecayis takenintoaccount. Ingeneral,straddlesshouldbeboughtintimesoflowimpliedvolatilities.

SellingaStraddle

Strategy

SellanATMcallandanATMputwiththesamestrikepriceandexpirationdate.TimeDecayEffect:Helpful.Situation:Lookforahighlyvolatilemarket thatseemstobeenteringaperiodoflowvolatility.Profit:Limited to the net credit received.The less themarketmoves, the betterchanceyouhaveofkeepingpremiums.Risk:Unlimitedonbothsides.Marginisrequired.UpsideBreakeven:Strikepriceplusnetcreditreceived.DownsideBreakeven:Strikepriceminusnetcreditreceived.

Sellingastraddleconsistsofsellingaputandcallofthesamestrikeprice.This is one ofmy favourite strategies and I don’t think I have to repeatwhy.This strategy is best employed when options are trading at high impliedvolatilitiesand themarket isexpected tobecomerangebound.Suchastraddlemakesmoneyifthevolatilitiesdecline,itmakesmoneybecauseoftimedecay,andofcourseifthemarketstaysrangebound[Figures8.7(a)&(b)].Here,too,theobjectiveshouldnotbetoholdtillexpiry.

Figure8.7(a)

Figure8.7(b)

In the foregoing Nifty example, selling the 1,500 call and the 1,500 put

wouldconstitutesellingastraddle.

ItwouldmakemoneyiftheNiftyweretoremainbetween1,400and1,600.ThenetcreditwouldbeͲ100pershareoftheNifty.Thestraddlelosesmoneybothover1,600andunder1,400.If the Nifty closes at expiry at 1,500, the straddle could achieve themaximumprofitofͲ100pershare.IftheNiftyclosesat1,540atexpirythecallwouldbeͲ40in-the-moneywhiletheputpremiumofͲ48andthebalanceofͲ12onthecall—atotalofͲ48+12=Ͳ60—becomestheprofit.If theNiftyclosesat1,640, theputwouldexpireworthlesswhile thecallwouldbeworthͲ140,sothetotallossinthestrategywouldbeͲ40.

Generally, I consider the sellingofa straddle tobeaplayonhigh impliedvolatilities and if thesedrop, theprofit is good enough tobe carriedhome. InIndiaduringthelastcoupleofyears,sellingstraddleshasbeenmoreusefulthanbuying straddles even during the budget period. This is because people still

expect the market to move 100 Nifty points post-budget, whereas smartprofessionalsarenowbeginningtotreatthebudgetasmoreorlessanon-event.Mosttimesthestraddleisprofitableifexecutedbyproperlycapitalizingonthehighimpliedvolatilities.Butduringtrendingmarkets,actionsometimesneedstobe taken tochange thepositionaccording tomarket conditions.Remember, inthis strategy a margin of Ͳ 40,000 may have to be paid for a one contractstraddle,i.e.onecallandoneputsold.Alsosincesellingnakedoptionsisalwaysdangerous,itisimportanttokeepopenyourhedgingoptionsasthepricesmovetowardsdangerzones.

The example below would explain how a short straddle position may bemanaged.

ThiswasarealtradeItookon21October2003.TheNiftyhadralliednon-stop to 1,570 from 920, and it then corrected about 30 points to 1,540. So Iexpected the Nifty to stay range bound between a 100-point range andconsolidate.Alsoasonlyelevendayswereleftforexpiry,withsomeholidaysinbetween, so a straddle seemed safe. I, therefore, sold a Nifty 1,540 Octoberstraddleforabout60pointson20October.Thelowerboundaryofthestraddlewasthus1480andhigherboundarywas1600,whichlookedsafeatthatpoint.

What actually happened was that the very next day Nifty fell another 35pointsto1,505,andsuddenlythestraddlepositionseemedtolooklikethemostdangerous position to have. The Nifty had a huge support at 1,500, and itbouncedupfromitacoupleof times,but finally itwentstraight through,so Ibought 1,480 puts forͲ 16 in order to protect the downside.With the Niftytrading at 1495 and having decisively broken 1,500, I covered my short put,whichwas the losingposition forͲ 60 and tookon a further bearish positionbuying in-the-money Nifty 1,500 puts for Ͳ 30. As the market continued toweakenitbecameclearwewereontherightsideofthetradeandsoweheldon.Nifty closedat1,473on23October. I checked theNifty’sdaily7-periodRSIand it was close to 40. Now this was the signal that themarket had droppedenough.Sothenextdayasthemarketdroppedto1,460wesoldthe1,500putsforͲ 45 and the 1,480 puts forͲ 32 which gave us a nice profit. The onlyposition we then had was short 1,540 calls, which seemed like a safe distantposition.Assoonaswesoldourputsintraday,themarketstartedmovingupandkeptonmovingupandfinallyclosedat1,506afterhavingtouched1,453onthesameday.Thiswason24October,the25thand26thwereSaturdayandSunday.Sonowtheshort1,540callscameunderthreat,andwewereclosetotheoptionsexpiry(31October2003)sowedecidedtobuy1480and1,500Novembercalls

at the beginning of trade on 27October, one set of calls as a calendar spreadbecausethemarketwasmoving40pointsaday.

Well, thankfully, as we bought the calls on Monday the market startedcorrectingandthenralliedsomeonThursday.The1,540callsexpiredworthlessasthemarketclosedat1,520,whichwaswhatwehadoriginallyexpected.Ifthe1,540OctobercallshadnotexpiredworthlessourplanwastosellonesetoftheNovembercallsonthedayoftheexpirytocoveranylossesontheexpiringcall.Asitturnedout,inthebeginningofNovemberwewerelongtwosetsofcalls—1480atͲ54and1500atͲ47—andthemarketralliedcloseto90pointsonthefirst two days and we liquidated these two sets of calls forͲ 85 andͲ 75,respectively. So the total transaction yielded us a profit of about 93 points,although themarkethadfirstgonedownbelowourexpectationsand thenrosebeyondourexpectations.We were never right about the market, but we took the right actions as themarketchanged.Wewerenimbleinrecognizingthatthemarketwasnotactinglike we’d expected and took remedial action immediately, without hoping orpraying.Also,we tookquickprofitsas soonaswemade50%ormoreonourpositionsinsteadofexpectingtoomuch.Thelessonisclear:thekeytomakingmoney in the derivatives market is leaving your ego at home when you gotrading.Ifthemarketisnotbehavinglikeyouwantitto,youneedtofallinlinewiththemarketquickly.Ofcourse,sometimesyouarelikelytogetwhipsawedbutthenthatisanoccupationalhazard.

Chapter9

TheCoveredCall

WhoSays4%ReturnsperMonthareHistory

Times have changed since the early 1990s when even true-blue Indiancorporates had to borrow funds at 16% per annum. As the Indian economyliberalised, interest rates started falling asotherwise the Indian industrywouldhave been rendered uncompetitive in theworld economy.Good as the fall inrateswasfortheIndianeconomy,itwasbadnewsforthosedependentonfixedincome investments. Till 2001, Indian stock market traders had the badlasystem,whichwasamethodofinnovativestockmarketfinancing.Inthebadlasystem, the leveraged positions ormargin tradingwas financed by borrowingfunds from individuals andcorporates at stockmarketdetermined rates.Theseratescouldbeashighas4%permonthingoodmarkets,withtheaveragebeingabout2.5%.

Theproblemwas that some smart operatives likeKetanParekhcould takethe system for a ride. They bought shares through badla by paying the 10%margin,andwhenthesharesrose,theyusedtheirpapergainsasfurthermargintobuyevenmoreshares.Thesehighlyleveragedshareswerethenpledgedtoco-operativeandotherbanksfromwhomadditionalmoneywasborrowedtoinvestin the market. Some banks merrily lent them money without any regard tobanking norms. The stock market fell and we all know what happened. Iconsider these to have beenmore of banking scams rather than stockmarketscams.Once the technology stocks fell outof favour,whatwasan investmentgonesourbecameascam.

Theregulators,however,concludedthattheloopholeinthesystemwasthatIndiancashandleveragedmarketswereinter-linked.Ofcourse,thatisthewayitoughttobebutintheirzealtobeseentobemakingthestockmarketasafeplaceto invest, the regulators held the badla system responsible for all ills in thecountryandbanned it in2001.Thus,asourceofregularhighreturnsfromthe

stockmarketfortradersandcorporatealsoended.In2001,thestockmarketregulatorSEBIintroducedthefuturesandoptions

marketinIndia.Thederivativesmarketcanactuallybelookedatasaleveragedmarket being financed by sellers (writers) of derivative products who take afixedinsurancepremiumfortherisktheyareassuming.

Why do these option sellers assume this risk? And how are they hedgedagainstadversemovementoftheunderlying?

Well, theanswer is that theydosobyowning theunderlying.Writingcalloptions when you already own the underlying is called writing covered calloptions. Some people like to own particular stock futures or index futuresinstead of the actual stock or basket of stocks. If investors and traders findnothingelseusefulinthisbook,Ithinkthisonestrategywillpayforthebook’smodestpricemorethanahundredtimesover.Readersshouldrememberweareagainstwritingnakedoptionswhichcanhaveunlimitedrisk.

WhyCoveredCallWritingMakesSenseinIndia

Let’s understand how writing covered call options works. As discussed inChapter7,acallistherighttobuyanunderlyingassetaboveacertainprice,andbefore a certain date. Now the only liquid calls in India are the near-monthexpirywhichmeansthatthereare,atmost,30daysforthecallstoexpire.IfyoueliminateSaturdaysandSundays, it leavesonly22days.Throwinacoupleofmoreholidaysand theperiod reduces toanaverageof20 trading sessionspermonth.Nowlet’sunderstandthenumberofwaysthecoveredcallsellerbenefits:

1. If the options volatility reduces, hemakes the difference of the volatility

premium.2. Asthetimetoexpiryreduces,hemakesmoneyonthetimevalue.3. Ifatexpirythepriceisbelowthestrikeprice,hemakestheentirepremium,

noquestionsasked.

Turntheaboveadvantagesontheirhead,andtheyturnintodisadvantageforthecallbuyer.Thepoorfellowthinksheisminimisinghisriskbecausehehaspaid a fixed amount and that is all he is risking. Actually, though, hemakesmoneyonly if thepriceof the stock rises,nay trendsup, strongly.Experienceshows thatmarkets and stocks trend only 25-30%of the time. Sowhomakes

money most of the time? Clearly, the option writer does. World-wide datasuggeststhatonly15%oftheoptionsareactuallyexercised.Thereasonforthisissimple;marketsdon’ttrendmostofthetime.Itisonlyduringtheserelativelyraretrendingperiodsthatoptionbuyersmakemoney,therestofthetimewhenmarketsconsolidateorturnsideways,itistheoptionwriterwhomakesakilling—or,asIcallit,getsrentfromhisbuilding.Amonthissimplytooshortatimefor an option buyer tomakemoney except in a raging bullmarket.The retailinvestorsalwaysforgetthatthereisnofreelunchinthemarket.

I like looking at stocks as assets and Indians identify very much withbuildingandrealestateandenjoyearningfancyrentseverymonth.Well,nowtheycandosoandalltheyneedtodoistobealittlecareful.

Ifthestockstartstrendingupwards,howisoptionwriterprotected?Well,heis protected because he owns the underlying. In a delivery settled system hewoulddeliverthestockbutinIndia’scashsettledsystemheneedstopayonlythedifferencebetweenthestrikepriceandthestockpriceprevailingattheendofthemonth,whichhecandobysellingthestockheowns.Sotheupsideriskiscoveredbecauseof his ownershipof theunderlying. If the covered callwriterwritesacallalltwelvemonthsoftheyearinagoodmarketandmakes4%permonth,it’sareturnof48%perannum,andthattoowithoutcompounding.Therearenotall thatmanyassetsaroundwhichcangivethatkindofreturnwith thelevelofriskbeingassumed.Generally,thecallisnotexercisedtillitisdeepin-the-money.Howeverwhen it is exercised, the trader can simplywrite a new,highercalloption.

But,remember,thecoveredcallwritermayloseifthestockstartsdecliningsharply.This is theonlyeventuality, inwhich thecoveredcallwritercan lose.Butthispossibilitycanalsobereducedbyatechnicalanalystwhochooseshiscoveredcallstocksproperly.Thecallwritercanthusgreatlyreducetheriskofwritingcalls.Inreality,therefore,thecallbuyerisnottheonereducinghisrisk.Actually,he is theone that is takingall the riskand isgiving thecall seller aconsistent,highreturnonhisstockholding.

For the purposes of this chapter wewill assume a one-to-one relationshipbetween stock ownership and call writing, although ratio writing and mixedwritingarealsomethodsthatareused.Thesearenothingbutmodificationinthenumber of calls written or shares owned to change the risk/return equation.Thesemethodscanbedevelopedbythecallwriteronceheiscomfortablewiththe concept. This is the gist of covered call writing; now let us delve into adetailedanalysisofhowtowritecoveredcalls.

Also, I would like to make it amply clear that this chapter assumes asideways, mildly bullish, or an extremely bullish market. If the marketenvironmentisverybearishwhereeverystockisgettingslaughteredtohalfitsvalue, writing covered calls may not do you any good. In such situations, itwouldbeadvisabletowaittillthemarketcompletesitssharpfallsandgoesintoa sideways mode in forming a basing formation. These bases often take sixmonths to form, sometimes it could take as long as two years. Investors andtraderscanthenagainstartwritingcoveredcallsoncethemarketbottomsout.

WhatKindofReturnsAreWeTalkingAbout?

Let’s have a look at all at-the-money call optionswhichwere available on 12December2003togetanideaofthemonthlyandannualreturnsonecanaimfor.Theexpirydateforthatmonthwas24Decemberwhilethecontractstartedon28November.ThewayIliketocalculatethenearestat-the-moneycalloptionisbyusingarounding-offsystem.Forexample,ifthestockpriceofACCisbetweenͲ 210andͲ 215, thecalloptionweconsider is theͲ 210calloption; if it isgreaterthanͲ215butlessthanͲ220,weconsidertheͲ220calloption,andsoon.Suchrounding-offfitswellinmyschemeofthings.Aggressiveinvestorscansell one strike further out-of-money, conservative investors can sell one strikefurther in-the-money; I just happen to like themiddle ground.Readers shouldrememberthatsincealloftheseoptionshadonly12daysleftforexpiry,someamount of time value had already been realised. The option premiums at thebeginningofacurrentmonthcontractcanbeexpectedtobemuchhigher.Thisexerciseisjusttogiveaflavourofthekindofreturnsavailable.Obviously,thesereturns are approximate and can vary from month to month since optionpremiumsdependonvariousfactors.(Table9.1)

Someof the abovehigh returnsmay lookvery attractive, but there canbe

issuesofliquidityandbid-askspreads.

HowCoveredCallWritingCompareswithSimplyGoingLong

Suppose one had bought ACC stock at Ͳ 215, sold a 220 call for Ͳ 15 onDecemberof2003(Figure9.1).

Figure.9.1:StockPriceatExpiration

In theabovecase, thecoveredcallperformsbetter thanjustholdinga long

stockatallpointsotherthanaboveͲ235.WethereforemakemoneyiftheACCstocktradesabovetheͲ200mark.ThatisbecauseiftheprevailingstockpriceisͲ215,yougetͲ15upfrontandsoyourbreakevenisͲ200.SotheoreticallywehaveastoplossofͲ15evenbeforewegetintothetrade.

Nowlet’sexaminethethreescenarios,whichcanoccur.ACCClosesBelowā220IfthestockclosesbelowͲ220attheendofthemonth,sayatͲ210,youpockettheentireͲ15premium.Infact,wearefinesolongasthestockdoesnotclosebelowͲ200,becausewehaveaͲ15hedgeagainstafall.Asaruleofthumbitis reasonable to assume that the hedge is 50 paise to every rupee loss in thestock,i.e.ifthestockgoesdowntoͲ200,theoptionwillgodowntoͲ7.5.Theproblemstarts if thestockstartsdecliningbelowͲ200. Inmyexperience thatcanbeavoidedby:

1. Usingtechnicalanalysis,and2. Writingadeeperin-the-moneycall.

Typically, I would like to write an at-the-money call, or a call one strikeabovetheprevailingstockprice,ifACCandthemarkethadjustgonethroughareactionandACCwaseitheratasupportoratthelowerendofatradingrange.If themarketand/orACChadjustralliedsharply,Iwouldlike towriteoneortwo in-the-money strikes if possible in order to get more protection on thedownside. This may get me lower time premium but the protection on thedownsideiswelcome.Forexample,ifthestockpricewasͲ215afterarally,Iwouldrathersellthe210callwhichwouldsellforaboutͲ20.ThiswouldgivemeͲ5asanextrahedgeagainstafall.Iknowtraderswhosellonlyonedeepin-the-moneystrike,whichisaconservativeapproach.Anotherchoicewouldbetolookforadifferentstockwhichhasnotrecentlyrallied.ACCClosesAboveā220IfitclosesaboveͲ220youmakeͲ5instockappreciationandͲ15inoptionpremium,soyoureffectivereturnfor themonth isabout10%If,however, thestockclosesatͲ230attheendofthemonth,yougetͲ15asstockappreciationbutsincethecallyouhavewrittenwouldbeexercisedagainstyou,youendup

keeping onlyͲ 5 out of that and paying outͲ 10.AboveͲ 220, your returnremainsconstantatͲ20('5+Ͳ15)andyougetnofurtherappreciation.

AssumingACCclosesatͲ235forthecurrentmonth,IwouldonlywritethecallforthenextmonthifthetechnicalpositionofACCindicatedthatthepricewould hold steady for another month. This could be a Ͳ 230 or a 240 calldependingonthetechnicalpositionofthestockandthemarket.Incaseofabigverticalrun,Iwouldlookforanotherstockthatfulfilsmycriteria.ACCClosesatā220ThisistheidealsituationintermsofgettingthebestofbothworldsanditdoeshappenwithastocksuchasACC.Itallowsyouanothermonthofwritingat-the-moneycalloptionsatͲ220.SinceIlookatacoveredcallintheIndianscenarioasfreshinvestmenteverymonth,Iwouldliketoevaluatewhethertheconditionsforwritingthecoveredcallarestillthesameastheywereinthepreviousmonth,andthestrikesavailable,ormoveontosomeotherstock.

There isonepoint investorsand tradersmust remember if theycontinue toholdthestockforlongerthanamonthandkeepwritingoptionsonit.IntheUS,thestock iscalledwhen thecalloptions isexercisedand that is theendof thestory.But in the Indian context of cash settlement, if the stock goes up everymonthandthecallsagainstthemareexercised,youwillhaveanetcashoutflowbecauseyouwouldneed topay thedifferencebetween thestrikepriceand theprevailingprice.Nodoubtthestockwouldhavegainedinintrinsicvalueaswellduring that period but those gainswill remain notional unless, of course, onesellsthestock.Soifthestockdropssharplyinvalue,whichmeanswaybeyondtheavailableoptionpremiums,investorswouldstandtolosethegainstheymadefromthecoveredcalls.Soitisimportantthatanevaluationbedoneafresheverymonth as towhether the same stock should be used again forwriting coveredcallsbasedonitstechnicalposition.

Thiswasreallythebasecasewhereanat-the-moneycalliswrittensincethetimepremiumyoureceivehasthemaximumtimevalue.Laterinthischapterwewill discuss writing lower and higher cases and the conditions in which suchchangesmightbenecessary.

Aswesawabove,thecoveredcallwriterdoesbetterforallpricesunderͲ235.Whichmeanswegetamonthlyreturn6%ifthestocksustainsabove'215.Ifyouarealong-termholderofthestock,andthestockdoesnothingforayear,youcanmakeͲ180inayearonastockthathardlymoved.

ACCisoneofmy favourite Indianshares towritecoveredcallson.There

areseveralreasonswhyIlikeACC.Forone,Iliketoworkinabsolutenumbers.At a stock price ofͲ 215, and with a market lot of 1,500 (you need to buyoptions in market lots of the underlying to hedge on the upside, so this is afactor)requiresaninvestmentofͲ322,500atthetimeofwriting,outofwhichyougetͲ22,500upfrontbywritingaͲ15,220call.Thisisareturnofabout6.9%.Thisisunheardofreturnanywhereoutsidethestockmarket.Thereasonwhymanymorestockmarkettradersdon’tgoinforthisstrategyisprobablythatit’snotconsideredsexytomakemoneyinthis“passive”manner.

Let’snowturn to theACCchart for the3-yearsperiod,2001-2003(Figure9.2)

Figure9.2

As you would note, the ACC chart really did nothing exciting for long

periods of time. This is because the cement industry shows bursts of activityonce in awhile, but generally does nothing exciting. SoACCdid nothing foraboutthreeyearsandmovedinarangeofͲ130180,andwhenlatein2003andearly2004theentiremarketrallied50%,itralliedonly20%,thusdisappointingitslong-termshareholders.

It is true that the6%permonthreturn isabullmarket returnforwritingacoveredcalloption,agoodaverageforalltimesforanat-the-moneyACCcallcouldbe3percentmonthly.Ifyouhadbought1,500ACCsharesin1999atͲ180andheldon to them till 2003, youwouldnot exactlybedelighted.As an

investorwhowaslongonlythestockyouwouldhavemadeͲ60,000(atapriceofͲ220).Bywritingcoveredcallsatareturnof3%permonth,whichisaboutͲ8,100permonth takinganaveragepriceofͲ180,youwouldhavemadeͲ97,200annually.ForthefouryearstogetheryouwouldhavemadeͲ3,88,800.Yes,folks,andthatiswithoutcompounding.So,ineffect,youwouldhaveyourentireinvestmentback,plusyourstockholdingwouldhavebecomefree.

You can find the difference in the percentage return yourselves. And theimportant thing is that you don’t have to watch the markets closely andcontinuously like you have to when trading futures. So what you have is apropertywhichgivesyourenteverymonth,andwhereyouhave theoptionofdecidingwhatyouwanttodoeverymonth.Forthe70to75%ofthetimethatthemarketsmovesideways,Idon’tknowofanystrategytobeatthisone.

DecidingontheStockstoBuyandtheStrikestoWrite

SelectionofStocksACC is the perfect example of a stock forwriting a covered call, a sidewaysmovingstockofalargecompanywhichisnotexpectedtogobankruptanytimesoon.Suchstocksareno longergrowthstocks in themarketandmakeperfectcandidatesforcoveredcallwriting.Thisisthefirstcriterionforselectingstocksforwritingcoveredcalls.

Youcanselectgrowthstocksaswellbuttheyaremorevolatileandtherisk-adjusted returnsmaynot be in your favour.We all sawwhat happened to thegrowth oriented technology stockswhen the growth fell off in 2003. Sowithgrowthstocksyoumightlosetheupsideandgetchoppedonthedownside.Itisveryimportantthatthestockyouchooseshouldnothaveaspeculativebubble,atleastnotofthekindthathastakenthestockpricetentimeshigherandmadeitclearly overvalued. That is the reason I select industries that are not currentlyfanciedby themarket.Also, Inever selecta stock that isnotamarket leader;undernocircumstancesdoIwantthestock’spricetofall.Evenifitdoesfall,itshouldnotloseitsbottomaltogether.

Iwould notmindgivingup a percentage on the premium for a lower riskstock.Infact,Iwouldadvisecoveredcallwriters todesistfromchoosingveryrisky or volatile stocks, no matter how high be the premium they might get,becauseifthestockdrops25-30%,investorswillgenerallylosemuchmorethanthepremiumtheyreceive.

Mychoicesgenerallyarestockswhichtradeheavyvolumeseveninthecashsegment, such as Reliance (big market heavyweight), Satyam (yes, it’s atechnologystock,butIwouldtakeitwhenit’snotinasharplydecliningmood),Tisco, Gail (very stable stock, monopoly in its business), Hind Lever (whichdoesnothing foryears,has strong institutionalholdingand sowillnot see thebottomfallingout;thepremiumyoureceivemaybealittlelow,butwellworththecapitalprotectionitgives),andsometimesspecialsituationstocks,butverycarefully.ThesecouldbeHPCLandBPCLwhenpeopleareexpectingacabinetdisinvestment committee meeting. (As of this writing the market has becomeusedtopoliticalsquabblingoverdisinvestments.Sothedivestmentthemeisnotexactlyasfanciedasitwasearlier).Otherinterestingcandidatescansometimesbestocksofcompanieswhicharefundamentallystrongbutwhichdeclineforacoupleofdaysbeforetheirquarterlyresults.Thereasonforcapitalisingonthesesituationsisthatunlessthenewsisearthshattering,itsimplicationsarealready

built intotheoptionpremiumasvolatility.Andevenif thestockdeclinesafterthe news is out, there is enough cushion. This is not an exhaustive list butcertainlygivesaflavourforwhatyoumightliketolookatwhilechoosingstocksforcoveredcallwriting.

Insum,thekeyhereisthat:

1. Thestockshouldnotbeataresistanceorbeoverbought;and2. Thecompanyshouldnotbe“operatordriven”andshouldbewellrunand

backedbyinstitutions.

AlthoughIamatechnicalanalyst,Ibelievethattechnicalsworkmuchbetterwith well-run and highly liquid companies which have widely-spreadshareholding. Iwould avoid any stockwhich has had a vertical run and is upagainstoverheadresistance,nomatterwhichcompanyitis.

Stocks for covered calls can be selected on the basis of an averageknowledge of technical analysis. By average, I mean sufficient knowledge toenable you to select stocks which are either in uptrends or in sidewaysmovement.Icallthisaverageknowledgeoftechnicalanalysisbecausetoensurethat a stock does not fall beyond a certain value is perhapsmuch easier thanidentifyingafuturesset-upwhichneedstoworkinthreedays.Oneshouldavoidstocks which have bearish patterns, or those which may have a tendency ofdecliningvery sharply. If youobserve the chart of any stockover the last 4-5years,youwillbeabletoseeitsprice“character”.

Liquidity

ThekindofstocksIlikeforwritingcoveredcallsareoneswhoseonestrikein-the-money,out-of-the-moneyandat-the-moneyoptionsareveryliquid.AmongtheIndianstockswhichhavederivatives,thisispresentlynottrueforall.Sothepricediscoveryisnotequallygoodinallcases.Alsoifyoushoulddecidetorolloveryouroptionsposition,youwouldneedtofindbuyersandsellers.Don’tLettheTailWagtheDog

It is important for a trader to remember that it is the underlying stockwhichdeterminesthevalueof thecall,andnot theotherwayaround.It issometimeseasy to get carried away in trying to earn the maximum premium, but theobjectivesofthisentireexerciseare:

1. Toensuresafetyofcapital,and2. Tomakeaconsistent,steadyreturninthemarketandreducingthevolatility

oflong-termsreturns.

Theobjectiveisnottotakeundueriskbychasingthebestpremium,buyingunderlying stocks of questionable nature, or buyinggood stocks at overvaluedconditions. I am stressing this point again because awrong stock, or the rightstockboughtatthewrongtime,caneasilyleadtoatraderlosingconfidenceinagoodstrategy.

StopLoss

As the covered call only protects the covered call writer to the extent of thepremium,it’sextremelyimportantthattraderskeepsomekindofastoplossincase the stock starts declining in a major way, such as breaking of crucialsupports,breakingdownfromarange,someunexpectedfundamentalnews,etc.Generallyspeaking,inmostcasesIwouldnotkeepthestockifitstartstogiveback the entire premium and/or starts breaking down supports. If you do notwanttogetridofthestockthenbuyingputsbasedonthechartpatternsmaynotbeabadidea.Butthekeyideaisnevertogetstuckonasinkingshipinthehopethatacoveredcallwillbailyououtintheend.

Let’s look at some charts of the Indian companies I consider worthycandidatesforwritingcoveredcalls(Figures9.3,9.4and9.5).

Figures9.3

Figures9.4

Figure9.5

WhichStrikestoWriteLet’snowtaketheACCexamplefurtherandseehowonecandecidewhich

strikeofcoveredcallshouldbewritten(Figure9.6).

Figure9.6

Therulesforthisareverysimple:

Write one strike above the prevailing price when the stock has had areaction,andWriteonestrikebelowtheprevailingpricewhenthestockhashadarally.

Oscillatorssuchasthestochasticscanhelpusoutinthis.Letussuppose,theprevailingpriceisͲ215.Checkthestochastics;ifit’sin

overbought territory,sellonestrikein-the-money, i.e. the210call. In thiscaseyouaresellingsomeextraprotectiontoguardagainstacorrection.

Ifthestockhashadareactionandisnearitsoversoldterritory,selltheͲ220callsothatifthestockralliesyourreturnsimprovebecauseofstockappreciationaswell.

Thegood thingabout coveredcall is that it’snot catastrophic if youdon’tchoosetherightstrike.Choosingtherightstockismuchmoreimportant.

Investorswhodon’twant toget ridof their stockandyetget somecapitalappreciation can choose two strikes out-of-money. In the case of our ACC

example, they couldwrite a 230 or a 240 call. Theywould then earn a lowerpremium,butitwouldreducethechancesoftheoptionbeingexercisedagainstthem—andevenifitissoexerciseditwouldgivethemcapitalappreciationaswell.

TheExpirationMonthLifeiseasyinthisregardsinceotherthaninthelastfivedaysbeforeexpiration,onlythenear-monthoptionsarereallyliquidinIndia.NowifIwerewritingacalloptioninthelastfivedaysforthefirsttime,thenIwouldliketodosoforthenextmonthandearnbiggertimevalue.Thereafterinthelastweekofeverymonth,Iwouldliketoreevaluatemypositionsandjudgewhichstocksarelookinggoodforanotherroundofwriting,andwhichneedtobedroppedinfavourofothers.Alwaysremember,acoveredcallinIndiaisapositionforamonth.AndsinceIamaswingtrader,Idonotbelieveinholdingstockslongterm.Market Lot of the Option BeingWritten Investors and traders should not have a lopsided covered callportfolio.Asdiscussedintheearlierchapters,changesinlotsizesoftendonotkeeppacewiththechangesinstockprices.Yesterday’sdogistoday’shero.SoifatraderwantstoinvestͲ20lakhinacoveredcallportfolio,heshouldavoidallstockswhichhavehugelotsizes.Forexample,IwouldnotincludeTelcoatapriceofͲ419anda lotsizeof3300 insuchaportfolio. Iwouldratherhavefouror fivesmallerstocksinstead.Thereasonforthisisthatnotwithstandingalltheanalysisintheworld,themarketwilldoitsownthing.Havingalopsidedportfoliomeansthatthedownsideonasinglestockcouldbeveryhigh.Andthatcouldwipeoutallyourgainsonallothercoveredcallwrites.Thechapteronmoneymanagement(Chapter12)providesdetailedguidanceonpositionsizing.

FollowupStrategies

DoNothingThis is the strategy that works best in India since options of fundamentallystrongstockscontinuetohavesometimepremiumlefttillthelastday.Ipreferwritingat-the-moneycallssincethesegivethemaximumpremiuminflow.Itiscritical,however,thatoncecoveredcallwritingisacceptedasastrategy,tradersshouldwritecallsonanongoingbasis.OnthelastThursdayofeverymonth,itshouldbearitualtowritefreshcallsforthenextmonth.Takingagainthe“rentfromabuilding”example,tradersandinvestorsshouldlooktoinvesttheirfundseverymonthinordertogetconsistentbenefitsofcallwriting.

Generallyspeaking,optionswritteninbigstocksdonotgetexercisedanditispossible toeither squareup the transactionon the lastday,or let theoptionexpire and sell the stock as well towards the close in order to initiate newpositions. In case the same stock still looks good, traders can sell fresh callswhile letting the old ones expire. This might entail some cash outflow if thestockhadmovedupverysharply in thepreviousmonth, thecall solddeep in-the-money, and the fresh call is written for a lower premium inflow. Theadditionalpremiumpaidontheexpensivecalliscapturedastheintrinsicvalueinthestock,whichremainsnotionalif thestockisheld.Againtheapproachisdifferentfortraderswhoareusingcoveredcallasastrategyandforthosewhohavethestockasapositionandjustwantsomeextraincome.

WhatiftheCallisExercisedAgainstYou

Insomecasesthecallsyouwritemightbeexercisedbythebuyer.Typically,thishappens when the price of the stock rises very sharply. And this can happensince individual stocks haveAmerican optionswhich can be exercised at anytimeduringthemonth.

Shouldthishappen,thetraderneedstoreviewtheentiresituationanddecidewhether the stock could be expected to risemuch further, or if the risewas aone-off-move.This isnevereasy todetermine.Nevertheless,somepointssuchasvolumes,breakoutafteranarrowrange,or fromabullishpattern,wouldbethelikelysignalstolookat.

In suchcases traders shouldgoonwritingat-the-moneycalls as soonas apreviouscall isexercisedagainst them.Theycanalsowriteoneor twostrikesfurther fromtheat-the-moneycall if thestock looksbullishand isexpected to

risefurther.Youshouldnotbeworriedabout theexerciseagainstyoubecauseyouhavecapturedtheentiregainintheintrinsicvalueofthestockinanycase.Freshcallwritingneedstobelookedatasafreshsituation.Sometimeswritingacallonanotherstockwhichisrangeboundmightbemoreuseful.

ClosingaPartortheWholePosition

ThereisonlythesituationwhenIwouldclosemyentirecoveredcallposition—ifthestockbreaksdownbelowallitssupports.Asmentionedearlier,acoveredcallneeds tohaveanultimate stop loss should thestockstart tanking.Despitethebesttechnicalanalysis,sometimesastockstartsfailingitssupportsandgoesintoadowntrend.Atthatpointitiscriticalthattheentirecoveredcallpositioninthestockbeclosedatastoplossdeterminedbyastrongsupport.Youmighttoywith the ideaof closingout a part of thepositiondrivenby the fact that youroutlookonagivenstockmighthavechanged—younowhaveamorebullishviewonthestock.Thismighttemptyoutobuybackaportionofyoursoldcalls,maybe at a higher rate, and aim for some capital appreciation too. I do notsubscribe to thisbecauseonceyouhavedecided towriteacall,youshouldbeclearthatyouaregivinguptheupsides.Changingone’sobjectivemidwayonlyleads to higher transaction costs and sometimes the gain envisaged does notmaterialise.

RollingUp

Rolling up is the condition of buying back the short call andwriting a highercall.Again,intheIndianconditionitisgenerallynotusefultorollupevenifthestockistrendinginthegivenmonth.Thisisbecauseitisgenerallydifficultforastock tobeat the covered call return in amonth.Myexperience is that over aperiod of twelve months, you generally end up making the same amount ofmoneyincoveredcalls, ifnotmore,as ina trendingstock.This isbecauseallstockstakebreaths,theypauseforconsolidation,whichevensoutthingsintheend.Thusother than increasingyour transactioncosts, Idon’t think rollingupservesanypurpose.Itwouldserveapurposeifmid-monthcallscouldbewrittenbecause there is a greater possibility of the stock slipping from sideways tobullishoveraperiodofacoupleofmonths.

RollingDown

This is a strategy I often use when, in a given month, the stock that I havebought retracesabit,orconsolidateswithina range,and theat-the-moneycallmovesonestrikelower.Bydoingthis:

1. Ibuybacktheshortcallcheaper,and2. Igetsomeextrapremiumbysellingalowercall.

This is the only case where I would think of changing my strategy mid-month.Let’sunderstand, I am talkingof amild retracement andnot the stockgettingbutchered.Ifthestockstartsfallingsharply,yourneedtoclosetheentireposition.

In the game of covered call, youwill generally not lose if you take in asmuchpremiumasyoucan.

WritingIndexCoveredCallOptions

Foralargemutualfundorveryhighnetworthinvestors,itmakessensetowriteindex options to enhance returns as well as hedge in times of uncertainty orconsolidation.Forsmallertradersandinvestors,sellingindexoptionsisagoodway of playing in the index futures market. Trading naked index futures isgenerallyprettytoughevenforseasonedtraders.Foraretailtrader,ontheotherhand,itisofteneasiertojudgeiftheindexwillholdaparticularlevel.

Sobygoinglongintheindexfuturesandsellinganat-the-moneyindexcalloption,theretailtradergetsalargerstoplossintermsofbreakdown.Bydoingso,hegetsintotheadvantageoussituationoftheoptionseller,ratherthanbeingtheoptionbuyerandgettingthewrongendofthestick.Indianmarkets,andforthatmatterallmarkets,gosidewaysforlongperiodsoftime.Sobuyingfuturesand selling at-the-money call options can be a profitable option. Still, asdiscussed earlier, it is critical to apply a stop loss in all futures and stockpositions. Generally in bullishmarkets, at-the-money Nifty index call optionssometimessellforevenͲ50,sothetraderimmediatelygetsͲ50wouldbe150points.Ithinkthatunlessthetraderreallygetsthetrendwrong,a50-pointstoploss isgenerally enough.This ismuchbetter than the call andput spreadswediscussed. However, since index options are still not so liquid in the Indianmarket,sosquaringuptwosetsofilliquidoptionscansometimesbedifficult.Aswith all futures relatedpositions, the leverage—andhence the risk—of theentirestrategyisgreater.

AdvanceImplementation

Tillnowwehaveassumedthatthenumberofcallswrittentostockownedisaone-to-one relationship, in terms of derivative lots. Also generally speaking,unlessspecifiedotherwisethecallsareassumedtobewrittenat-the-money.ThatisthewayIdobusinessanditworksformyobjectives.Ihavefoundthatinthestockmarket the simpleryoukeep things, thegreater are the returns.The lessyouneed tochange things, thebetter the returns.Asa tradersaidverywisely,profitabletradingshouldbeboring.Butnowwewilldiscussstrategieswheretheaboverulesaremodified.Itisnotasifwerecommendthesestrategiesbutthesedemonstrate the flexibilitywhichcanbeachievedcomparedwithoptions.Onegood reason why these strategies cannot easily be implemented by smallerplayersisbecauseofthelotsizesinvolved.Mostsmalltradersandinvestorsmaybe uncomfortablewithmultiple lots; by small Imean trading accounts of lessthanͲ50lakh.

PartialWriting

This involveswritingcallsonapartofyour stockholding thereby fine tuningyour portfolio to achieve fixed as well as variable returns. Taking our ACCexample, its derivatives lot is 1,500 shares.Assuming you have 3,000 shares,andthoughyouthinkACCismildlybullishbutyoudonotwanttoforegotheentire upside if it does occur. Assume the prevailing price isͲ 215, and youexpectthequarterlyresultstobedeclaredbytheendofthemonthandwouldnotliketotakeanunhedgedbetontheresults.YourtargetonACCisͲ250ifthenewsfromthecompanyisgood.SoyousellaͲ230callforͲ11andleavetheother1,500sharesunhedged.Iftheresultsareindeedgood,halfofyourshareswill gainbecauseof capital appreciationwhile theother halfwill provideyouregularincomeanddownsideprotectioniftheexpectationisnotmet.AsIhavesaidbefore,writingcoveredcallsonallofyourstockholdingisagoodideainthe Indian scenario. In twenty trading sessions, it’sdifficult formost stocks toconsistentlybeatthecoveredcallpremium.

MixedWriting

Mixed writing is done by writing calls at different strike prices. Again therecouldbelotsizeproblemshere.ThisisanotherwayoffinetuningreturnsbutintheIndianscenarionotveryviablenorprofitable,mainlybecause:

1. Youenduphavingalargepositioninasinglestock.2. Stockmovementmightnotbeaccordingtoexpectationunlessthestockis

trending.

InourACCexample, the stockwas trading atͲ 215 and if youhave twolots,youcansellone230call,andanother240call.

RatioWriting

Ratiowritingmeanswritinghighercallsintheratioof1:2,ormore,tothestockheld. I would not advise anyone towritemore than 1:3, because I have seenstrangerthingshappeninthemarket.Thisstrategyisalsousedwhereyouhaveashortenedmonthandthecallpremiumsarehigh.Itiscriticaltounderstandthebreakeveninthistransactiononbothsides.

LetmetakeyouthroughatradeIpersonallytookandwhichIthoughtwasagoodpercentagetradeinabullishmarket.

Iwasmoderatelybullishon theReliancecounter inaparticularmonthbutthemonthhadonlyabout ten tradingsessions.SoIwent longon theReliancefutures atͲ 500, and sold twoͲ 530 calls forͲ 6.50 eachwhich created aninflowofͲ13.ThisgavemeastoplossofͲ13forbreakeven.AnotherbenefitwasthatIcouldevenputanenhancedstop.ReliancehadstrongsupportatͲ480but I did notwant to riskmore thanͲ 7 on this trade, so the extraͲ 13wasfinanced by writing higher calls. On the upside, if Reliance did crossͲ 530beforeexpiry, Iwouldnothavebegunmakinga loss tillͲ566since I’dhavegainedͲ 30 on the futures andͲ 6.50 on the second written option. So mybreakevenontheupsidewasͲ566.

BenefitsoftheCoveredCallStrategy

ItImprovestheOddsofSuccessfulTradingThebiggestbenefitofthecoveredcallstrategyisthatitcanbeimplementedintwo of the three possible stockmovement scenarios. If the stock goes up, it’sprofitable.Ifthestockgoessideways,it’sprofitable.Theonlycasewhenit’snotprofitableiswhenthestockgoesdown.Anystrategythatworks66%ofthetimeautomaticallyhashigheroddsofsuccess.

On the other hand, when buying either options or stocks, traders andinvestorsmakemoneyonlyinoneoutofthreepossibleeventualities,whichisifthestockgoesinthedesireddirection.Also,thecoveredcallputsapremiumontime;astimepassesyougainthetimevalueoftheoption.Beingaveryfuturestrader, the covered call both protects my capital and also makes my overallreturns less volatile since my money is never idle but is always generatingdecentreturns.

YourBestChanceforMakingMoneyWhenImportantNewsisExpected

Whenacompanyresultoranelectionresultisexpected,oradivestmentmeetisbeingheldbythegovernment,oftenthesmartestofmindsareprovedwrongintheir anticipationof results. In such situations, themediaanalystsoftenadvisepeopletotakepositionsinoptionsinsteadoffuturesorstocks.EverytimeIhearthis,IlickmylipsasIsmellcoveredcallopportunities.Whennewsisexpected,the normal response of people is to buy calls or puts. Now this increases theimpliedvolatilityoftheoptionsandmakesthemveryexpensive.

Sogenerally thebest courseof actionbeforeanevent is to takea coveredcall exposure because the expectation is built into the option premium. Inmyexperience,unlessthenewsbreaksthecompany’sormarket’sback, it isfairlywelldiscounted in thecallpremiumandyouendupmakingmoneynomatterwhichwaythenewsannouncementgoes.

IparticularlyrememberoneinstancewhenTiscowasexpectedtoannounceitsquarterly results.Tiscohadbeenrisingsteadily for theprevioussixmonthsbuthaddeclinedforthelastcoupleofdaysonlightvolumeandwasthentradingatͲ340,downfromaboutͲ360adaybeforetheresults.Sincethesteelcyclewas up, the results were expected to be good. The problem to consider waswhether the anticipated good results had been discounted andwould there besell-off after the results, or would Tisco’s performance beat even the best ofestimatesandtakethestockbackup?

Noamountoftechnicalanalysiswillgetyoutheanswertosuchaquery.Theresultsweretobeannouncedonthenextdayat12noon.By11a.m.thestockhad dropped to about Ͳ 332. There was a strong support at Ͳ 320, and itappearedoversold.SoIcheckedthe330calloptionanditwasquotingatͲ26,whichisarichlyvaluedoptionbecauseofexpectationoftheresultbuiltin.Myanalysiswasthatiftheresultswereaccordingtoexpectation,thesell-offwouldnottakethestocktoͲ304whichwasmybreakevenforthisoption.Andsincethestockhadalreadysoldoffquiteabitbeforetheresult,itwaslikelyitwould,infact,bounceback,oratleastnotfallawholelotfurther.Ihadadecentstoplossforthistradeandstoodtomakean8%gainforthemonth—Iwouldtakesuchacallanyday.

And, lo andbehold, the resultswere slightlybetter than expected. InitiallythestocksoldoffanotherͲ5,andthenbouncedbacktocloseatͲ345.ItthenstartedgoingsidewaysandupandclosedthemonthataboutͲ358.Assoonas

the company declared the results, the call lostͲ 6, since the uncertaintywasover. So that was the immediate gain. In such circumstances where a nakedpositionmightappear risky, it’s alwaysbetter to takeacoveredcall exposure.Ontheothersideof this trade,somepoorretail investormusthavebought theTiscocallforͲ26.Well, tobefair tohim,heboughtagoodstockoption;heforecasttheresultscorrectly,thestockmovedupverynicelyand,yet,whatdidhemake?AgainofͲ2comparedtotheͲ26thatwereearnedbythecoveredcallstrategy.

Had the results been below expectations, the stock would have taken abeatingbutwehad a cushionofͲ 26.And as the stockhad fallenbefore theevent, the technical positionwas lookingmuchbetter for a rise or a sidewaysmovement than a fall. It is, therefore, always worth remembering that thetechnical position of a stock ismuchmore important than the premium beingearned.

BeatsStockMarketReturnsOvertheLongTerm

Inmyexperience,coveredcallwritinghastakenthestressoutofstockmarkettrading. The odds ofmakingmoney in naked futures, options, and stocks arestacked against both the buyer and seller.This is because their probability formakingmoneyisoneoutofthree.Coveredcallistheonlystrategyinwhichthetradermakesmoneymostofthetimeandevenwhenheiswrong,thelossesarelower than in the case of the other strategies. In long bear phases,markets aswellasindividualstockstakeyearstoformbasesandmoveup.Coveredcallisagoodwaytomakemoneyduringsuchperiods.InIndia,thecallandputbuyerswouldactuallyneedamiracletomakemoneyinthefifteentradingsessionsthatthereeffectivelyareinamonth.Thisisbecausethereareeighttotenholidaysinamonthandinthelastfivedaysbeforeexpiry,thedecayintimevalueisoftenhigher or equal to any favourablemovement. In India, therefore, currently thecoveredcallisasgoodasitcanget.

WhyDon’tManyOtherPeopleDoIt?

TherecanbeavarietyofreasonswhymanyIndiantradersdon’tcurrentlywritecalls.

Oneofthereasonsisthemyththatfuturesandoptionsareinherentlyrisky.On the contrary, as we have seen futures and options are excellent tools for

managing risk and returns. Like anything else they can certainly cause greatharmifnotusedproperly.Ifafterreadingthisbook,youstillthinkfuturesandoptionsaretobeavoided,thenIhavetrulyfailed.

Anotherreasonis thatmostpeople like tofollowthecommonpracticeandaresuspiciousoflookingatanythingnew.Sellingcoveredcallsisnotsomethingthattheearliergenerationsoftraderseverhadtheopportunitytodo.Peoplewerescaredofcomputerswhentheyfirstcame,itwasflyingbeforethat,etc.

Thereisanothermyththattheoptionbuyeristhesmartestandthemostriskaverse person around, and that options are sold by people who are eithergamblersorveryrichsincesellingoptions is, theoretically,veryrisky.Neitheroftheaboveistrue,particularlyinthecaseofwritingcoveredcalls.Ihavetriedto prove time and again in this book that, in general, the option buyer alwaysgetsarawdeal,andthisisparticularlytrueinIndia.

Readersmightalsoask, “If this is so smart,whyaren’t theFIIsdoing it?”Well, the FIIs probably are doing it, but they are not going to admit it ontelevision! They are not supposed to get their fat salaries for writing coveredcalls.TheFIIs do something even simpler; namely, borrowmoney at 1.5% intheircountryandarbitragebetweenthefuturesandthecashmarketinIndiaandmakeabout6%permonth.

Anotherpossible reasonwhy individual tradersdon’twritecoveredcalls isthat theyseem tobelieve it isonly forprofessional tradersandhighnetworthinvestors.Oftentheyalsomistakenlybelieveit’saninvestor’sdutytostandbyastock through thick and thin even if it does nothing for them. Well, gettingmarriedtoanystockisacardinalsin,mostinvestmentbookstalkabout.Bethatas it may, the covered call strategy also caters to people who like retainingstocks forever by giving them a regular income. A stock is an investmentpositionandnothingmorethanthat.

My reason for writing covered calls is simple — it makes money andgenerally it does so better than most naked stock, futures or options buying.Actually, the concept is so simple that peopleget confused and think they aremissingsomething.Thebestpartaboutthecoveredcallisthatitoutperformstheothermethods70to75%ofthetimewhenmarketsgosideways.

Sure,writing covered calls is not as exciting as swing trading, nor is it asglamorousasafuturestradebutitgivesyouhardcash.Youdon’tneedtobeafinancialwizardtodothis;youdon’tneedthehighlevelsofdisciplineorlookfor set-ups like we discussed in the earlier chapters on futures trading usingtechnicalanalysis.And,atmosttimes,itprotectsallofyourcapital.Whatelse

doyouwant?

Chapter10

DerivativeStrategiesforSpecialSituations

There are some events typical to the Indian economic calendar when impliedvolatilities and the costs of carry are at abnormally high or low levels.As anactivetraderyoushouldalwaysbereadyforsuchlowrisk,highreturnsituationsbecausederivativesgiveyoutheabilityofadjustingriskandreturn.Andthisisdonebysellingoptions,notbuyingthem.Whathappensinsuchsituationsisthatretailinvestorsoftentendtobuycallsorputsdependingonthetakeofthemediaanalysts,erroneouslythinkingthattheycanloseonlyasmallamountandhencearereducingriskbybuyingoptions.Theincreasedoptionpricethusappearsasincreasedimpliedvolatilityintheoptionprice.

Also, the sellers are aware of the increased demand fromoption buyers atsuchtimesandtendtopricetheoptionshigherthanusual.Oftentheeffectofthenewsisdiscountedintheoption’spricebeforetheactualsituationorevent.Sotheselleroftheoptionisstillabletogetoutatalmostbreakevenifthenewsisadverse.Whatactuallyoftenhappensafterthenewsispublicisthatthedemandofthecallorputoptiongoesdowndrasticallyand,regardlessofthemovementoftheunderlying,theimpliedvolatilityoftheoptiondrops.Sotheselleroftheoptionimmediatelymakesmoneyonthelowerimpliedvolatility.Thiscushionhelpstheoptionsellerbothwhenthenewsisasperexpectations,andevenifthenewsturnsouttobeunexpected.It isimportanttounderstandthatsomeoftheeventsdiscussedheremightloseimportanceovertime,andneweventsmaytaketheirplace.

Writing Covered Calls Just Before Important Announcements orNews

Thelogicbehindwritingcoveredcalls justbeforeimportantannouncementsor

results is that theoptionsellers like toprice in thewidestpossiblevariation inthenews.Indoingso,theyincreasetheimpliedvolatilityoftheoptiontosuchalarge extent that unless the news is catastrophic, the premium is more thansufficient to take care of everything. Of course, sometimes catastrophes dohappen,butonlyrarely.

LetusrecallwhathappenedinApril2003whenInfosysreduceditsannualguidanceto10-15%growthinprofit.Thestocklost50%ofitsvalueinasingleday.Thewaytoguardagainstsucheventsistolookattheresultsofthestock’speergroup.Ifthestockinquestionisabellwetherandhasagoodmanagement,itwilldoatleastaswellasitspeers—ornoworse.Thisduediligenceexerciseneedstobedonebeforeinvestinganymoney.Donotwritecoveredcallsontheresults of the second and third rung companies, or ones with dubiousmanagementtrackrecord.

Theotherreasonforwritingcoveredcallsisthatvolatilityalternatesbetweencontractionandexpansion.Thusbysellinghighvolatilitybeforeaneventoranannouncement, it becomes likely that the volatilitywill reduce after the eventand a profit can be made just by trading the volatility. This extra volatilitypremiumalsoprovidesacushionagainstanadversemovementintheunderlyingifthenewsisadverse,oriftheunderlyingmovescontrarytoexpectations.

Let’slookattheaccompanyingNiftychartandseehowvolatilityvariesoveraperiodortimeandhowitcanbetraded.(Figure10.1)

As we can see in the chart, there are two lines which give a historicalperspectiveofimpliedvolatility,bothhighandlow.Thehigh-impliedvolatilityisfollowedbylowimpliedvolatility,andviceversa.Thereforeallotherthingsbeing constant, itmakes sense to buy implied volatility and sell high impliedvolatility.

Figure10.1

FavourableNews

Inmost cases, it iswise togo in for a coveredcall, obviouslyhoping that thenewswouldbepositive.So,forexample,ifsomenewsisexpectedinRelianceandthetraderdoesnotwanttotaketheriskofanakedposition,onecanbuytheReliancestock,sayatͲ455,andselltheͲ460near-monthcallatͲ20.Oncethenewsbreaks,thecalldropsinvalueevenifthepriceoftheunderlyingmovesfavourably.SoifafavourablenewsisannouncedandthestockmovesupbyͲ10 toͲ465,youmight find thecallappreciatingonlybyͲ5 toͲ25.So,onexpiry,thetradermakesͲ5tillͲ460andkeepstheͲ20premiumfromthecallaswell,ineffectmakingͲ25onͲ455,whichisatradeequivalenttothestockmoving5.4%intwentysessions.ThetradercanalsounwindbothpositionsandstillmakeͲ5ifheisnotinterestedinholdingthepositionfortheentiremonth.

AdverseNews

Incasethenewsisnegative,andthestockgoesdownͲ10:

1. Youarehedged to aboutͲ 435on thedownside, sinceyouhave alreadymadeͲ20fromthecall;

2. Thecalldepreciatesonthedownsideevenfasterastheimpliedvolatilityofthe call goes down and it becomes further out of money. You might,therefore,findthecalltradingaboutͲ8inthecaseofanadverseevent.Soyoumightstillgetoutatbreakeven,evenifthenewsisadverse.

LetusnowconsidersomespecialeventsintheIndianeconomiccalendar:

Budget;Companyresults;Electionresults;Cabinetcommitteemeetings;Eventsthatcangoineitherdirection.

Budget

ThebudgetpresentedbythecentralgovernmenthastraditionallybeenthemosteagerlyawaitedeventoftheIndianeconomiccalendar.Allofthegovernment’sfinances are discussed in it. New taxes are proposed, old ones waived orreduced,customsdutiesareleviedorremoved.Thereusedtobeatimewhenitwas theonlydocumentwhichgaveacomplete, ifnotacorrect, assessmentofthe economy’s health. Also since most business was regulated by thegovernment, an increase or reduction in taxes and duties used to make a bigdifference to the bottom lines of companies. So the budget always kept thecapital markets interested in several ways. Of course, every year the capitalmarket also had its own budget wish list. In the last few years, prior toderivativesbeingintroducedin2002,mostcapitalmarketparticipantshadgrownusedtoseeinga60-70Niftypointsriseorafallonthebudgetday.Asthecapitalmarkets were generally in the doldrums between 1999 and 2003, so thesebudgetseitherbeliedexpectationsorsuddenlyraisedthemveryhigh.

Let’slookatchartsofsomeofthepastbudgetsessions.(Figures10.2,10.3,10.4and10.5).

Figure10.2:Budget2003

Figure10.3:Budget2002

Figure10.4:Budget2001

Figure10.5:Budget2000

Budgetsfrom1991-2002

In the year before 2002, the budgets used to trigger large movements in themarket. Even on the budget day in 2002, the index saw a large intradaymovement,butoveralloveraone-monthperiodoneitherside,themarkettradedrangebound. Inmostyearsbefore2002,budgetdays sawhugemovements in

theindexandestablisheddecisivetrends.Ibelieve thebudget isan indexplayand try tokeepawayfromindividual

companies.Also,thebudgetdoesnotnowaffectindividualcompaniesasmuchbecauseoftherationalisationoftaxesanddutiesintobandsandthetendencyoffinanceministersnottochangetheseabruptly.Astimegoesby,thebudgetwillfurther lose its importance of being the annual ritual as the Indian economybecomes more developed and as governments make economic decisionsthroughouttheyear.MarketResponsetotheBudgetAfter2002

Aftertenyearsofliberalisationasthegovernmentcontrolofbusinesslessened,themarketshavebecomedelinkedfromthebudgettosomeextent.Also,sinceeconomic announcements from the government now come all year long, thebudget is further diminishing in importance. These days the market responseseemstobeturningrangeboundaroundthebudget.Buttheretailinvestorstillseemstobankonbuyingastraddleeverybudget,paying'100ontheNiftyeveryyear.Whathappened in2003and2004was that theoptionpremiumafter thebudgetbecamehalfofpre-budgetlevels.SotheNiftystraddlebeingsoldforatotalofͲ100ontheNiftylosesimpliedvolatilityoncethebudgetisannounced,because stockprices alreadydiscount thebudget inadvance.Alsowithall therationalising of excise and customs duties, there is generally very little in thebudgetthataffectsstockprices.Idonotknowhowtheoptionspremiumswillbeinthefuturebut,asabenchmark,ifIamgetting100pointsonsellinganat-the-moneystraddleorimpliedvolatilitysubstantiallyhigherthanusual,Iwouldsellastraddle,whichastraderswouldrecallissellingboththecallandtheputofanat-the-moneystrike.

Thekeyhere isnot to speculateonwhat announcements thebudgetmightcontainbuttoseeiftheimpliedvolatilityoftheoptionpremiumishighenoughto sell.Nifty’s historical volatility in 2003-2004was around27%.An impliedvolatilityofaround37-38%shouldbegoodenoughtosell.

Youmustlooktobuybackbothlegsofthestraddleassoonasthevolatilitycomesdown.Ingeneral,ifIget100pointsinsellingthestraddlepre-budgetandifaftertheannouncementofthebudgetIcanbuyitbackforanythinglessthan60,Iwoulddoso.

CompanyResults

Companies often declare results before the markets open or after they close.

Accordingly, when the stock opens in the subsequent trading session it oftendoes sowith an up or down gap. Even if the expectations are good from theresults,it’softennotclearifthestockhasrunupenoughbeforetheresult,oriftheresultswouldmeetorbeatexpectations.Ihavefoundthatmosttimesthecallpremiumdiscountstheuncertaintyattachedtotheresult.Aswithallcoveredcallwriting,theriskofdownsideneedstobethoughtthrough.

TheparametersIwouldlookatwhiledecidingthestockonwhichtowriteacovered call are thosewhich couldminimise thedownside risk.First, Iwouldconsider thegrowthof the industryand the sector; they shouldbe in theearlystages of growth and not in amatured phase. For example, in commodities Iwould like to write covered calls when people are discovering the uptrend incommoditypricesandtheresultsarelikelytosurpriseontheupside.

In sunrise sectors like ITorpharma, Iwouldwrite coveredcallswhen thecompaniesareintheearlyphaseoftheirgrowthcycle.IwouldnotdoitatatimesuchasFebruary2000whenpanicwas ruling the roost andevengood resultsweregettingpunished.Iwouldliketoseetheresultsofoneortwooftheotherbellwethers in the sector. The stock on which I would write the covered callshould have great management quality and be a large-sized company. If thestockhascorrectedabitbeforetheresults,Iwouldbuythenextavailablestrikefromthepriceofthestock.Ifthestockhasrunupsignificantly,Iwouldwritealower call and take in as much premium as possible just to have protectionagainstanypostnewssell-off.Ifthenewsturnsouttobeworsethanexpected,Iwouldunwindtheentirepositionwithoutanyfurtherado.

Ultimately,thereareonlytwoparametersinwritingcoveredcalls:

1. Theimpliedvolatilityshouldbehigh,and2. Thestockshouldnotbehighlyoverbought.

Ifyoupaysufficientattention to these twoparameters,youshouldbe fine.Evenifyouarewrong,rememberyouarebetteroffthanwithanakedposition.

ElectionResults

Myviewonthefrequentelectionsandtheirresultsisthatitdoesnotmatterinthe long runwhether theCongressor theBJPwins the elections.Bothpartieshavesimilarviewsoneconomicpolicyandreformsareinevitable.Ofcourse,theusualproblemsofademocraticpolityaregoingtooccurforbothparties.These

dayswithopinionpollsandexitpollsavailable,themarketisabletotakeaviewon thedirectionof theresults. Ihaveobserved that theoptionsofPSUshares,particularlythedivestmentcandidates,tendtopriceinsomevolatilitypremium.But, broadly, like in the case of the budget, election results now have limitedimpactonthemarketsolongasthereistheprospectofastablegovernment.

Of course, the condition of themarket should be taken into accountwhendecidingaboutwritingcoveredcalls.Inabullmarket,thereisnobadnews.Inabearmarket, there isnogoodnews.Theusualduediligenceofanoverboughtand oversold market for writing covered calls is a must. Generally speaking,writinga coveredcall shouldbebasedon the impliedvolatilityof theoptionsbeingwritten.If impliedsarelow,chancesarethemarketbelievestheelectionresultsareinconsequential.Inthelongruntheyareinconsequentialanyway.

CabinetCommitteeMeetings

We all know about the famous cabinet on divestment meetings that thegovernmentholdsfromtimetotime.Thesemeetingsgenerallyendwithabagfulof announcementwhich are the namesof the companies next on the block—andsomeweirdsolutionsforHPCLandBPCL.TherewasatimewhenHPCLand BPCL used to rise and fall by up to 20% on favourable or adverseannouncements. But themarkets have now grownwiser to the fact that thesebehemothsaredifficulttodivestandnowtakethesemeetingsinitsstride.Still,beforewritingcoveredcalls it’s important tosee if thestockhasrunup in thehope of any announcement, and by how much. If the stocks are not veryoverbought and have not run up, at-the-money call options can bewritten forwell-runPSUoilcompanies.Iftheyhaverun-upalot,Iwouldeitherwritedeepin-the-moneyoptionsorletitpass.Iwoulddefinitelyensurethatthelongtermtrendofall thesecompanies isup. Idonotbelieve that in today’smarketanyonebelievesthatanyofthesecompaniescanbedivestedeasily.So,themarketneverpricesinextraordinarynews.

Chapter11

TradingDiscipline

Nobookor seminaron trading is completewithout a sermonondiscipline—andwithgoodreason.Mostnovicetradersbelievethatoncetheyunderstandthenuancesof technicalanalysis, theywillautomaticallybesuccessful.This is farfromthetruth.Disciplineforms80%ofagoodtrader’s,make-upandonly20%ofa trader’ssuccess isasa resultofhis tradingknowledge.This is the reasonwhy there are many successful analysts but very few successful traders. It isimportant to knowwhether themarket is in a trending or trading phase. In atrendingphase,yougoandbuyorsellbreakouts,butinatradingphaseyoubuyweaknessandsellstrength.

A lot of analysts have trouble implementing their own analysis. This isbecause the market is not there to favour anyone. It is there to punish theindisciplined.

Themarkettakesawaymoneyfromindisciplinedtradersandgivesittothedisciplined ones. A trader can have cutting-edge software, the best tradingsystem,hemaybeamasteratreadingchartsandstillbeunsuccessfulifhelacksthe discipline to execute his analysis. Learning to read charts is perhaps theeasier bit of technical analysis. Learning to overcome fear and greed andwinningoverone’semotions isamuchbiggerchallenge.Lookingatwinsandlosseswiththesameeyeisnevereasy.Curbinghumanemotionsofeuphoriaandpanic is always difficult. Talking and writing about strategies is easier thanputtingmoneyonthelineandtrading.

WhatisDiscipline?

Disciplineinanyfieldmeansfollowingacertainsetofrulesinordertoachieveobjectives one has set for oneself. Discipline is the foremost quality in allprofessionals.Forexample, inthedefenceforcesdisciplineis inculcatedinthe

recruits so that they can be trained to vanquish the enemy. Discipline isimportant for sales teams so that they can plan a strategy and achieve theirtargets.Discipline is important fordoctors, lawyers andall otherprofessionalswhoneedtosolvetheproblemsoftheirclients.Butnowhereisdisciplinemoreimportant than in trading. Lack of discipline can put a trader out of businessfasterthananythingelse.

Let’s consider the differences between a disciplined and an indisciplinedpersoningeneral.Theobjectiveofthisexerciseistoidentifythingsthatmightpegusbackintradingandtoshunthemoutofoursystem:

Adisciplinedpersonislikelytobedisciplinedinallhisdailyactivitiesandmuchmorelikelytobeasuccess.Adisciplinedpersonhasaplanforeverythinghewantstoachieve.Heknowswheretogettheresourcesandtheskillstoimplementthatplan.Lastbutnottheleast,hehassethimselfgoalstoachieve.Adisciplinedpersonisanexcellenttimemanager.A disciplined person builds frameworks for various situations and knowswhattodowithinthoseframeworks.Whenadisciplinedpersonfails,helooksatitasasteppingstonetosuccessandlearnsfromhismistakesinsteadoflookingforscapegoatstoblame.Adisciplinedpersonkeepshiscomposureatalltimes.Adisciplinedperson ispositive aboutwhateverhedoes in life andkeepsnegativityaway.Adisciplinedpersonisconfidentofhissuccessandisabletodealwiththeinevitable tough times and is thus able to keep himself mentally andemotionallystable.Adisciplinedpersonispatientinanalysingallsituations.

Nowlet’sconsideranindisciplinedperson.Someoftheweaknessesofsuchan individual come naturally tomost of us. Theseweaknesses aremercilesslyexposedintradingasnowhereelse:

Anindiscipinedpersonislikelytofailatalmostwhateverhetakesone.Theindisciplinedpersonisunlikelytohaveeithergoalsorplans.Anindisciplinedpersonisnegativeinhisapproach.Anindisciplinedpersonloseshistemperandsometimeshismentalbalanceintoughtimessincehehasnocontingencyplan.

Anindisciplinedpersonislikelytoblameeveryoneelsebuthimselfforhisfailures,thusfailingtolearnfromhismistakes.Anindisciplinedpersonisnotpreparedforchangingsituationsbecausehedoesnotdohishomeworkregularly.An indisciplined person looks to other people or equipment tomake himsucceedbutfailstolookathimself.The efforts of an indisciplined person do not pay off, leading him into acycleoffrustrationand,hence,moremistakes.An indisciplined person is impatient, assesses situations incorrectly andtakesincorrectactions.

Thecostofnotbeingdisciplinedissohighintradingthatthistopicdeservesanentirechapter.

In trading, as in life, your success and failure depend on yourself. Everyperson ishisownboss.Whenall issaidanddone,everyperson is responsibleforhisactions.Nowhereisittruerthanintrading.Inmostbusinessesonceyoumakecertainsystemsandprocedures,youmaynotneed toworrya lot.But intrading,wheredecisions tobuyandsellneed tobe takeneveryday,and takenconstantly,itisimpossibletosucceedwithoutdiscipline.Allofuswhotradefora living need to root out the weeds of indiscipline before it eats up all one’scapital.The onlywayout is to be self-criticalwhenever you see indisciplinedbehaviourinyourselfwhiletradingandtrytoavoiditbysettingrulesforsimilarfuturesituations.

QualitiesofaDisciplinedTrader

ADisciplinedTraderhasaTradingPlanandDoesHisHomeworkDiligentlyManytraderstaketotradingbecausetheythinkitisthesimplestwayofmakingmoney.Farfromit,Ibelieveitistheeasiestwayoflosingmoney.ThereisanoldWall Street adage, that “the easiestway ofmaking a small fortune in themarkets is having a large fortune”. This game is by no means for the fainthearted. This battle is not won or lost during trading hours but before themarketsopen.

Winning traders diligently maintain charts and keep aside some hours formarketanalysis.Everyeveningawinningtraderupdateshisnotebookandwriteshisstrategyforthenextday.Winningtradershaveasenseofthemarket’smaintrend.They identify the strongest sectors of themarket and then the strongeststocks in those sectors. They know the level they are going to enter at andapproximatetargetsfortheanticipatedmove.Personally,Iamnotfinickyaboutexacttargets;Ibuywhenthemarketisactingoversoldonanintradaybasisinadaily uptrend.This oversold level can come in even ten points before or afteryouthoughtitwould.Butit’simportanttohaveageneralideaofwhereitmightbelocated.

Similarly,Iamwillingtoholdtillthemarketisactingright.Oncethemarketisunabletoholdcertainlevelsandbreakscrucialsupports,Ibookprofits.Again,thisdependsonthetypeofmarketIamdealingwith.

Inastronguptrend,Iwantthemarkettothrowmeoutofaprofitabletrade.Inamilduptrend,Iama littlemorecautiousandtry tobookprofitsat the

firstsignofweakness.Inachoppymarket,notonlydoItradethelightest,Ibookprofitswhilethe

market is still moving in my direction. The same goes for identifying theweakestsectorsandtheweakeststocksinthosesectorsforgoingshort.

Goodtechnicaltradersdonotworryordebateaboutthenewsflow,theygobychartingsignals.

ADisciplinedTraderAvoidsOvertrading

Anotherreasontodoyourhomeworkwellandsincerelyistoavoidovertrading.Onlywhenatraderisclearaboutwhatheshouldbedoinginthemarketcanhetake theright tradesandbackthemupsufficiently.Themarket tries itsbest tomisleadtradersbyswinginginbothdirections.Themarketwantstotakeawayyour trading capital from you. Unprepared traders who do not know if themarket is trending or trading obviously can’t decide whether to buy and sellbreakouts, or to buy weakness and sell strength. They implement the wrongstrategies in thewrong phase of themarket and by the end of the day have ahugestatementintheirhandsfromtheirbrokers,inwhichalongwiththelossesthattheyhavemade,theyhavehelpedthebrokerrakeinalotofcommissions.

Overtradingisthesinglebiggestmalaiseofmosttraders.Adisciplinedtraderisalwaysreadytotradelightwhenthemarketturnschoppyandevennottradeiftherearenotradesonthehorizon.Forexample,myregularvolumeintheNiftyfuturesbasedonmymoneymanagementpolicyis3,000sharesofNiftyfutures.ButI tradefullsteamonlywhenIseea trendingmarket. Iamopen to trading2,000sharesofNiftyfutureswhenIamnotconfidentof theexpectedmove. Ieven go down to 1,000Nifty futures if themarket is stuck in a choppymodewithverysmallswings.Adisciplinedtraderknowswhentobuildpositionsandstepon thegas andwhen to trade light andhecanonlymake this assessmentafter he is clear about his analysis of themarket andhas a tradingplan at thebeginningofeverytradingday.

ADisciplinedTraderDoesNotGetUnnervedbyLosses

Awinningtraderisalwayscautious;heknowseachtradeis justanothertrade,sohealwaysusesmoneymanagementtechniques.Heneveroverleveragesandalwayshasset-upsandruleswhichhefollowsreligiously.Hetakeslossesinhisstrideandtriestounderstandwhythemarketmovedagainsthim.Oftenhegetsimportanttradingsignalsfromhislosses.ItradeNiftyfuturesveryactivelyanddomostofmytradesbasedonchartpatterns.Ioftenusealossasanimportantindicator for takingaposition in the reversedirection.Figure11.1 isanactualtradeItookbasedonafailedbuysignal.

Figure11.1

The conditions surrounding this trade were that the market had recently

touchednewhighs(Nifty2015),thencorrectedmarginally,andwasnowabouttoagainchallengethenewhighof2015.Thedilemmathateverytraderfacesatsuch times iswhether themarketwill just kiss the newhigh and fall back, orwhether itwouldmakenewerhighs.And theonly reasonableway to find thisoutistoactuallytakeatradewithadecentstoploss.SinceIgenerallytrade15contractsofNiftyfutures,IdecidedthatIwouldgolongon7contractsbeforethe Nifty touched new highs, and another 8 contracts once it convincinglycrossedthem.ImustpointoutthatthoughIwasgoinglong,Iwasalsocautionsbecause themarketwas extremelyoverbought.So I took thebuy trade, as themarketappeared tobeholdingsomelevelsandhad juststartedrallyingafteraminorcorrections. (Ibelieve in theadage that“inbullmarketsyoudonotbutsomepullbacks,butbuyallpullbacks”).

WhenI initiated the tradeat1,957,mystop losswasat1,940.Themarkettraded on the upside to about 1,963 and then turned hesitant for a couple ofhours, trading in the1,952 to1,963band.Thiswasanotherwarning;amarketabouttocrossnewhighsshouldbemuchmoreactivethanthat.Also,slowlythebreadthwasdeteriorating.Thensuddenly themarket startedsellingoffandhitmy stop loss. That did not unnerve me but I thought that if even after acorrectionthemarketwasnotabletoholdup,maybethatwouldbeasignaltosell.After hittingmy stop loss, itmade aweak rallying attempt and then fellthroughthepreviouspivot.ThissignalledashorttradeandIwentshortat1,940

withall15contractsoftheNifty,keepingastopatthehighsandthusgotahugemoveonthedownside.Icoveredat1,794.

Thekeyherewasbeingalertandnotworryingaboutthestopsbeinghit.Theclearmessageisthatifastopgetshit—providedit’snotbeenplacedtooclose—themarketisnotasstronginthedirectionofthetradeasyouthought.

Themarketkeptgoingdownforthenextfourdays,anaverageof50Niftypointsaday.Sothestoplosscostme17pointsbutputmeonatradethatgaveme146points.

HereIwould like tomention that if I think there isagoodset-up, IwouldalwaysbewillingtoriskthenormalamountthatIgenerallydo,about1%ofmytradingaccountvalue,whichisabout20points.Ifthestopgetshit,Itrytolookforwhat themarket is trying to tellme and reassesswhat the situation of themarketisatthatpoint—whetheritisoversoldoroverbought.ButInevertrytogetintoanegotusslewiththemarketbecausethemarketisalwaysright.Ifthemarket tells me I am wrong, I keep open my options of taking trades in thereverse direction as well. Sometimes the market gives confusing signals andwhipsawsme;at thatpoint,myeffort is toavoidovertrading.Isimplywaitonthesidelines till themarketgivesaclearer indicationof itsdirection.Treat themarketasaladyandyouwillbehappy.Whenaladysaysno,gentlementakeitasno.Itworkswellwiththeladies,asitdoeswiththemarket.

ADisciplinedTraderTriestoCapturetheLargeMarketMoves

Novice traders often book profits too quickly because theywant to enjoy thewinningfeeling.Sometimesevenonthemediaonehearsthingslike,“Youneverlose your shirt booking profits.” I believe novice traders actually lose theiraccountequityquicklybecausetheydonotbooktheirlossesquicklyenough.

Knowledgeabletradersontheotherhand,willalsolosetheirtradingequity—thoughslowly—iftheyaresatisfiedinbookingsmallprofitsallthetime.Bydoing that the only person who can grow rich is your broker. And this doeshappenbecause, inevitably,youwillhaveperiodsofdrawdownswhenyouarenot in syncwith themarket.Youcannevercovera15-20%drawdown ifyoukeepbookingsmallprofits.Thebestyouwilldoisbeatbreakevenattheendoftheday,which isnot,andshouldnot,be thegoalof tradingfull time,orevenparttime.

Those who trade for a living cannot sustain an equity account that is notgrowing.Thuswhenyoubelieveyouhaveenteredintoalargemove,youneed

torideitouttillthemarketstopsactingright.Traderswithalotofknowledgeoftechnicalanalysis,butlittleexperience,oftengetintothequagmireoffollowingverysmalltargets,believingthemarkettobeoverboughtateverysmallrise—anduniformlysoinallmarkets.Suchtradersareunabletomakemoneybecausetheyaretoosmartfortheirowngood.Theyforgettoseethephaseofthemarket.Not only do these traders book profits early, sometimes they even take shortpositionsbelieving thatacorrection is“due”.Marketsdonotgenerallycorrectwhencorrectionsare“due”.Thebestpolicyistouseatrailingstoplossandletthemarketrunwhenitwantstorun.Thedisciplinedtraderunderstandsthisandkeeps stop losses wide enough so that he is balanced between staying in themoveaswellasprotectinghisequity.Capturingafewlargemoveseveryyeariswhatreallymakesworthwhiletradingprofits.

ADisciplinedTraderAlwaysKeepsLearningNewTradingTechniques

Youcannotlearntradinginadayorevenafewweeks,sometimesnoteveninmonths. Disciplined traders keep reading all the new research on technicalanalysis they canget their handson.They also read anumberof books everymonth about techniques, about trading psychology and about other successfultradersandhowtheymanage theiraccounts.Alotofveryaffordableseminarson trading are often held on weekends; experienced traders too should try toattend them,asevenonegreat trading ideagainedcanbeworth the seminar’sfee. I often like to think about traders as jehadis; unless there is a fire in thebelly, unless there is a strongwill and commitment towin, it is impossible towinconsistentlyinthemarket.

My educational background is in engineering, after which I completed anMBAintheUS.ButIcansafelysaythatfortradingIhavereadmorethantentimesthenumberofbooksthatIreadinboththosecoursescombined.WheneverI see a bookstore where trading books might be available, I go in and buywhatever isnew. Ialsovisita lotof Internet tradingsitesduring theweekend,readingall thematerial that iswrittenabout trading.Alotof it isnotofmuchuse but you often find nuggets that help your trading. Learning how toconsistently trade profitably is a lifelong struggle and winning it a mostsatisfyingexperience.

A Disciplined Trader Always Tries to Make Some Money with Less RiskyStrategiesAsWell

Inthisbookwehavefocusedonthreestrategiesofmakingmoney:

1. Position trading, swing trading and day trading in the futures market; Iconsiderthelastonetobethemostrisky.

2. Writing covered calls— less risky than the above and amore consistentwinner.

3. Futuresandcasharbitrage—noriskatall,butequallythereturnsarethelowest.

Futurestradingisaveryriskybusiness.Thebestofchartistsandthebestoftraders sometimes fail. Sure, it gives the highest returns but thesemay not beconsistent—andthedrawdownscanbelarge.Tradersshouldalwaysrememberthatnomatterhowgoodyouranalysisis,sometimesthemarketisnotwillingtooblige.Inthesetimesthe4-5%thatcanbeearnedincoveredcallsorfuturesandcasharbitragecomesinveryhandy.Itimprovesthelongtermsustainabilityofatradingmodelandkeepsyourprofitregisterringing.Tradersmustlearntolivewithlowerriskandlowerreturnatcertaintimesinthemarket,inordertoprotectandenlargetheircapital.Futurestradingshouldbethoughtofasanicingonthecake.Iknowit’snotglamoroustotellanyonethatonemakesmoneyoncoveredcallsorcashandfuturesarbitrage,butthenbreadandbutteractivitiesareneverglamorous.

Diversification is not a hollow term. Consistent profits not only add to atrader’s equityover aperiodof timebut also takes thepressureoff a trader. Ibelieveatradershouldhavesomeexposureincoveredcallseverymonthwhentheopportunityarises.Whenthereisnocoveredcallopportunity,i.e.whenthemarketisstretchedontheupside,youshouldkeepalargearbitrateposition.Asthemarketgoes into a correction and the cost of carrybecomesnegative, youcanshiftfromthearbitragepositiontothecoveredcallposition.Ifatradercanhave some less risky returns to back up his futures trading, this adds to hisconfidenceandimprovesthefuturestradingaswell.

Disciplinedtradershavereasonableriskandreturnexpectationsandareopento using less risky and less exciting strategies ofmakingmoney,which helpsthemtideoverroughperiodsinthemarkets.

ADisciplinedTraderTreatsTradingasaBusinessandKeepsaPositiveAttitude

Tradingcanbeanexpensiveadventuresport.Itshouldbetreatedasabusiness

andshouldbeveryprofitoriented.Disciplinedtradersreviewtheirperformanceat regular intervals and try to identify causes of both superior and inferiorperformance.Thefocusshouldbeonconsistentprofitsratherthanerraticlargeprofitsandlosses.Also,tradingperformanceshouldnotbemadeajudgementonan individual; rather, it shouldbe considered a consequenceof right orwrongactions.Disciplined tradersareable to identifywhentheyareoutofsyncwiththemarketandneedtoreducepositionsize,orkeepawayaltogether.Successfultradingislikedancinginrhythmwiththemarket.Unsuccessfultradersoftencutdown on all other expenses but refuse to seewhatmight bewrongwith theirtradingmethods.Denialisacostlyattitudeintrading.Ifyouseethataparticulartrade is not working the way you had expected, reduce or eliminate yourpositionsandseewhat isgoingon.Mostdisciplinedandsuccessful tradersareveryhumble.Humilityisavirtuethattradersshouldlearnontheirown,elsethemarketmakessurethattheydo.Egoandan“Icandonowrong”attitudeingoodtimescanleadtoseveredrawdownsinthelongterm.

Also,baddaysintradingshouldbeacceptedascheerfullyasthegoodones.Thereisacostoftradingthatthefamilyofeverytraderbearsaswell.Theyarethe ones who need to live with the trader’s frustrations and depression. Sodisciplinedtradersmaintaincomposurewhether theyhavemadeaprofitornoton a particular day and avoidmood swings.A goodway to do this is to alsoparticipateinactivitiesotherthantradingandletthemindrestsothatitisfreshforthenexttradingday.

ADisciplinedTraderDoesNotBlametheMarket

Disciplinedtradersdonotblamethemarket,thegovernment,thecompaniesoranyone else, conveniently excluding themselves, for their losses. The marketgivesampleopportunitiestotraderstomakemoney.Itisonlythetrader’sfaultif he fails to recognise them. Also, the market has various phases. It isoverbought sometimes and oversold at other times. It is trending some of thetime and choppy at others. It is for a trader to take maximum advantage offavourablemarketconditionsandkeepawayfromunfavourableonces.Withthehelp of derivatives, it is now possible to make some money in all kinds ofmarkets.Sothetraderneedstolookforopportunitiesallthetime.

Tomymind,theimportantkeystomakinglongtermmoneyintradingare:

Keepinglossessmall.Rememberalllossesstartsmall.

Rideasmanybigmovesaspossible.Avoidovertrading.Nevertrytoimposeyourwillonthemarket.

It is impossible topractice all of the aboveperfectly. If youcan, thenyouwouldnotbe reading thisbook. I certainlycan’tbut I am improvingoneveryaspectwithevery trade. Ibelieve ifa tradercanpracticeallof theabovewithsomedegreeofsuccess,improvementintradingperformancecanbedramatic.

ADisciplinedTraderKeepsaCushion

Ifnewtradersareluckytocomeintoamarketduringaroaringbullphase,theysometimes think that themarket is the best place to put all one’smoney.Butdisciplinedandseasonedtradersknowthatifthemarketstartsactingdifferentlyin the future,which it surelywill, profitswill stoppouring in and theremightevenbeperiodsoflosses.Sodonotcommitmorethanacertainamounttothemarketatanygivenpointoftime.Takeprofitsfromyourbrokerwheneveryouhavetheminyourtradingaccountandstowthemawayinaseparateaccount.Iwouldgototheextentofsayingthatyoumightevenconsiderinvestinginrealestateaswelliftheprofitsaresubstantial.Isaythisbecausethemarketislikeadeepandbigwell.Nomatterhowmuchmoneyyouputinit,itcanallvanish.Sobyhavinganaccountwhereyouaccumulateprofitsduringgoodtimes,ithelpsyouwhenmarketsturnunfavourable.

This also makes drawdowns less stressful as you have the cushion ofpreviouslyearnedprofits.Tradingisaboutwalkingatightropemosttimes.Makesureyouhaveenoughcushionifyoufall.

ADisciplinedTraderKnowsThereisNoHolyGrailintheMarket

There is nomagical key to this or any other stockmarket. If there were, theinvestment bankswho spend billions of dollars on researchwould snap it up.Thereisnosoftwareortradingbookwhichcangiveyouenormouswealth.Theycanonlygiveyoutoolsandskillsthatyoucanlearntoapply.And,finally,thereisnofreelunch;everytradingpennyhastobeearned.Iwouldrecommendthateachtraderidentifyhisownstyle,hisownpatterns,hisownhorizonandtheset-upsthatheismostcomfortablewithandpracticethemtoperfection.Youneedonly to be able to trade very few patterns to make consistent profits in the

market.Ingeneral,agoodchartingsoftwareismorethanenough.Iuse5-minute,30-

minuteandend-of-daydataformytradingandit’smorethanenoughforme.Noamountofgizmoscanmakeadifference toyour trading.Thereareno signalsthat are always 100% correct, so stop looking for them. Focus, instead, onpercentage trades, trying to catch largemoves and keeping yourmethodologysimple. What needs constant improving are discipline and your tradingpsychology.Atendoftheday,moneyisnotmadebyhowcomplicated-lookingyouranalysisisbutwhetheritgetsyouintherighttradeattherighttime.OntheNet, a lot of experts often suggest highly complicated strategies as well asindicators but remember nothing is perfect, least of all complicated strategies.Over-analysiscanleadtoparalysisandthatisdeathforatrader.Ifyoucan’tpullthetriggerattherighttime,thenallyouranalysisandknowledgeisawaste.

Rememberanalystsarepaidapittanceofwhatsuccessfultraderscanmake.Alsomostanalystsarenotgoodtraders,possiblybecausetheirfocusistoowide,or because they get too involved with overvaluation and undervaluation.Analysis should be implementable in order to make trading profits. A lot ofpeoplebelievethatlookingattheUSmarketallnightlonggivesanindicationofthe activity in Indianmarkets, or looking atNasdaq futureswould give a hintabouthow the Indianbourseswouldbehave. Ibeg todifferwith them.Unlessthereareextremereadingsbecauseofaspecificreason,everymarkethasitsownrhythmand thechartpatternsaloneshouldbeseriously lookedatand takenasthefinalword.Ifyouarewrong,theworstthatcanthenhappenisthatyourstoplosswouldgethit.

TraitsoftheIndisciplinedTrader

IamqualifiedtospeakonthissubjectbecauseIwasanindisciplinedtraderforalong timeand themarkethammeredme into lineandforcedme tochangemyapproach.

IndisciplinedTradersJumpinDuringtheFirstHalf-houroftheTradingSession

Thefirsthalf-hourofthetradingdayisdrivenbyemotion,affectedbyovernightmovements in theglobalmarkets, andhangoverof thepreviousday’s trading.Also,thisistheperiodusedbythemarkettoenticenovicetradersintotakingapositionwhichmightbecontrary to the real trendwhichemergesonly later intheday.Mostexperiencedtraderssimplywatchthemarketsforthefirsthalfofthedayforintradaypatternsandanysubsequenttradingbreakouts.

IndisciplinedTradersFailtoHeartheMarket’sMessage

Personally, I try tohear themessageof themarkets and then try to confirm itwith thecharts.During the tradingday, I like towatch if themarket isable toholdcertainlevelsornot.Iliketogolongaroundtheendofthedayifsupportedbypatterns,andifthepricesareconsistentlyholdingontohigherlevels.Iliketogoshortifthemarketisgivinguphigherlevels,unabletosustainthemandthepatterns support a downmove of the market. This technique is called tapewatching and all full-time traders practice it in some shape or form. If themarkets are choppy and oscillate within a small range, then the market’smessageistokeepout.

Hearingthemessageofthemarketcanbeparticularlyimportantintimesofsignificant news. The market generally reacts in a fashion contrary to mostpeoples’expectation.LetusconsidertworecentIndianeventsofsignificance.

OnewastheGujaratearthquakethattookplaceon26January2001andtheotherthe13December2001terroristattackontheIndianparliament.Boththeseevents appeared catastrophic at first glance. TV channels suggested that theearthquake would devastate the country’s economy because Gujarat has thelargestnumberofinvestorsandtheirconfidencewouldbeshattered,makingthestockmarketplunge.

Tragicasboththeeventswere,themarketreactedinadifferentwaytoeachbytheendoftheday.Inbothcasesthemarketsplungedaround170pointswhenitopened,inbothcasesittriedtorecoverandwhileitmanagedafullrecoveryinthe caseof theGujarat earthquake, it couldnot do so in theParliament attackcase. Themarket was proven correct on both counts. TheGujarat earthquakeactuallyheldthepossibilityofboostingtheeconomyasreconstructionhadtobetakenup,andalsobecausemostofthebiginstallations,includingtheJamnagarRefinery, escaped damage. In the case of the attack on parliament, althoughtraders assessed that terrorist attackswere nothing new in the country but themarketdidnotrecoverbecauseitcouldseesomekindofmilitarybuild-upaheadfrombothIndiaandPakistan.Andmarketshatewaranduncertainty.

Inboth thesecaseswhathelped thecauseof the traderswere thecharts. Ifthechartssaythatthemarketisactinginacertainway,goaheadandacceptit.Themarketisrightallthetime.Thisisprobablyevenmoretruethanthemorecommon wisdom about the customer being the king. If you can accept themarket as king, youwill end up as a very rich trader, indeed.Herein lies onereasonwhypeoplewhothinktheyareveryeducatedandsmartoftengettrashedbythemarketbecausethismarketdoesn’tcarewhoyouareandit’scertainlynottheretohelpyou.Soexpectnomercyfromit; infact, thinkofitassomethingthatistheretotakeawayyourmoney,unlessyoutakestepstoprotectyourself.

IndisciplineTradersIgnorethePhasetheMarketIsIn

Itisimportanttoknowwhatphasethemarketisin—whetherit’sinatrendingoratradingphase.Inatrendingphase,yougoandbuy/sellbreakouts,butinatrading phase you buy weakness and sell strength. Traders who do notunderstand themoodof themarketoftenendupusing thewrong indicators inthewrongmarketconditions.Thisisanareawherehumilitycomesin.Tradinginthemarketislikeblindmanwalkingwiththehelpofastick.Youneedtobeextremelyflexible inchangingpositionsand in trying todevelopafeel for themarket.Thisfeelisthenbackedbythevariousindicators,suchastheADX,inconfirming the phase of themarket. Indisciplined traders, driven by their ego,oftenignorethephasethemarketisin.

IndisciplinedTradersFailtoRealisethatReducingPositionSizeDoesNotMeanaLackofFaithinOne’sAbility

Tradersshouldbeflexibleinreducingtheirpositionsizewheneverthemarketisnotgivingclearsignals.Forexample, ifyou takeanaveragepositionof3,000sharesinNiftyfutures,youshouldbereadytoreduceitto1,000shares.Thiscanhappeneitherwhentradingcountertrendorwhenthemarketisnotdisplayingastrongtrend.Yourexposuretothemarketshoulddependonthemarket’smoodatanygivenpointinthemarket.Youshouldbookpartialprofitsassoonasthetradestartsearningtwotothreetimestheaveragerisktaken.

Indisciplined traders often think that a particular situation is sure to giveprofitsandsometimestakeriskseveraltimestheirnormallevel.Thiscanleadtoaheavydrawdownassuchsituationsoftendonotworkout.Everytradeisjustanother trade and only normal profits should be expected every time.Supernormalprofitsareabonuswhenthey—rarely!—occurbutshouldnotbeexpected. The risk should not be increased unless your account equity growsenoughtoservicethatrisk.

IndisciplinedTradersareOver-EagertoBookProfits

Profits in any trading account are often skewed to only a few trades. Tradersshouldnotbeover-eagertobookprofitssolongthemarketisactingright.Mosttraders tend to book profits too early in order to enjoy the winning feeling,therebylettinggosubstantialtrendsevenwhentheyhavegotagoodentryintothemarket. If at all, profit booking should be done in stages, always keepingsomepositionopentotakeadvantageoftherestofthemove.Remembertradingshouldconsistofsmallprofits,smalllosses,andbigprofits.Biglossesarewhatmustbeavoided.Thepurposeoftradingshouldbetogetapositionsubstantiallyintomoney,andthenmaintaintrailingstoplossestoprotectprofits.

Mosttradingisbreakeventrading.Accountssizesandincomefromtradingareenhancedonlywhenyoumakeeighttotentimesyourrisk.Ifyoucanmakethishappensonceamonthorevenonceintwomonths,youwouldbefine.Theimportantpointhereistonotgetshakenbythedailynoiseofthemarketandtoseethemarketthroughtoitslogicaltarget.Remember,mostmoneyismadenotbybrilliantentriesbutbysittingonprofitablepositionslongenough.It’sboringtodonothingonceapositionistakenbutthematurityofatraderisknownnotby thenumberof tradeshemakesbut theamountof timehesitsonprofitabletradesandhencethequantumofprofitsthathegenerates.

IndisciplinedTradersOftenUseTradingforEmotionalHighs

Tradingisanexpensiveplacetogetemotionalexcitementortobetreatedasanadventure sport. Traders need to keep a high degree of emotional balance totradesuccessfully.Ifyouarestressedbecauseofsomeunrelatedevents,thereisnoneedtoaddtradingstresstoit.Tradingshouldbeavoidedinperiodsofhighemotionalstress.

Indisciplined Traders Don’t Realise that Trading Decisions Are Not AboutConsensusBuilding

Our training since childhood often hampers the behaviour necessary forsuccessfultrading.Wearealwaystaughtthatwheneverwetakeadecision,weshouldconsultanumberofpeople,andthendowhatthemajoritythinksisright.Thetruthofthismarketisthatitneverdoeswhatthemajoritythinksitwilldo.

Trading is a loner’s job. Traders should not talk to a lot of people duringtradinghours.Theycantalktoexperiencedtradersaftermarkethoursbutmoreonmethodologythanonwhattheothertraderthinksaboutthemarket.Ifatraderhas to ask someone else about his trade then he should not be in it. TradersshouldconstantlytrytoimprovetheirtradingskillsandbytradingskillsImeannotonlychartingskillsbutalsopositionsizingandmoneymanagement skills.Successful traders recognise thatmoney cannot bemade equally easily all thetime in themarket. They back off for awhile if themarket is too volatile orchoppy.Theabovearegeneralideasonwhatshouldandshouldnotbedone.Obviously,therearenosetwaysonhowtoachievethesegoals.Asinmostcases,theendiswhatmattersandnotnecessarilythemeans.

MyTradingManual

Different traders develop their own methods to deal with the issues andpsychology in trading. IampresentingbelowamanualofhowIapproachmytradingandwhatIdobeforeandafterIinitiateatrade.Thisisjustonewayofdoing things; traderscan improveupon thisas theygoalong,or follow totallydifferentmethodstoachievesimilargoals.

PreparationforTrading

HereishowIdoit:

EveryeveningIgettheendofdaydataaround4p.m.ThatiswhenIbeganmyanalysis.Mychartsarereligiouslyupdatedeveryevening.This isoneritual I do not miss if I have to trade the following day. Remember, atrader’sdayneverends.FirstofallIgothroughallthebroadindicesinthefollowingorder:Nifty,S& P CNX 500, Nifty Junior, Defty. This gives me a feel for the broadmarket and thebreadthof anymarketmove.Theconclusion Idraw fromthisistheunderlyingstrengthofamarketmove.Iftheindicesaresecularintheirmovement,Iammoreconfidentofthemove.Ifthemoveisrestrictedonly to index stocks while the other indices are moving in the oppositedirection, I take it asa time togetcautious. If the indexstocksaredoingnothingand themidcapsaremoving, thesemovesdonot sustainbecauseit’s theretailerswhoaregenerally in themidcapsandunless thefrontlinestocksmove, themidcapmoves cannot be sustained. Also, I look at theADX of all these indices to see the strength of the ongoing trend andidentifythephaseofthemarketintermsofwhetheritistradingortrending.The objective of this stage is therefore to identify the direction and thestrengthofthemarket.I then lookat thevarioussectoral indices. In theIndiancontext, thesearebanking, pharma, technology, PSU, FMCG, auto, etc. and separate thestrongsectorsfromtheweakones.Basedonwhetherthemaintrendofthemarketisupordown,Iselectthestrongest and the weakest sectors and then select their strongest andweakeststocks.Ithenlookthroughthechartsofallthesestockstoseeifanyspecificset-ups exist. At this point, I write all the set-ups that may breakout on thefollowingdayalongwithstoplosses,entryandexitlevels.Other situations I like to look for are volume breakouts. Most technicalanalysissoftwareallowsforcheckingthevolumegainers.Thiscanalsobedoneat theYahooIndiafinancesite. I like to lookat this listbecause the

top volumemovers can often be stockswhich have broken out on heavyvolumefromset-upsandtherecouldbelikelyfollow-up.ButhereItrytoignore the cashgroup stocks and concentratemainlyononeswhichhavederivatives.InIndia,itiswisetocheckthepedigreeofthecompanybeforetakingthevolumeleaderstooseriously.At theendof thisexercise Ihaveanice listof set-upsand tradeswrittendowntothelastdetailinmynotebook.Itrynottooveranalyse,also,nottooversimplifythings.Ifsomethingisnotclear,Imoveontothenextone.Iliketotradeonlythesurestpatternsandset-ups.

TradeExecutionNomatter howmuch net practice (paper trading) one does, the true test of atrader comes only on the real pitch and in playing with the big boys. Tradeexecution is very important to ensure that youdonot endupbuying tops andsellingbottomsalthoughthattoowillsometimeshappen.Thegoalofgoodtradeexecutionistogetintolowrisksituationswhichgiveyouawidestoplossandthetradegetsenoughroomtogyratebeforemovingonandyouneedtoactuallybewrongforthestoplosstobehit.Buyingoversoldsituationsinanuptrendandoverboughtsituationsinadowntrendshouldbethegoaloftradeexecution:

Thebestentriesareachievedinthelatterhalfoftheday.Iavoidall tradeexecutioninthemarket’sfirsthour.Theadvantageofenteringtradeslate,andparticularly in the last hour is that by then themarket has had all itsintradayswingsandismovinginthedirectionitfinallywantstotake.Theoneexceptiontotheaboveruleisthatifthemarketgapsdownandthemain trend is up; I like to buy when the market opens. This generallyprovidesanexcellentbreakevenlevelandisusuallyaveryhighpercentagetrade.Onceyougetatradethatimmediatelymovesaboutoneaveragetruerangeintothemoney,youjustneedtotrailstopsandlettheprofitsrollin.Thesameappliestosellsidetrades.Ihaveaccessto5-and30-minutedataaswellasIliketotaketradeswhensomekindofabreakouthappensonapatternonanyof thesecharts;30-minute charts for daily entries and 5-minute chart for intraday entries,providedthemaintrendisinplaceonthehighertimeframe.Ifatradeon,say,theNiftyisexecutedonthelongsideandthestoplossofoneaveragetruerangeishit,Iwouldliketoseethebreadthofthemarketandseeif themarket ismakinglowertops.Ifso,Ireversethetrade.SoItakeastoplossgettinghitasasignalforatradepossibilityontheoppositeside. These trades are often big trades since, likeme, other traders couldalsobetrapped.Itakeprofitsonovernightpositionsattheopeningifthemarketopenswithafavourablegap,butnewpositionsshouldnotbeinitiated.Gapopenings in thedirectionof themaintrendshouldbedealtwithverycarefully.Personally,Iliketowaitawhiletillthemarketmakessomekindoftradingrangebeyondthegap,orthegapgetsfilledaftertheopeningand

takessupportatsomepointbeforetakingaction.Asriskfreeasthegapsintheoppositedirectionare,Ihavefoundgapsinthedirectionofthetrendtobe extremely risky.Keepingpatience in the caseof suchgaps is thebeststrategy.

TradeManagementContrarytowhatmostpeoplethink,thepartoftradingthatmakesyouthemostmoneyistrademanagement.Trademanagementisthepartthathappensonceatradehasbeentakenon.Manytradersdonotgetfarenoughtocriticallyreviewtheirtrademanagementskills,sincemosttradingcareersendwhilelearningthemumbojumbooftechnicalanalysis.

Oncethetradeison,threethingscanhappen:

1.TrademovesdeepinthemoneyquicklyThisisthesituationallofushopefor.Istart thetradewithaoneaveragetruerangestopandasthemarketmovesintothemoneybyoneaveragetruerange,Imovethestoptobreakeven.ThismeansIgivethemarketroomforatleastoneaverage true range togo through its intradaygyrations. Intradaypivots canbeusedasthestopsforintradaycharts.

Ijustletthetradereachitslogicaltargetswhichhavebeenidentifiedinmytradingplan.Iwillholdontothetradeaslongasthemarketkeepsactingright.Thismeansunlessthereisoverwhelmingevidenceoftrendchange,Iwouldnotgetoutofthetrade.Thismighttakeawaysomeprofitsfromyouifthemarketsturn exactly from the targets identified earlier but the tendency to stay longerwith the trade will help in the long-term because the market operates onexcesses. As the targets approach, however, stops can be tightened or partialprofitsbookedbutkeepingsomeofyourpositionwillkeepyouinthetradetilltheend.

Atthispoint,Iwouldsayattheriskofreducingtheimportanceofchartingthat traders should not become a slave to indicators or charts — the marketshouldhavethefinalword.Indicatorsandchartsprovidetheroadmapbutthesechartsdependonactualmarketaction,andnotviceversa.Also,trytotradewiththetrendunlessthereisoverwhelmingevidenceofatrendreversal.Incounter-trendtradesit’simportanttorememberthattechnicaltargetsmaynotbemetandyoushouldbepreparedtobookprofitsatthefirstsignofreversal.

2.TheTradeDoesNothingforanEntireSession

This can happen in choppymarketswhere the index and stocks can stay in anarrow range formanydays.The indexor the stockmaymeander around the

breakevenlevel,neitherhittingthestoplossnoradvancinganyfurther.Insuchsituations it’s best to get out of the trade andmake a fresh entry another day.Alternately, you could consider selling straddles or covered calls. But a tradethatdoesnotimmediatelymoveintoprofitseldomturnsouttobeawinnerintheend.

3.TheTradeImmediatelyGoesandHitsYourStop

Therearetworeasonswhythestoplossmightbehit:

1. Itwasplacedtoocloseandgothitbythenoiseinthemarket.Tocheckthisout,observe themarketforawhileandtry toenter thenextbreakoutandalsokeepawiderbreakout.

2. If a stop loss of one average true range gets hit, then you can be sure itprobably was not noise. You should then consider the breadth of themarket, look at intraday patterns on the index aswell as key stocks, andconsidersellingon thenext rally.Thebestmovesoccurwhen themarketinitiallychangesdirectionbecauseanumberof tradersdonot take timelyactionwhenthemarketisnotactingintheirdirection.

Finally,rememberthefollowingthumbrulesinalltypesofmarkets.

Extraordinarymarketvolatilityindicatesanimpendingdeclineandisasignofdistribution,particularlyatthetopofthemarket.If thevolumedropsinanupmoveandthemarketgoesextremelyquiet, itmeansthatthefuelneededtokeepthemarketisrunningoutanditwouldsoongointocorrection,orwillreversetrends.Ifthevolumedropsinadownmove,andthemarketbecomesquietitmeansaslowaccumulationmightbetakingplace.Looktotradethefirstbreakoutfromaconsolidationpattern.Ifamarketisdroppingonheavyvolume,itmeansthereismoredownsideyettocomeandpeoplearegettingoutinahurry.

Indianslovespeculation.Theylovetakingriskswithwhatevertheyhave.Oftenthey are cheated by lottery owners and casino owners into thinking that hugerichesawaitthem.Atothertimestheylosetheirshirtstofrivolousventuressuchasplantationcompanies.butderivativetradingisdifferent,itisagameofskillwherethebestmanwins.Itcannotbemanipulatedtogiveanunfairadvantagetoanyone.

Chapter12

MoneyManagement

TheSizeofYourTradingPositions shouldbeBasedon theSizeofYourTradingCapitalTomymind,oneofthemostneglectedaspectsof trading is money management. So neglected and ignored is thetopic thatmost traders never know it exists and go out of businesswithout actually knowing what they missed out on. Most tradingbooks and seminars focus on set-ups, entries and, sometimes, exits.The reason for this is thatmoneymanagement is not a particularlyglamorousormarketabletopicforanyseminarorbook.Buttradersofalltimeframesshouldtakethischaptermoreseriouslythananyotherbecause this is the topic that alerts traders about whether they cansustaintheirbusiness.

Peoplehavedifferentviewsonwhatmoneymanagement actually is.Let’sfirstbeclearwhatmoneymanagementisnot:

Moneymanagement is not the part of your trading system that indicateshow much you can lose on a given trade. Most retail traders have theplacementofstopsdrilled into themby technicalanalysts,erroneously,astheultimatemoneymanagementtool.Money management is not diversification. Many people believe thatdiversification is thebestway toproperlymanagemoney.Thiswouldbetakingtoosimplisticaviewintermsoftradingmethodolgy.Moneymanagement isnot riskcontrol. It iscertainlynotbuyingcall andputoptions.Moneymanagementisnotriskavoidance.Itiscertainlynothavingallyourassetsinfixedincomesecurities.Moneymanagement is not that part of the trading system thatmaximisesperformance.

Moneymanagement isnotpartof thesystemthat tellsyouwhat to investin.Itcertainlyhasnothingtodowithtechnicalanalysisorchartingandalltheothertechniqueswehavediscussedsofar.

WhatisMoneyManagement?

So,whatexactlyismoneymanagement?Money management is that part of your trading system that answers the

question“Howmuch?”throughoutthecourseofatrade.Trading, like every other business, needs to startwith a certain amount of

equity or “seed capital”. Traders remain in business so long as they have thisseedcapitalwiththem.

Drawdowns

Drawdownsare,ofcourse,apartofeverytrader’slife.Let’ssayatraderhastradingequityofͲ10lakhandafterastringoflosses

isleftwithͲ7lakh.Heisthussaidtohavehadadrawdownof30%.Afterthis,onlywhenthetraderisabletomakebackisoriginalcapitalcanhethinkaboutprofits.

Let’sconsidera simplegame tounderstand theeffectsofdrawdownsonatrader’s trading ability, something as simple as tossing a coin. Now the twopossibleoutcomesofthisgameareeitherheadsortails.Ourtraderinthegamewinsifhegetsheadsandlosesifhegetstails.HestartswithͲ1,000andrisksͲ100onevery toss.Let’sassumehe tosses thecoin three timesand loseseverytime,adistinctpossibility.NowheisdowntoͲ700.Ifhewerenowtoassumethathewillwinthenexttossbecausehehashadthreelossesinarow,that’sagambler’s fallacy because his chances of winning the next toss are still only50%,theprobabilityofafavourableoutcome.LetusassumethatbasedonthisfallacyhedecidestobetͲ300becauseheissosurehewillwin.However,helosesagainandnowhasonlyͲ400left.Fromhereon,henowneedstomake150%justtobreakeven.Itis,therefore,highlyunlikelythathewould:

Breakeveninashortperiodoftime,orMakeanysubstantialprofits.

Lesson: the trader failed in this simple game because he risked toomuchmoneyonasingletrade.

RecoveryafterDrawdowns

Table 12.1 clearly brings out that drawdowns upto 20% need only a 25%

gaintorecover;anythingover20%beginstogetverydifficult.Mosttraderscometotheequitymarketswithundercapitalisedaccountsbut

with pipe dreams of makingmillions and this is what ultimately causes theirdownfall. In India, particularly, the huge minimum derivative contract sizessuggest thatonlyhighnetworthinvestorsandinstitutionsshouldparticipateinit. Still everyday millions of small traders try to profit from the derivativesmarket and fail. That is because these people are practicing poor moneymanagement — their account size is simply too small to begin with. Andbecause of their inadequate account size, themathematical odds of failure areveryhigh.

Inmyopinion, if a personhasͲ 50 lakh as total account equity, the totalnakedderivativesexposure(excludingcoveredcalls)atanypointoftimeshouldnotexceed10-15%oftheportfolio,i.e.Ͳ5lakhtoͲ7lakh,andthebalance85-90%of theportfolioshouldbe inacoveredcallswithunderlyingstocksbeingheld.Thiswaythe85-90%oftheaccountgrowssteadily,albeitataslowerpace,whilethekickerisprovidedbythenakedderivativesexposure.Thisparametercanequallybeappliedtoaccountsofallsizes.Positionscanbeaddedasone’stradingaccountgrowsinsize.Thisismywayofmoneymanagement.

Notice inTable 12.1 howmuch your account has to recover fromvariousdrawdownsizesjusttorecovertobreakeven.

Table12.1Drawdowns GainNeededto

Recover5% 5.3%10% 11.1%15% 17.6%20% 25%25% 33%30% 42.9%40% 66.7%50% 100%60% 150%70% 300%80% 900%

80% 900%

PositionSizingStrategies

Professional gamblers like to talk about two typesof postion sizing strategies,namelymartingaleandanti-martingale strategies.Martingale strategies suggestincreasing bet sizes when equity decreases during a losing streak. Anti-martingale strategies, on the other hand suggest increasingone’s bet size onlyduringwinningstreaks,i.e.whenone’sequityincreases.

Ifyouhaveplayedrouletteorourveryown“Lucky7”atfairsor the localDiwaliMela,youmighthaveconsideredthepurestformofmartingalestrategieswhichsimplyamountstodoublingyourbetsizewhenyoulose.Forexample,ifyouloseͲ1,younextbetͲ2.IfyouloseͲ2,thenyounextbetͲ4,andsoon.When you finally win, which you eventually do, you will be ahead by theoriginalsizeofyourbet.

Casinoslovepeoplewhoplaysuchmartingalestrategies.Firstanygameofchancewillhavelosingstreaks.And,second,whentheprobabilityofwinningislessthan50%,thelosingstreakscanbequitesignificant.

Let’sassumethatyouhavealosingstreakoftenconsecutivelosses.IfyouhadstartedbettingͲ1,anddoubledeverysubsequentbet,thenyouwouldhavelostͲ2,047overthestreak.YouwillnowbebettingͲ2,048simplytogetyouroriginalrupeeback.Thusyourwin-lossratioforlessthana50:50betis1:4097.Lookedatanotherway,youwillneedtoberiskingalossofoverͲ4,000togetͲ 1 in profits.Andmost casinosmight have betting limits. So themartingalestrategiesgenerallydonotwork—whetherinthecasinoorinthemarket.

Most Indian traders will connect with this strategy as the loss averagingstrategywhichhasneverreallyworkedforanyone.Mytakeonlossaveragingisthat ifyouhavemadeagoodtrade, itworksfromthewordgo.Usuallytakingthe first loss results in the smallest loss.So it’s important not to try and tradeyourwayoutoflossesbuttocutthemstraightaway.

On theotherhand, anti-martingale strategies,whichcall for larger risk,dowork—bothinthecasinoandinthemarket.Positionsizingsystemsthatworkcall for increasing one’s position size when youmakemoney. This holds forgambling, trading and investing. The purpose of position sizing is to tell youhowmanyunits—sharesorcontracts—youshouldtakeon,giventhesizeofyouraccount.Apositionsizingdecisionmightevensuggestthatyoudon’thaveenoughmoneytotakeanypositionsatallbecausetheriskistoobig.Itallows

youtodetermineyourriskandrewardcharacteristicsbyworkingouthowmanyunitsyouwillriskonagiventrade—andoneachtradeinagivenportfolio.Italso helps you equalise your trade exposure among the elements of yourportfolio.

As a rule of thumb, I believe that the overall leverage used by a personshouldnotbemorethan33%.Thus,fora200shareNiftycontract,whichhasamargin ofͲ 32,000 at 1,600Nifty (at amargin of 10%) and a total contractvalue ofͲ 3,20,000, I would be comfortable having at leastͲ 2 lakh in mytrading account, whichworks out to approx. 66% of the contract value. Nowsome would wonder why I need Ͳ 2 lakh in my account when the marginrequiredinonlyͲ32,000.Thisistoensurethatadrawdownof15-20%,whichisalwayspossible,doesnotthrowmeoutofbusiness.Anothercontractcanbeaddedwhen the account increasesby anotherͲ 2 lakh, but not before that.Amore aggressive trader might believe Ͳ 1 lakh is enough to trade a similarcontract.But in the longrunmychancesofsustaining in themarketaremuchbetterthanhis.Thereisnoneedfortheother85-90%oftheaccountequitytositidle;itcanbeusedtoearnreturnsofabout4%amonthwithcoveredcalls.

Some people think they are doing an adequate job of position sizing byhaving a “money management stop”. Such stops can be placed through thetradingterminalandaretriggeredifparticularpricesarehit.Mostpeopledecideonsuchstopsbyjustconsideringtherupeelosstheyarewillingtotake.Butthiskindofstopdoesnottellyouhowmanyunitsyououghttobuyinrelationtotheoverall size of your trading capital, orwhat is appropriate for you for a giventrade, and therefore such a stop has nothing to do with position sizing.Controllingriskbydeterminingtheamountoflossifyouarestoppedoutisnotthe same as controlling risk through a position sizing model that determines“howmany”,andwhetheryoucanaffordevenoneposition.

We now turn to a discussion of the anti-martingale strategies for positionsizing,inwhichyourpositionsizegoesupwithyouraccountsize.

Wearegoingtouseatrendfollowingsystemforthepurposeofexplainingthese strategies using the Nifty futures; volumes should in any case be keptlowerinchoppymarkets.

Strategy1:OneUnitperFixedAmountofMoney

Thismethod tells you the size of your position for every “X” rupees in youraccount.The system I use is to tradeoneNifty futures contract for everyͲ 2

lakhofmytradingequity.Thismethodhas theadvantage thata trade isneverrejectedsimplybecauseit’stoorisky.

Considerthefollowingtwomoneymanagementstrategies:ThereisonetraderwhotradesoneNiftycontractforeveryͲ2 lakhinhis

account.ThistraderhasͲ6lakhinhisaccount.ThereisanothertraderwithatradingequityofͲ10lakhwhodoesnottakeatradeifithasmorethana3%risk.

NowconsideraNiftyfuturessetupwhichendsupbeingveryprofitable;thefirst trader took the trade anddidverywell for themonth.The second trader,sincehe limitshis risk to3%,avoided the tradeand thushadabelowaveragemonth.Thesame tradecouldwellhavehad the reverseconsequences,makingthesecondtraderlookverysmart.Asyoucansee,thebenefitofthefirststrategyisthatyoutakeeverysignal.

Ontheotherhand,therearecertaindisadvantagesaswellofthefirsttrader’stechnique.

NotAllFuturesareAlike

1,200sharesofNiftyfuturesataNiftylevelof1,500willattractamarginofͲ1.8lakh(10%)whichwillallowyoutoholdcontractsworthͲ18lakh.Ontheotherhand,1,200stockfuturesofRelianceatanunderlyingpriceofͲ510willattractamarginofͲ122,400atarateof20%margin(stockfutureshavehighermargin)andallowyoutoholdcontractsworthͲ612,000.

At the time of writing this book, Nifty had an average daily range, alsoknownasaveragetruerangeof30pointandReliancehadanaveragetruerangeof13points.Letusassumethatastoplossofaday’saveragetruerangeisputonboththefuturescontractsasissometimesnecessaryinvolatilemarkets.

The6NiftycontractscouldloseyouamaximumofͲ36,000whereasthe2Reliance contracts could lose you maximum of Ͳ 15,600. So each tradingopportunity in the futures market is different and the same criteria cannot beuniformlyapplied.VeryLowLeverageoraVerySmall-SizedAccountCanHinderRaisingthePositionSize

This can occur in twoways. Consider a trader trading one Nifty contract foreveryͲ5lakhwhohasaͲ10lakhaccount.Hewillneeda50percentreturnfor his account to go uptoͲ 15 lakh which will enable him to increase hispositionsize.

Ontheotherhand,ifatraderhasaͲ2lakhaccountandtradesonlyoneunit,he would need to double his account to be able to add another unit to hisposition.

A third traderwithaͲ30 lakhaccount, tradingonecontract foreachͲ2lakh,willneedonlytomoveuptoͲ32lakhtobeabletoaddanotherunit;thisisonlya6.6%increase.Thisismypreferredmethodofpositionsizing.

Strategy2:EqualValueUnits

The equal units strategy is typically used with stocks but can be used withfuturesaswell.

Assume a trader has an account equity ofͲ 20 lakh. (I have assumed thefigureofͲ20lakhforeaseofcalculation).Theequalvalueunitsstrategysaysyoudetermine thepositionsizebydividingyourcapital intofive,oranyothernumber,ofequalinstalments.Thus,wecanhavefiveunitsofͲ4lakheach.Inthefuturesmarket,youmightdecidethatwithͲ20lakhyouwanttocontrolasmuch product as possible. One bottleneck with this strategy in the Indian

derivativesmarketisthelargecontractsizes.ThiswouldbeamajorproblemasataNiftylevelof1,600,maybenotwithaͲ20lakhaccountbutwith,say,aͲ5lakhaccount;forexampleasinglecontractofTelco,consistingof3,300shares,willcontrolproductworthoverͲ10lakh,andsoonasshowninTable12.2

Nowsomewouldcallthisadiversifiedfuturesportfolio,butpersonallyIam

not comfortable about putting allmymoney into a leveraged product such asfutures. Shares for which derivatives are allowed all have very high beta andtend to riseor fall together. Iwould instead takeanexposureon theNifty fordiversificationandeaseof tracking.But that issimplymypersonalpreference.However,iftheNiftyisnotshowinganytrend,Iwouldthenlookatindividualstockfutures,oratabasketofstockfutures.ButundernocircumstanceswouldIhave a naked futures position totalling more than 15% of my total tradingaccount.

Traders should always keep track of the total product value they arecontrolling and their leverage. This strategy has the drawback that you canincreasethesizeofyourpositiononlyveryslowly,particularlyconsideringthelotsizesinIndia.

Strategy3:ThePerCentRiskModel

Whenenteringaposition, it iscritical fora trader tohavedecided thepointatwhichhewouldexit inorder topreservehiscapital. I think thatnomore than2%ofthetradingcapitalshouldberiskedonanysingletrade.Again,thiscouldvaryabitaccordingtothestock;foratechnologystockitcouldbeonthehighersidethaninthecaseofanoldeconomystock,butthemaximumshouldstayat

2%.Thusthepositioncanbesizedinsuchawaythatnomorethan2%ofyourentirecapitalisatriskatanypoint.That’swhatIpersonallydo.

TakingagainanexampleoftheNiftycontractforaͲ10lakhnakedfuturesportfolio,andconsideringa2%risk,theriskonthepositionneedstobecappedatͲ20,000.Supposethetradeyouaretakinghasa20-pointstoploss,thenyourfuturespositionshouldbenomorethan1,000sharesofNifty.

Ifatraderhasasystemwithverysmallstops,thenheneedstoadoptmuchsmallerrisklevels.Thus,forexample,ifthestopsarelessthanthedailyrangeofprices, then you need guidelines which are about half of 2%. Personallyspeaking,I focusa lotmoreongoodentryset-upsandkeepa little largerstopwhen I get into a trade, up to 5%of the naked futures portion ofmy accountwhichagainworksouttoabout2%ofmytotalaccount.ForalongtimeItradedfutureswithverysmallstopsandmystoplossesoftengothitbeforethepositionfinallymoved in the desired direction. Accordingly, I decided to increasemystoplossandsimultaneouslyfiltermyentriesevenmore,andonlyenteronceIhad the market perfectly set up. In practice, no matter how good you are atcharting, often positions initially move in the reverse direction, sometimesbecause of noise and sometimes because of a pullback after a breakout. So awiderinitialstopcanbeusedbutthenthepositionneedstobesizedaccordinglykeeping the daily range in mind.My results have been dramatically differentsince Iwidenedmy stops, but this should be done considering the size of theaccount.Onceatrademovesatleastonedailyrangeinthemoney,Iusestopsatbreakeven. I keep close trailing stops only in trading markets. In trendingmarkets,Iwouldlookforrealevidenceofreversalbeforekeepingaclosestop.Iwouldkeepatleasthalfadailyrangeorapivotasthestop,whicheveriscloser.Positionresizingcanbedoneastheaccountgrowsinsize,sodoesthepercentrisk.

Strategy4:ThePerCentVolatilityModel

Volatility refers to the amount of daily price movement of the underlyinginstrumentover an arbitraryperiodof time. It’s thedirectmeasurementof theprice change a trader is likely to be exposed to — whether favourable orunfavourable. If you equate the volatility of each position that you take bymaking it a fixedpercentageofyour capital, thenyouarebasically equalisingthe possible market fluctuations of each portfolio element to which you areexposedintheimmediatefuture.

Thus, if the various volatilities of stock futures are sized in terms of thepercentagerisk,thevolatilityoftheentireportfoliowouldbestandardised.

Let’strytounderstandthiswiththehelpofanexample.WeshallassumeanaccountsizeofͲ40lakhdividedequallyintofourparts

andariskpercentageof2%Now on a portfolio divided into four parts, the total risk on the entire

portfolioallowedisͲ80,000andisdividedintoͲ20,000foreachofthefourparts. As you can see from Table 12.3, the problem that arises is that theappropriate sizes are sometimes not available. But this is again a very safemethod, especially for beginner traders. Positions are sized according to thevolatilityaswellaspercentageofrisk.

Table12.3

Inmyview, the twobeststrategiesare thefirstand thefourth.Thebenefit

withStrategy1isthatyoucanmeasuretheamountofleverage,varyitaccordingtoyourcomfortlevel,andincreasepositionsasyouraccountsizegoesup.ThebenefitofStrategy4 is thatpositionsare sizedaccording tovolatility and riskpercentageandhencedefinetherulesfortraders.

Stops

Inconjunctionwiththemoneymanagementmethodsexplainedabove,stopsarea very important aspect of trading.A stop is that predecided point on a chartwhichdefinestheamountofriskatraderisgoingtotake.

Therearevariousmethodsofplacingstopsandthentradingthem.Stopsareas much about initiating trades as they are about trade management once theposition is in themoney. It is very critical for a person to be clear about themethodologyofplacingstops,andadheringtoitoncethetradeisinitiated.

Tomymind,keepingmentalstops,orhavingveryclosestops,orchangingstopsmid-tradeareall counterproductive.Stopsplaced toocloseoftengethitbecause of noise or random movements in the prices of futures, while stopsplaced too far may actually skew risk and return. However, a trader has toassumethatnotradewillbehislast;alltradersrealisethatsustainabilityinthebusiness is key to making profits. When a trader goes out of business, thepossibility of profits ends right there and then.We will discuss all of this indetailinthissection.

Mediaanalystsoftentalkofstopsasaphilosophy.Iwouldsaythatputtingrupee stopswithout any attention to one’s position size is a colossalmistake.Often, stops suggested on television shows are 510% below the prevailingmarketprices.Followingthis,atraderwillkeeprisking5-10%ofhiscapitaloneverytrade,andastreakoflosseswillcreatesuchabaddrawdownthathewillneverrecoverfromit.Stopsonanytradeorabasketoftrades,atleastinitially,shouldnotbemore than2%of the trader’s account equity; thevariable is thepositionsizeandnotthesizeofthestopasissometimessuggested.

The reason for putting stops is to pre-define your risk and also to avoidgettingfrozenintoinactionwhenapositionstartsgoingagainstyou.AnybrokeronNSEorBSEterminalswillputthestoplossforyou.Thestoplosshasbothatriggerpriceandthelimitprice.

TheFunctionsofaStop

Astophastwousefulfunctions.First, it preserves capital when a trader is wrong. As sustainability in the

business is thekey toprofits, it’s important that the traderdoesnot losemorethanapredefinedamountwhenheisprovedwrong.

Thesecondfunctionofthestoplossisthatithelpsmeasureprofitintermsoftherisktaken.IfatraderrisksanXamountineverytrade,hecanthusmeasurehisprofitintermsof2X,3X…..10X,etc.

Toillustrate thisconcept, letusassumea traderwins50%of the tradeshemakes. Suppose he has a trading capital (account equity) ofͲ 5,000 and, onaverage hemakesͲ 2X on everywinning trade and losesX on every losingtrade.NowtakethatXtobeͲ100andassumethetradertakes100trades.ThetwovariablesherearethenumberoftimesXandthewinningratio.Let’sdoasensitivityanalysisforboth,for100trades,andvaryingthenumberoftimesX.

Table12.4

Table12.4clearlybringsouthowdramaticallyprofitability improves if the

winmultipleimprovesevenjustmarginally.Thisclearlyprovesyoudon’thavetoberightallthetimetomakebigprofitsinthemarket.Manysuccessfultradershavewiningprobability only in the regionof 30-40%,yetmakemost of theirmoneyonbigtrades.

TacklingMarketNoise

Intra-day market movements usually have no material impact on the overalltrend. In fact, most of these gyrations are caused by very temporary demandsupplymismatches.Thus a trader needs to keep his stop losses far enough sothat the noise does not throw him off the trade. This judgement is usuallydevelopedwithyearsofpractice.Althoughtheoreticallyitappearsafineideatobuy breakouts out of ranges and patterns, or trade overbought and oversoldlevels, in reality a market often does nothing after these breakouts — andsometimesevenreversesforawhilebeforeproceedingwith theoriginal trend.Thekeyhereistokeepawiderstopandsizeyourpositionsasdescribedearlier.

Thekeyistohaveastrongbodyofevidencebeforeyouenteratrade.Buyorsellsignalsshouldbematchedacrosstimeframes,thebreadthofthemarkethastobeconsidered,andthenthestopsneedtobeplacedinanareawherethestopmay not apparently logical. I say this because “logical” stops will usually betaken out by themarket in case it reverses temporarily. Even after all care istaken,thestopsmaystillbehitbystrongcountermovescalledwhipsawsbutthenumber of such instances can be reduced. The average true range can beconsidered to be themeasure ofmarket noise. The charts in Figures 12.1 and12.2 show examples where the market can have temporary reversals after abreakdown.

Figure12.1

Figure12.2

Wenowturntosomeofthemethodsforplacingstops.

TightStopsBeingaswingtrader,Igenerallyholdmypositionsforfourtofivedays.IusetightstopsastrailingstopsonlyonceIamdeepinthemoneyintermsofprofit.Idosoasamethodforprotectingmyprofitsratherthanwhenenteringaposition.Thisismyopinionasaswingtrader.

Therearecertainotheradvantagesof tight stops.First,you losemuch lessmoneywhen a trade is aborted. Second, because of your small loss, you canmakemultiple attempts at re-entry. And, third, if you get such a move, yourprofitwillbemanytimestheamountofyourinitialrisk.

Equally,tightstopshavesomeseriousshortcomings.Tightstopsresultinmanymoretradesinordertogeneratethesameprofits.

Inmarketswhicharenottrendingverystrongly,sometimesyourstopcankeepgettinghitbeforethemarketmovesinthedesireddirection.Iusedtightstopsinthe initialphaseofanycareerand found that thenumberof times theygothitbeforeatrademovedinthedesireddirectionfarexceededthebenefitofmakinghighreturns.

Theotherdownsideisthattransactioncostsaddupsincetightstopsleadtoovertrading.Cheapas tradingis inIndia,asubstantialpartof theprofitcanbeeatenawaybytightstops.

My personal view on tight stops continues to be that they should be usedwhena trade is substantially in themoneyand themarket is showingsignsofreversing.Youcanthenprotectalargepartofyourprofitbyputtingatightstop.

ChoosingaStop

Thefactorswhichdeterminethenatureofthestopare:

A trader’s objectives and the nature of his trading — i.e. day trading,positiontrading,orswingtrading,Theconceptthatisbeingtraded,andThetrader’stemperament.Let’slookatsomeofthestopstrategies.

RupeeStop

Rupee stops have certain benefits; for one, they define beforehand howmuchyoucanloseonatrade.Thesestopsarealsonotpredictablebecausetheyarenotplacedon theobvious supports and resistances on the chart. If these stops areplaced some distance away from a support, they can be very effective. Forexample,atraderwithacapitalofͲ10lakhmaydecidetoriskͲ10,000onasingletrade.

But traders need to keep in mind the rules of money management andpositionsizingwhileusingrupeestops.Personally,Ibelieveinanupperlimitonthe amount being risked on every trade, but on the lower side each trade isdifferent,eachsituationisdifferent,anditwouldbeamistaketohaveastandardrupeestoplossforallsituations.

PercentageStop

Somepeoplesetstopsbyallowingthepricetoretraceacertainpercentageoftheentryprice.Forexample,ifthebuyingpriceinatradeisͲ100,astopisset10%lower, atͲ 90. This practice is fine so long as the percentage is based on anobjectivecriterialikeapivot.Arbitrarypercentagesontheotherhand;willoftenlead to inefficient trade management, which usually means not achieving theentireprofitspossible.

VolatilityStops

Volatility stops are based on the assumption that, to at least some extent, thevolatilityrepresentsnoise.Soifavolatilitystopisplacedatsomemultipleoftheaveragetruerange,thentheprobabilityisthatthestopisbeyondtheimmediatenoiseofthemarket.

TimeStops

AsIhavesaidatotherplaces in thebook,agoodtradeworks immediately.Atradewhichmeandersaroundthebreakevenlevel,orgoessideways;moreoftenthannotdoesnotworkout.TypicallyIwaitforacoupledays,includingthedayIinitiatedthetrade,andusethistimestopinconjunctionwiththepivotstop.Iwould also like to reiterate that technical analysis is not an exact science, andpatternsandbreakoutscananddofail,particularlyinnon-trendingmarkets.Soit’simportantforthetradertokeepanopenmindandifatradeisnotworkingout within the time that he is comfortable with, he should reevaluate theevidenceandre-considerwhether tocontinue in it.Gettingoutofapotentiallyunprofitable trade isalsoastrategy; the trader isnota loser ifhegetsoutofatradethatisnotworking.Youcanalwaysgetbackintothepositionifthestockortheindexstartsamove.Alwaysremember,youcannotarm-twistthemarkettogiveyouprofits,solearntoobserveitsstepsanddancewithitsrythm.

PivotStops

ThesearethestopsthatIusemostextensivelyandhavebeenveryusefulinmytradingsofar.Iliketoplacethesestopsacoupleofpointsaboveandbelowtheprevious pivots, since placing pivot stocks is awell knownmethodology.Thelarger the time frame onwhich the pivot is broken, themore is its relevance.Breakingof pivots often showsbreach of support or resistance; also, it showsstrengthandweakness.

TherearesomerulesIfollowwhileusingstops.FirstIneverchangemystop;unlessit’satrailingstop,myriskisthesame

oneverytradesinceIdonotdifferentiatetradesonthebasisofexpectation.Second, ifmy stops are hit and I take a loss, I stand back and review the

marketactionfortwopossibilities:

1. Myanalysiswaswrong.Inthatcase,ItrytoseeifIcanreversemypositioninthesametradebecauseafailedbreakoutinonedirectionleadstoastrongmoveintheother.(Figure12.3)

2. Itrytoseeifweareinachoppyphaseofthemarket.Ifthatisthecase,Ijustfoldmyhandsandsitbackbecausemyexperiencesuggests thatonlymarket trends give tradersmoney; and choppymarkets take all of it, andmore,back.Theworstactioninachoppymarketwouldbetogoonmakingtradesinbothdirectionsinthehopeoffindingonprofitabletrades.OftenIalsoreducemyvolumetonominalifIdohavetotestwaters.Themarketislikeagirlfriend;ifshesaysno,gentlemenmusttakethatasano.

I use pivots both to enter and exit trades. Breaking of an up pivot showsstrength,breakingofadownpivotshowsweakness.

Figure12.3

Ialwaysbuyamarketwhich,alongwithotherevidenceofamarketmovingup,breaksthenearestupwardpivot.I sell amarket which, alongwith other evidence ofmarket going down,breaksthenearestdownwardpivot.

So the pivot is trigger for all my actions. If a pivot is broken in eitherdirectionandthemarketwhipsawsbackintheoppositedirection,itisprudenttowait till the market makes the next move and reduce volumes drastically onfurthertrades.

But it is critical tobe confident about themove that a trader anticipates isbuildingup.In themarket thingsareneverclear tilleverybodyis in themove.Takingasmallpositiontotestwatersifyouarenotconfidentaboutthemoveisalwaysadvisable,thepositioncanthenbeenlargedasthemarketmovesinyourfavour.Inotherwords, thepositiontakenbya trader,withintheparametersofmoneymanagement,canvarywiththeamountofconfidenceatraderhasinthemove.(seeFigures12.4and12.5)

Figure12.4

Figure12.5

Exits

Mostunsuccessfultradersneverreallygettothispartofthestory.Bythetimetheyworkthroughtheentrymethods,theyhavebeenbeatenbythemarket.Theexitaspectoftradingisprobablymoreimportantthanevenentries.OnthispointIamremindedof themythologicalcharacter in theMahabharata,Abhimanyu,whoknewhowtoenterabattleformationbutdidnotknowhowtomakeasafeexit.Heprobablydecidedhewouldthinkabouttheexitoncehewasinsidetheformation,andweallknowthetragicresultofthatmisadventure.Mosttraderscommit thesamemistake in themarkets.Theybegin to thinkaboutexitsonlyoncetheyareinatrade.AndtheymeetwiththesamefateasdidAbhimanyu.

I like to treat exits as a separate part of technical analysis, called trademanagement.Ibelieveagoodentryintoatradeisonly25%ofthejob,albeitaveryimportantone.Thepartthatmakesmoneyistrademanagement.Theskillof keeping a position through the gyrations of the market is as difficult toachieve,ifnotmore,asaresoundentries.Ashighlightedearlierinthischapter,mostsuccessfultradersmakemostoftheirmoneyfromveryfewtrades.Soonceyou are in the right trade, it’s critical to manage it well in order to get themaximumprofitoutofit.Youcanbeassuredthatthemarketwouldtrytoshakeyououtmoreoftenthanyouthink.

RulesforGoodExitsYouNeedtoDecidetheExitBeforeEnteringaTrade

Onceyouseeanentryset-up,youmusthavetwoscenariosready:

1. Howdoyouexit if the trademoves against you; this is donewith a stoploss.

2. Howdoyoudecideonanexitifthetrademovesinyourdirection.Thisisdone with the help of chart patterns and certain back-of-the-envelopecalculationsofvariouspatterns.Inmyexperience,Ihavefoundthat thesepatternsaregoodapproximationsoftheminimumobjective.Sothatgivesyou the initial estimate of how far you are going to hold the trade. Thisincludeslocatingtargetsonintradayaswellasdailycharts.

The methodology for targets on chart patterns has been described in thechapterondaytrading(Chapter5).Herewewilllookatatradingmethodologywhichwasnotdescribedtherebutwhichisveryeffectiveintrendingmarkets.

All rallies pull back at some point, and then the rally resumes again. Onaverage, a pullback is about 50% not only of the previousmove but also thesubsequentmove.Thisruleworksbroadlyeveninabearmarket.Theimportantthinghereistoousefinesse.Targetsdonotmeanthatatraderneedstoblindlyexithispositionatthatpoint.Rather,hethenneedstobealittlecautious,lightenpositionsortightenstops,etc.inordertoprotecthisprofits.(seeFigure12.6)

Figure12.6

LetmedescribearealtradethatItookandhowImanagedit.The Nifty was in an intermediate correction and had bounced back from

1,509.LookingattheintradaychartIdecidedtotakethetradeat1,556,asthemarketbrokeout. Iputmyfirststoprightbelowthe intradaypivotwhichwas1,540,whichwasalsotheday’slow.SureenoughassoonasItookthetradethemarketwentbackto1,546,andthenstartedrallyingfromthere.Asitclosedat1,572,Imovedmystoptobreakeven.Nowasthemarketkeptmovingup,IkeptatrailingstopofoneATRforcontinuingintheposition.Asthemarketreached1,670,veryfavourableelectionresultsweredeclared.Themarketinitiallyralliedto1,680butthenclosedsortofindifferentataround1,670.Nowwhatwasthemessageofthemarkethere?

Itwasthatthemarketwastiringoutandevengoodnewscouldnotmoveitmuchhigher.SoImovedmystoptothepreviousintradaydownpivotof1,660.Idecided that I should takemy profits the next day, particularly as themarketbreadthhad also deterioratedby the endof the day.On the intraday chart tootherewerebearishpatterns.Sothenextdayasthemarketralliedagainto1,680,I took my entire profits. After that, I waited. As the market began to breakbeyond 1,680, Iwent long again at 1,684, keepingmymind alert that a falsebreakoutcouldhaveoccurred. Ikept thestopfor this tradeat theday’s lowat1,676.Themarkettriedtorallyseveraltimes,evenwentupto1,689butcouldnotsustainthoselevelsandmoveddownsharplytakingmystopwithit.Assoonas it took my stop, it also broke a downward pivot and I reversed the entirepositionand insteadwentshortat1,676withastopabove thehighof thedaywhichinthecaseofNiftyfutureswas1,685and,loandbehold,themarketwentdownsharplytocloseat1,645whichgavemehandsomeprofitsonadaywhichhadnotbegunsowell.IwouldliketopointoutthatIbookedtheseprofitsonthedownmove on the same day because themarketwas still in an uptrend and itcould move back up at any point. If you are getting sharp profits on acountertrendday,youshould take thembecause themainmovecancome intoplay at any time. This tradewas described in parts in earlier chapters; Figure12.7showstheentiretradeandthevariousstopsIplaced.

Figure12.7

The point I’m trying to make is that it is critical for traders listen to the

market,andifthemarketisnotactingastheythinkitshould,youneedtobookprofitsimmediatelyandwaitforthemarket’snextmove.Ifyourstoplossishit,it’s not as if you have been proved wrong or have lost something. It cansometimesbethesignalforbiggerprofits.Ifyoucanlistentothemarkets,youdon’tneedmostofthefancyindicatorsaround.Themarketdropsenoughhintsaboutwhat it’sgoingtodonext.Marketre-entryathigherpriceshouldnotbeseenasanadmissionoffailure,butasaprudentdecisiontowaitforthemarkettoshowitshandmorefully.

TrailingStop

Onceinprofit,IliketokeepatrailingstopatoneATR(averagetruerange)sothat thedailygyrationsof themarketdonot throwmeoutofapositionthat isworking.Atrailingstopisonewhichtrailstheprice.Puttingitveryclosetotheprevailingpricecanthrowyououtofatradewhichhassomewaytogo.

ScalingOutofPostions

Anothergoodidea,thoughnotmyfavourite,istoscaleoutofpositionsastheygointoprofits.Scalinginandscalingoutarecommonstrategiesusedbymanytraders. These traders take a small position first and then keep building if thetrademovesintheirdirection.SometradersIknowsellapartofthepositionandthusessentiallymakeitafreeposition,oronethathasalowerbreakeven.Theirprofitsaregenerallylowerthanfortraderswhotakeanentirepositiontogether.IpreferthelatterbecauseIlookatentryset-upsverycarefullyandmakeanentryinalowrisksituation.Idonotenterintotradestillthemarketissetupperfectly.Traderswhoscalepositionscanbealittlemorerelaxedabouttheirset-upsandentries, since scaling involves both gradual building of positions and gradualprofittaking.Thisway,scalingreducesatrader’sinitialrisk.

OtherMethods

Alotoftradersuseavarietyofothermethods,suchassomemovingaverageortrendchannelbreakdownormultiplemovingaverages.Allthesemethodscanbefoundinmostbooksontechnicalanalysis.Whatisnotfoundistheperspectiveon exits and the markets. As we all know by now, there are two kinds ofmarkets, the trading market and the trending market. The trading market hasshortermovesandhasatendencytoreverseafterbriefperiodsofupanddownmovements.Thusthestopsandtargetsneedtobecloserandtradersshouldfocuson booking profits keeping in mind the smaller moves. In trading markets,traders should try to trade overbought and oversold areas with the use ofindicatorssuchas theRSIandbecomfortablewithbookingsmallprofits.Thetrendingmarkets,ontheotherhand,offerbiggerprofitsasthemainmovesaremuchlarger.Soatraderneedstobeinsuchamarkettillthemarketthrowshimoutofatrade.Atradershouldalsorememberthetimeframeheistradinginandshould lookforhints in the lower timeframefor toppingoutorbottomingoutpatternswhichmightsuggestcaution.

Also,atraderneedstohaveaplanandapproximatetargetsinmindbeforeheentersatradesothathecanmanagehisstoplosseseffectively.Therearetimeswhenthemarketswanttogivehimhugeprofits;atothertimesonlysmallprofitscan be made. Trade management to a large extent determines the trader’sprofitability.Thisgameisnotasmuchaboutthenumberofprofitabletradesasitisaboutthesizeofprofits.Failuretorememberthiscanleadeithertotradersnotrealising the full profit potential of their trades, or in giving back substantialamountsofprofits.

Ordinary traders can win with the help of charts and good moneymanagement.As thecountrygrowseconomically,a lotwealthwillgetcreated—anda lotofwealthwillbe lost aswell.Andmostof itwill happenon thestockmarket. Thewealth creators and accumulatorswill be traderswho alignthemselveswith themarketandmakeuseofall the sophisticated trading toolsavailable. Peoplewho losewealthwill be the buy and hold investorswhogetintoexpensivestocksandthendon’tgetoutevenwhenthestocksgoesdowntohalfitsvalue.

Inacapitalistsociety,theopportunityofcreatingalargefortuneiswithinthereach of all of us.The road is long and arduous and experience often a harshteacher.But aligning risks to return expectations is possible like never before.Never before was so much flexibility available to individual investors and

tradersintermsofavailableinstrumentsandliquidity.ThederivativesmarketischangingtheIndianinvestor’slandscapeforever.Itis,finally,possibletomakeafortuneontheIndianstockmarkets.

Chapter13

SelectionofStocksandFutures

ChoosingWhatYouPlay

Earlyin2006,TV-18startedapaidwebsite,calledPowerYourTradewhereaselect team of technical analysts each give two trading ideas every day. Thiswebsite became very popular and lots of people liked the recommendations Imade. Ioftenheardstories thatpeoplewent to theirbrokers’officessimply totake the trades I’d suggested. As time passed, these recommendations almostacquired a cult status. In this chapter I will reveal the relatively simplemethodology that I use every evening to come up with those dailyrecommendations.

YoumaywellaskwhyIwouldsharemysecretsinabookpricedatamereͲ400?

Well,becauseactuallythereisnosecret;it’sjustpurecommonsensewhichIfiguredoutasaresultoftradingformanyyears.

Let’s go back to the same cricketing analogy that we started with in thisbook’sIntroduction.

It is said that Indianbatsmenare tigers at home.Why?Becauseon Indianpitches they justgeton to the front footandpulverizeanybowling.Butwhenthey go abroad, they limply hang their bats outside the off stump and get outmeekly to the moving ball. This difference in performance is because of thedifferencesbetweenIndianpitchesandthosefoundoutsideAsia.Thesameskillset which works great on one type of picthes fails when applied to differentpitches. Another analogy is the difference between driving a great car on asmooth6-lanehighway,andonasmallvillageroad.Thecaristhesamebutthecomfortandperformancewouldbevastlydifferent.

Similarly, ifbrilliant technical analysis is applied to thewrong stocks,youcan’tgetrightresults.

Generally, thereare two typesof stockanalyses thatgoon in themarkets:

topdownandbottomup.

BottomUpAnalysis

Bottomupanalysisconsistsofanalysingeachindividualcompanybasedonitsearnings,cashflow,growthprospects,areviewofitsbalancesheets,profitandloss statement, etc., and is generally used by fundamental analysts and othermarket players who are hunting for value. Such analysis is of little value totechnical traders as it does not sufficiently position the odds in their favour.Hencetheytypicallylookattopdownanalysis.

TopDownAnalysis

Themarket’smaintrendplaysanintegralpartinwhereanystockisheaded.Justasarisingtideliftsallboatswhetherbigorsmall,sotooarisingmarketbuoysupallstocks toagreateror lesserextent.Soit is themaintrendof themarketthatatechnicaltraderfirstseekstofigureout.Suchananalystnextlooksatthetrend of the particular sector or industry, and only then comes the trend of aparticularstock.Thisishowtechniciansviewthemarket.

By identifying situationswhere all three— namely, themarket trend, thesectortrendandthestock’strend—aremovinginthesamedirection,theoddsofmakingmoneyintheshortestpossibletimearethehighest.Sotradersneedtofirst assess the market direction, and then the sector direction before takingtradesinaleveragedmarket.

The methodology that I am about to explain below has a very simplepremise:

All assets which attract money, continue to attract money till they become very expensive.Conversely,allassetswhichloseinvestorinterestcontinuetoslidetilltheybottomout.

Wecanidentifysuchsectorsandstocksbyusingtheindicatorcalledrateofchange(ROC).

Thusas a traderwith amonth’sview, if I couldget a list of stocks sortedfromhighesttolowestintermsofROC,itwillgivemetherightlistofstocksorfuturestotrade.

RateofChange(ROC)

Rate of change is a very simple technical indicator and is available in most

proprietarytradingsoftware.ROCprovidesinformationregardingthechangeinthepriceofastockinagiventimeperiod.Foraswingtrader,therateofchangecanbecalculatedover20days.Stockswhichhavethehighestrateofchangeareobviously the ones attracting themost amount ofmoney. The stockswith thelowest rate of change are the ones which are either not attracting money, ormoneymayevenactuallybedesertingthem.

Onecanaddsomeadditionalparameters,suchaslookingatstockswhicharepriced overͲ 200— this reduces the chance of a stock being cornered andmanipulated, though it’s still possible—and those that have an averagedailytradingvolumeofatleast1lakhshares.

TheROCparameterforthenumberofdayscanbe20,asamonthhasabout20tradingdays.Amediumtermtradercanlookat60ashisROCparameter,asheistradingalargertimeframe.Suchmediumtermtraders,ontheotherhand,mayactuallybeinterestedinbuyingstockswhichseemtohavecompletedtheircorrectivephases,inwhichcasemaywanttousethislistupsidedown.

Let’snowseehowthisstrategyworks.A traderwhoneeds about amonth’spointofviewuses a20-periodROC,

100,000+volume,andastockpriceofoverͲ200.TheIndianmarkethada largecorrectionwhenNifty fell from3,770(May

2006)to2,600(June2006),followedbyapullbackrallyinwhichNiftybouncedbackto3,200beforeresumingitsdecline.Atthatpointwewereanticipatingaretestof2,600.Soweneededtolookforstockswhichwereshowingweakness.Incase2,900held,wewould’vereassessedthesituationagain.

Figure13.1depictsthemarketsituationaround23July2006,andit’sclearlyvisiblethatthemarketformeddistributivepatternsbetween3,770-3,380ontheNifty,and thenagainat3,200-2,900.Alsowecansee that the50DMA(dailymoving average)was then about to cross and slip below the 200DMA, clearsignsthatthemarketwouldsoonbeheadingdown.

Figure13.1:Nifty

The first quarter results were also then coming in. Technology, cement,

metals, etc. turned in great results, actually better than what the market hadexpected.Aseachbrilliantresultwasannounced,themarket,however,beatthestockdown.Since themarket continued to sulk, itwas sendingout amessagethatitwaslookingatapossibleearningsdeclineinfuturequartersasaresultofrisinginterestratesandinflation.It’simportantnottoreacttoresultslikeanewschanneldoesbut like themarketwhich, in itswisdom, tries to lookaheadanddrivewhilekeepinganeyeontherearviewmirror.

Asnotedearlier,atthispointweneededcandidatestosell.Accordingly,wegenerated a list of stocks, based on their ROC in descending order, from thefutures and options segment using the above listed parameters. Thismethodologyissimilartotherelativestrengthmethodology.Generallywelookfortheweakeststocksinaweakmarket,butwhenthemarketsarereadytobreakdown we should also look at strong stocks which are beginning to weaken.However,sincemanystockshadalreadylostalotofgrounditwasimportanttoidentifystockswhichstillhadroomtodeclinefurther.Ioftenstartwiththetop10andbottom10stocksinsuchalist,butherelet’sreviewonlythetop5andbottom5.

Anotherimportantpieceofinformationthatsuchalistgivesusisaboutthesectorswhicharebecomingstrongerand thosewhichareweakening.Thiskeyinformation helps me back strong or weak sectors. All things being equal, Iwouldratherbuyastrongstockinastrongsector—ratherthanastrongstockinaweaksector—andshortaweakstockinaweaksector.

So as shown by the list in Table 13.1, the sectors growing strong weretechnology,FMCG,andcement,whiletheweakeningsectorswereauto,metals,oil. Such information, alongwith the rate of change of individual stocks,willkeep you positioned in the right stocks even in a sideways market. This isbecause evenwhen themarket is in a sidewaysmode, there is a bull or bearphaseplayingitselfoutinsomesectorortheother.

Table13.1

Let’s consider the chart of the stock at the very top, Punj Lloyd (Figure13.2):

Figure13.2:PunjLloyd

Myassessmentwas that though the chartwasweak, the sharehad already

declinedalotanddidnothaveroomforsignificantfurtherdecline,soIwouldn’tpickthisstockformyshortlist.

Let’s now look at the chart of the second stock from the top, that of JetAirways(Figure13.3):

Figure13.3:JetAirways

Again a weak stock, but one which in the short run had possibly already

declinedtoomuch.Let’smoveon.Let’snowlookattheweeklychartofRelianceCapital(Figure13.4),togeta

better assessment of its weakness at that point. This stock initially held firmwhentheentiremarketwascollapsing,andhadonlyrecentlystarteditsdecline.Nowlookatthelastblackcandle,thebestshortisonethatinitiallyrisesinpriceandthenlateronstartsitsdecline.Thisgivesitacloserstop.Thehighandlowof thepreviousblackbar is482and407, respectively.Theweekly lowbeforethatwas450.Sowedesignthetradeasfollows:Sellabove407(sothatwesellintoarally),keepastopofthepreviousweek’slowof450,sothatthestopisclose.

Thetargetofthismoveis328soyouarebroadlygettinga1:1.5risk-rewardonthetrade,whichisfineinasidewaysmarket.

Figure13.4:RelianceCapital

Figure13.5:PatniComputers

Let’snowmovealong to thedailychartof thenextstock inourROClist,

PatniComputers(Figure13.5),whichhadthenbeenaconsistentunderperformerin the technologysector.Thestockhad justundergonea3-4daypullbackandlookedripeforanothershortingopportunityabove276.Thetopofthepullbackwas292,whichcouldbeusedasastop.Atargetofthisshortcanbecalculatedbymeasuring the lengthfromthe lowestpivot (250) to the topof thepullback(292-250=40),andthensubtractingitbackfromthatlowestpivot(250-42=208),whichnowbecomesatarget.

SothetradeforPatniComputerstooktheshape:Sellabove276,stop292,target208.

NowwelookatthedailychartofSterliteIndustries(Figure13.6).Asmoneythen seemed to be leaving themetals sector, Sterlite appeared to be in a hugerange,270-450.Asitschartshows,Sterlitewastheninashorttermdowntrendandsawaweakpullbackrallyto387.Thisseemedanothergoodcandidateforshorting.Followingthesamerules,wedesignthefollowingtrade:

Figure13.6:SterliteIndustries

Sellabovetheclose377,useastopof412insteadof387whichisthetopofthepullbackbecauseyouwantthetradetohavesomeroom.Agoodtargetforthisswingcouldbe270-280.

Let’snowconsidersomeofthetoppositiveROCstocks.Thebreakdownofthe strongest stocks would happen only when the whole market goes into adecline.It’sworthkeepinganeyeopenforsuchaneventualitybecausewhenthemarketdoesbreakdown,thestockswiththestrongestgainssometimesseethemaximumdeclines.Sincethemarketat thattimeappearedalittlesideways,sothereweren’talotofshortingopportunitiesamongthestrongstocks.

Nevertheless,let’stakealook.TataPowerhadgone throughapullbackrallyafterasharpdecline(Figure

13.7). The stock would weaken below 445-450, so we continued to watch it.Anotherwayistolookforabreakoftheupwardslopingtrendline.

Figure13.7:TataPower

IFlex (Figure 13.8) also showed strong gains but then seemed to haveentered a strong resistance area between1350-1380—but itwas too early toentershortshere.

Figure13.8:IFlex

The results seasonwas justover and, the techshadproducedgreat results.Yet,theywereunabletotakeoutresistancesontheupsideascanbeseenfromthechartsofTCS(Figure13.9)andInfosys(Figure13.10).Sothoughtheywere

outperforming,theywereunabletomovetonewhighs.Werethemarketsbreakdown,therecouldbesomedownsideposttheresults.

Figure13.9:TCS

Here, then, is thedrill that I followon adailybasis for selecting the right

stocksandfuturestotrade:

Takeaviewonthemarket,i.e.determinethemarket’smaintrend;GenerateanROC-basedlistofstockssortedfromthehighesttothelowest;Identifythestrongandweaksectors;

Figure13.10:Infosys

Basedonthemarketandsectoraltrends,choosethestrongestandweakeststocks;Lookforpatternsonindividualstockswhichshowabreakout;Designthetradewithalogicalstopwhichallowsenoughroomformarketnoise.

Why is it necessary to choose the right stocks? This is because technicalanalysisisthescienceofgraphicallyassessingstrengthandweaknessofstocks.It’simpossibletoapplyalltherulestothethousandsoflistedstocks.Henceweneedashortlistofthestrongestortheweakeststocksamongthegroupthatweare interested in trading. Technical analysis too has a failure rate, hence asuccessful trader tries toputasmanyodds inhis favouraspossible.Knowingthemarket’sdirection,andthestrengthofdifferentsectors,isanimportantkeytosuccessasstocksmoveingroupsandtrends.

It is important to emphasise here that the above methodology works very well in a trendingmarketbecausestocksgenerallymoveinadirectionaltrendintrendingmarkets.

Alsothisrelativestrengthmethodologyworksbestovertheshortterm.

This brings us back to the important distinction between the concepts of

tradingandtrendingmarkets.Inarange-boundsortofmarket, it’s importanttolookat thelistbothfrom

the top — and from the bottom. This is because when the entire market isranging,moststocksarealsorange-bound.So theoneswhichhavemade theirmove either rest for a while, or correct. And the underperformers then startmoving.You should, therefore, not be looking for breakouts in such amarketbecauseattemptedbreakoutstendtofail.Youneedtotrytobuysupport,andsellresistance.

As you can see, it is important to be understand whether the market istrendingorrange-boundbeforeyoucandecidehowyouwilllookatthelist.

Figures13.11to13.20demonstrateafewotherchartsoutliningsometypicalpatterns Iwant fromanROC list in a trendingmarket.Theseare thekindsofstocksthatwillgetintomydailytradinglist.

Figure13.11

Figure13.12

Figure13.13

Figure13.14

Figure13.15

Figure13.16

Figure13.17

Figure13.17

Figure13.18

Figure13.19

Figure13.20

AddingaFundamentalValuationParameter

Ihaverecentlyaddedafundamentalvaluationparameter,suchaspricetosalesfor most companies, and price to book value for banking and commoditycompanies.Thus,whenusingattheROCmethodology,Iwouldalsolookatthehistoricalpricetosalesandpricetobookvalueoftheparticularstocksbothoveraperiodof timeandacross the industry. Iwouldavoidanycompanywhich isselling several times its past ratios.An examplewould be the choice betweenAnsalInfrastructureandUnitech in the latterpartof2006.WhileUnitechsoldfor 23 times sales, Ansal sold for 4 times sales. It’s clear that given strongtechnical picture in both the stocks, I would choose the one which was notoverlyfrothy.

chapter14

MyTradingDiary

TheBubbleandtheCrash:February-June2006

Niftywasat2,100whenthisbookwasfirstpublishedinearly2005.Fromthereit had risen almost 80% to 3,770 by May 2006, after which there was acorrectionof40%to2,600byJune2006.

As theNifty’sweeklychart (Figure14.1) shows, thebubblehad started toformbetweenFebruaryandMay2006.ManypeoplewhocameintothemarketafterFebruary2006werewipedout totally.Investorswhokeptarationalheadhad started booking profits beyond February, while sophisticated traders keptlookingovertheirshoulderfromthenonforacorrection.

Figure14.1:WeeklyChartoftheNifty(April2004-June2006)

Sothecreationofabubblewasclearlyvisibleandonecouldalsoobservea

situation of euphoria. Themarket offered several opportunities to get out andsomeanalystskeptwarningofanimpendingcorrection.Buttotheunwary,themarket seemed to offer extremely easy opportunities of making money. Aspricesbegantoscaleeventhemostoptimisticpredictions,andvaultedoveralltherealtriggerswhichcouldpushthemarketshigher,analystsstartedjustifyingtheir predictions of a further uninterrupted rise on the basis of the real estatewhichcompaniesowned.Itwasclearthatanendcouldbenear,butpeoplejustdidnotwanttolisten.

The same excesses can be observed on the downside: as the Nifty wentbelow the downward sloping trendline, a bouncewas expected and it retracedabout50%ofthefallasofthewritingofthischapter(July2006).

Theapprehensionofabubblehithometomewhenaformerdomestichelpphoned me for suggestions about investing in the market. I started gettinginquiries fromarmyofficersposted inKashmirand, equally, fromhousewiveswantingmy services to impress their husbands,withgreed in their voice as ifthey had found a magical key.My phone would not stop ringing; every fiveminutes there was a new person interested in the markets. People who hadabsolutely nothing to dowith themarkets nowwanted to jump in.Whenmywife’sfriends,withwhomtillthenI’donlyexchangedpleasantries,andwhohadno background of the stock market, wanted to take up futures trading as aprofession, Iknewwewereapproachingamomentof truth.Thiswas inApril2006.

Asall thiswasunfolding,IwenttobuyacarinMarch2006andwasonlyjustabletosqueezemyloanapplicationthroughICICIBankattheoldinterestrates,asithadalreadyhikeditsinterestrateoncarloans.Bythetimetheloanwaspassed,itwasalreadyApril2006.Alltheseeventstogethersuggestedtomethatwhile on the onehand therewas extreme euphoria in themarkets, on theother hand liquidity on the ground was starting to tighten. Observing thesedichotomiesIputmyearextremelyclosetotheground,readytoexitatthefirstsignof trouble.Otheralert investorsand traders toowouldhave takennoteofsuch signals. Inmymedia appearances during this period I continually urgedpeoplenottoincreasetheirtradingvolumeandbookprofitsinstead,butIdon’tthink toomany peoplewere listening over the euphoric roar of themarket. It

happenseverytimewhenabullmarketisabouttotakeabreak.Were the charts at all indicating how one could have gotten off without

damagingoneselftoomuch?Maybetheywere.Afterthemarketmadeanewhighat3,770on11May2006,andthenclosed

lower, we had a very normal down day. There always are several one-daycorrections even in a strong bullmarket. So the next day (12May 2006),welookedforasupportandwentlong.Themarketdidnotquiteclosestrongontheseconddaybutsinceitclosedasadoji(seethesectiononcandlestickchartinginChapter3),wecarriedforwardourlongs.On13May,afteralukewarmopeningthemarket started tanking and broke through the first strong support of 3,590andclosedalmostnearitsintra-daylowat3,480.NowIwasseriouslyworried,but we still carried our longs since 100-point correctionswere normal at thattime.Also,myfinalstopof3,430hadnotyetbeenbreachedthoughthemarkethad shown enoughweakness for me to be onmy guard. As it happened, themarketturnedfrom3,430andstartedmovinghigher.

ButIhadseenenough.IusedFibonacciretracementsonthefallfrom3,770to3,430,andfound50%retracementat3,630.Sotheinstructionswereclear:assoon aswe saw levels higher than 3,600, itwasControl+Alt+Delete from themarket.On17May2006themarkettouched3,643andIclosedallmypositions.Whentheshipisonfire,youjustjumpoffandsavewhateveryoucan.Thedeckof a burning ship is not the place for a lot of analysis. Leave analysis to theanalysts, traders should thinkonly aboutmaking and losingmoney.The samedayI left forafortnight’sEuropeanvacationadvisinginvestorsonCNBCthatthey,too,shouldsellandgoonholiday.Inhindsight,thatwasgreatadvice.Sothiswas thestoryofmyexit from thebullmarket.At thispoint IknewIwassavingmoneybynotputting it at risk. In such situations, traders should standasideandwait;not losingmoney is, ineffect,makingmoney.Oftenatmarketturns,thingsarenotclearenoughtoact,soit’swisetowaitforsomeclarity.

SoIactuallygotoutofthemarketasIwasalreadyonthealert.Someofyoumaysaythateverythingseemsclearinhindsight.Yes,IacceptIcouldhavebeenwrong here, and I did actually exit the market a couple of times earlier too,lookingatseveralsignsofatop.TheimportantthinghereisnotwhetherIrodetheentiremoveexactlytill3,770;theimportantthingisthatIprotectedmostofmy profits and my capital to live to fight another day. If you survive in themarket,youfinallymakemoney,thatismymantra.

Figure14.2:MarketMayheminMay2006ontheDailyChart

BythelastweekofJuly2006,peoplewantedtoknowwhetherwewerethen

inabullorabearmarket.BasicallywhattheywantedtoknowwaswhethertheNiftywasgoingtoquicklytop4,000,orslidebackto2,100.Myanswertothemwasthat in theshort termprobably itwasgoingtobeneither,andprobably inthemediumtermaswell—andthatanywayit’snotallthatimportanttoknowwherethemarketisgoingsolongasyoucanridetheshorttermswingswhichcanoftenbeaslargeas600pointsontheNifty.

I believe that a bearmarket is amore than 20% fall from the top and itsbeginningisaccompaniedbyallkindsofexcesses,suchasleveragedmoneyandextremeeuphoria,whichwereallpresent inMay2006.SoinJuly2006itwaspossiblethatthemarketcouldbreakthrough2,600andgolower,andaspeoplegrewincreasinglydisenchanted,bottomoutonlyaround2,100.Theotheroptionwas that themarketcouldholdon to2,600andkeepmovingsideways for thenext few months before moving to new highs. Equally, neither of the abovemight have happened.What is important for a trader is to be able to trade asmanyofthemarketswingsaspossible.Anearapproximationofsuchascenario

isthewayS&P500hadmovedsinceMarch2001;formorethanfiveyearstillJuly2006itkeptmovinginarangewithoutmakingfreshnewhighs.

A lotof tradersand investors toldmestoriesofhowmuch they lost in thesavage fall of May 2006. In each case, I found that money managementprincipleswereputonthebackburnerasgreedtookoverandpeopleabandonedallcommonsense.WhereIhadreducedmyvolumesfrom150NiftyfuturesperͲ1lakhofcapitaltoalmost50Niftyfuturesperlakhduringthisperiod,therewere peoplewhoheld on to their leveragedpositionswithout any stop losses,andwithoutanyregardtosoundmoneymanagementprinciplesevenwhile themarkets came crashing down. Itwas like giving a person an aeroplane to fly,whenallhehadexperienceofwasdrivingacar.Ithinkthedifferencebetweensmarttradersandamateursisthatsmarttradersknowwhentotaketheirfootoffthegaspedal,whileamateurspressitevenharderduringsuchtimesandthatisthereasontheylose.

There are some hard lessons that the crash of May 2006 taught us. AllthroughMarchandApril2006,Irepeatedlysuggestedthattradersshouldreducetheirtradingvolume.MyTVanchorswouldignoreandlaughatsuchadvicefortheneedofcaution.Finally,Ibelievewhathadtohappenwouldhavehappenedanyway,butbeingrationalandreducingone’stradingvolumeat therighttime—i.e.,whenthingsappearedoverheated—wouldhavedonemuchlessdamage.Intheoverwhelmingnumberofcasesitwasnotthefallinpricewhichdestroyedpeople,itwastheheavyvolumetheytraded.

The other advice I have for people is to not come into marketundercapitalised, or merely for the short term, or for the lack of anotheroccupation.Allof these reasonsmisfireandrippeopleoffcapitalall the time.Futures trading, in particular, is not a part-time occupation. Some peoplemistakablybelieve that it does not need toomuch attention, and that they canbecomeexpertfuturestraderswhilestayingfocusedonanothercareer.Ifitweresoeasy,Iwouldnotbewritingthisbook,andneitherwouldIhavespentagoodpartofmylifelearninghowtotradebetter.Unlessyouarewillingtodothehardwork,andhavethe timeandcommitment tomakeasuccessof it, tradingmaynotberightforyou.

Chapter15

TheAGLastHourTradingTechnique

Itissaidthat95percentofdaytraderslosemoney.Well,notanymoreifyouoperateintherighttimezoneofthedayandintherightstocks.Infact,youcandaytradethemarketswith80percentaccuracy.

Theoverallmarketvolatilityseemstobeincreasingeveryyear.So,morethetimeyouspendinthemarkets,thegreatertheriskyouaretaking.Ontheotherhand, ithasnowbecomepossible to slice the tradingday into themost activeandmost profitable time periods and the least profitable and least active timeperiods.

TheAGLastHourTradingTechniqueisa“buytoday,selltomorrow”—or,conversely,“sell today,buy tomorrow”—day tradingstrategy. Itcanbeusedforentryinthelasthourofatradingdayandexitinginthefirsthourofthenexttradingday.

Thisstrategyhasbeencrystallizedbythe“mother”ofallinventions,namelynecessity.

IhavebeenappearingdailyontheIndianbusinesstelevisionnewschannel,ET-Now. The last hour every day has a programme which is like the Indianversionof the famousUS“FastMoney”programme.Thishas led to real timeback testing of this strategy on a daily basis for one year. The strategy has adocumentedbacktestingaccuracy,withingivenparameters,ofabout80percentoddsofgetting2percent,orbetter,returnonadailybasis.Anotherbeautyofthis strategy is thatyoualwayshaveaplay for theday, andyoudonotbreakyourbackwatchingaquotescreenallday.Iknowofpeopleholdingregularjobswhotakeextended lunchbreaksfrom2:00-3:30p.m. inorder just to trade thisstrategy. They often take homemoremoney in a day than the entiremonth’ssalaryfromtheirregularjobs.

What’s SoSpecial about theFirst andLastHours of aTradingDay?

It’s awell documented fact that the first and the last hour are themost activeperiodsofanytradingdayintermsofpriceandvolume.Thisissobecausemostlargeinstitutionstendtooperateinthepost-lunchsession.Also,usuallythereareseveralupanddownswingsduringtheday,withthemarketrevealingitsfinalhandonlyinthelasthour.

Thefirsthourofatradingdayisalsointerestingandactivebutforadifferentreason.Theunderlying reasonhere is that stockswhichhaveclosedstrong,orweak,intheprevioussession,tendtoopennextmorninginthesamedirectionastheir close. This is also true for the overall market because all the televisiontechnicalanalysts,newslettersellers,andretailtradersarelookingatdailychartsforbreakouts.Soastrategycanbecreatedwhereyoubuy/sellintandemwiththebiginstitutionsinthelasthourofthedayandbookprofitswhentherestofthemarkettriestogetontothebandwagoninthefirsthourofthenexttradingday.

Presently,Indianmarketstradefrom9:15a.m.to3:30p.m.Sothetechniquedescribedhereiskeepingthesemarkethoursinview.Thusthefirsthouris9:15-10:15a.m.,andthelasthouris2:30-3:30p.m.Theseprinciplesarevalidandcanbeappliedinallmarketsandtimezones.

TheContextoftheMarket

Bysittingitouttillthelasthour,thetrendforthedaybecomesabsolutelyclear.Hence,bythe lasthouryouknowwhichsideyouneedtoacton;whetheryouneedtolookforshortingcandidatesoryouwanttogolongonsomething:

If the market has moved higher throughout the day, or generally kept apositivebias,youlookforstockstobuy.In case the market is heading lower for the day, or keeping a generallynegativebias,youlookforstockstosell.Ifit’sanarrowrangeday,cutyourtradingvolumetohalf.

HowtoSelecttheRightStockstoTrade

So, aswe have seen, on a daily basis by the last hour it’s clearwhich is thestrongestortheweakestgroup,whatstocksarebreakingdown/outonthedailycharts, and onwhat kind of volumes.A larger than usual volume results in a

volumebarwhich,aroundthe lasthour, isbigger thantheclosingvolumesformostdays.Thebiggerthevolume,thebetterthemove.

In my experience, it’s possible to identify at least one idea which worksbecausethereisalwayssomeactionortheothersomewhereinthemarket.Andyouneedonlyonegoodideatoworkinthemarketeveryday.

Personally,Itendtouseoneofthefollowingtwoset-upstoselectthestocktotrade.Set-up 1: Breakdown / breakout from a narrow range on a larger thanusualvolume(seeFigure15.1)Narrow range breakouts and breakdowns generally give large moves in aparticulardirection.Themoveisparticularlysignificantintheotherdirectionifanarrowrangeoccursafterasignificantmoveinonedirection.

Figure15.1:Narrowrangebreakdown

Thisset-up isachievedbymaintainingamarketwatchwhich listsgainsor

losses in percentage in various stocks according to aminimum traded volumecriterion. It takes only about half-an-hour to scan through the20 top losers orgainersamongst that list. Iwouldmuchratherchooseahighbetastock thanadeaddefensiveone.Wehaveonlyacoupleofhoursandweneed tomake themostofit.

Youcanaddyourownhighprobabilityset-upstothetwoabove.Set-up2:Breakout /breakdownofapreviousupordownpivoton larger

thanusualvolume(seeFigure15.2)

Figure15.2:Pivotbreakdownonlargerthannormalvolume

ForBestResults

All of the above analysis should be done having a viewonwhat kind ofmarketwearedealingwith—bull,bear,orsidewaysmarket.Whichgroupsorsectorsareleadingandlagging.Whichstockshavebeenthebestandworstperformingones.Thebreakout/breakdownbarshouldbeatleast3percent.Onthechart,Igenerallyhave20and30simpleDMAtogivemeanideaofthelocationofpriceonthechart.A Donchian channel makes it easier to see whether a pivot or a narrowrange is getting broken on any time-frame. I use an ordinary 20-periodchannel.Trytoget7-8percenton3to4daysinamonth,althoughaverageprofitswillbe2percentplus.Chooseatleasttwostockssothatifevenoneofthemworks,itmakesyourday.The technique fails20percentof the time.When itdoes so, justgetoutfast,as“somethingiswrong”.Allexitsmusthappeninthefirsthourofthefollowingtradingday.Alloftheaboveareusedasadditionalinformationwhichmayormaynot

beusedwithatrigger.

Havingthissortofacontexthelpsinchoosingthebeststockstogoshortorlongon.Thiswill becomeclearerby looking at the examples that follow (seeFigures15.3to15.8).

Examples

Figure15.3:ThedailychartofJetAirwaysshowshowthestockbrokedownfromanarrowrangeon

8December2011.

Figure15.4:Thisisthe5-minutechartofJetAirwaysforthesamedayasde-pictedinFigure15.3,i.e.

8December2011:At2:30p.m.thesellsignalistakenbecausethereisanarrowrangebreakdownonthedailychart(seeFigure15.3).Themarketcontextwasweakandsowastheairlinegroup.Inthe

firsthourthenextday,Jetfellonlargevolume.

Figure15.5:ThedailychartofEducomp,signaldate16December2011:Thelasttradeddayisthebreakdownbar,plusyoucanaddconfirmationsuchasbreakdownofa20-dayDonchianchannel.

Largerthanusualvolumeisalwaysaplus.

Figure15.6:The5-minutechartofEducompfor16December2011:Thebreakdownat2:30p.m.just

keptgoingtilltheday’send.Also,notetheriseinvolumesince1:30p.m.—thatwasanearlyindicationoftheimpendingfall.

Figure15.7:DailychartofJubilantFoodworks,signaldate15December,2011:Afterfourdaysof

decline,thestocktookouttheupsidepivotwithgoodvolumeandhencecameonourlist.Notice,too,thelargerthanusualtradingvolumes.

Figure15.8:5-minutechartofJubilantFoodworksfor15December2011:Entertradeonthelower

barasstocksurgesonheavyvolumeandeasilymake2percentinthefirst10minutesofthefollowingday.

Conclusion

Mostdaytraderslosemoneybecausetheycravetoomuchaction.Alotoflosingtradeshappenduringthedullperiodofthetradingday.Ifnothingelse,TheAGLostHourTradingTechniquesharpensyourday tradingbykeepingyouawayfromthechoppyperiodinthemarketandmakesyouanetprofitabletrader.Thekeyideaisthatit’smostprofitabletoparticipateinthemarketonlyduringthesetwohours—itissimilartoparticipatinginatrendingmarketinanyothertime-frame.

Appendix-I

PermittedContractSizesThe contract sizes in the Indian derivatives markets are decided by theexchanges.Thesecanbeimportantinatrader’sdecisionmakingprocess,sincethelargerthecontractsizes, themorelikelythemovementscanbeandgreaterthe risk for every unit of movement in the underlying. As a rule of thumb,traders should avoid contracts where the contract size exceedsͲ 5 lakh. TheminimumallowedbytheexchangeisͲ2lakh.Pleasenote:ContractlotsizescanbechangedbyNSEfromtimetotime.YoucanalwayscheckthecurrentpositionatNSE’swebsite—www.nseindia.com

Appendix-II

CalculatingImpliedVolatility

Impliedvolatilityispossiblythemostimportantconceptinoptionstrading.Alltradersshouldlearntocalculatetheimpliedvolatilityorknowofwebsiteswhichofferimpliedvolatilitiesoftheindicesandindividualstocks.Oneofthemethodsofcalculatingimpliedvolatilitiesisdescribedbelow.Thiscalculatorisapartofthe options strategy evaluation Excel spreadsheet available atwww.hoadley.com/options.

Forexample,ifweneedtocalculatetheimpliedvolatilityoftheSatyam320calloption,theinputsrequiredare:Ͱ Risk Free Rate: This can be the prevailing interest rates on bank deposits,annually6%.ͰDividends:Theseneedtobeincludedifit’sadividendmonth.Generallyoptionsofstockwhichgoex-dividendinthecurrentmonthshouldbeavoided.ͰOptionType:CallͰOptionMarketPrice:Thisisavailablefromthebroker.ͰStrikePrice:320ͰValueDate:It’sthedateonwhichthevaluationisbeingdone.ͰExpirationDate:Thisisthedatewherethecontractsinquestionexpire.

(Thenumberofdaystoexpiryiscalculatedautomatically.)AlldatesneedtobeenteredintheAmericandateformatwhichismm/dd/yy.Once all the inputs are entered, you get the following output on your

computerscreen. ImpliedVolatilityCalculator

RiskFreeInterestRate: 6.00%UnderlyingAsset:Marketprice(Ͳ): 318.00Dividends:

ExdateAmountOrContinuousrate

Option:

Optiontype:Optionmarketprice: 20Strikeprice: 320.00ValueDate 5/7/04Expirationdate: 5/27/04Daystoexpiration: 20Pricing:Pricingmodel:Number of steps for binomialmodel:

100

ImpliedVolatility: 68.91%

Now this implied volatility needs to be compared with the historicalvolatility in order determine if higher volatility is priced into the option thanwhatishistoricallyappropriate.

Appendix-III

UsingthePeterHoadleyOptionsStrategySoftware

This software can be used to test various strategies and construct profitdiagrams.Belowwewillgothroughanexampleofasellingastraddleandhowthe software is used with this strategy. More help is available atwww.hoadley.com/options.Thesoftwareisavailablefreeofcostfromtheabovesite. There are a number of inputs which you need to change in the defaultscreen. This should be done very carefully as a mistake here can spoil thecalculation.Step1Whenyouopentheoptionsstrategysoftware,youseethefirstscreenasshownbelow. We’ll consider the example of Nifty options for the purpose of thisillustration.

Step2

Now the inputs to this main screen need to be set up. This can be done byclickingontheunderlyingassetssettingsmodule.AsyoucanseethattheNiftyoptionisaddedattheend.

The historical volatility of 17% is available at various websites withinformationon Indian derivatives andwith somebig brokers aswell.Anotherchangethatistobemadehereistherisk-freeinterestratewhichwewillchangeto6%.

Step3

Thenextstepischangingtheinputsonthemainscreenwhicharefairlysimplewithexplanationsoncellswhicharenotimmediatelyclear.

DealDetails—This is a pulldownmenuwhichwill now show the newadditiontothesamplelist.StockPrice—Theprevailingstockprice,or in thiscase the indexvalue,i.e.1800isenteredhere.Thedealdateandtheexpirationdateoftheoptionsareenteredhere.Thesedatesareenteredinthemm/dd/yyformat.Priceinthecentrerofgraphcanbethepricearoundwhichwewouldliketostudytheimpactofthemovementofunderlying.Thiscanvaryfromcasetocase.Thegraph incrementcanbeadjusted togetmaximumrelevantmovementonthegraph.Theoptiondetailsarefedintoaction,buy/sell,numberandstrikecells.Now thenext3entriesarenotusedall the timebutonlywhen there is aparticularsituation:

(i) Implied volatility needs be entered if it’s different from thevolatilitysetupofthestockunderthe“underlyingassetssettings”sheet.

(ii) Tradeexpirydateneedstobeenteredifit’sdifferentfromthedealexpirydate,forexample,inacalendarspread.

(iii) Overrideprice—Enteranoptionpricehereif it’sdifferentfromthe option price calculated by the option model. In the case ofNiftytheyareandsothosedifferentpricesareentered.

Right next to the foregoing screen is the profit diagram which showsprofit/losspositiononthedealdateaswellasattheexpirydate.