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Anatomy of a ‘Good’ Trade
Author: Price Headley (info)
Website: http://bigtrends.com
Posted: September 25th, 2007 at 10:36 am EST
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It seems like we always get the question “What does a perfect trade look like?” Unfortunately, there is no specific answer. In fact, there may not even be one single answer. As much as we can try and describe many of the factors that are ideal for a trade, only time and experience can really get you comfortable with the difference between ‘good’ and ‘not so good’.
With that in mind, I’d like to start walking you through our thought process on some of our recent trades…sort of a ’stand over our shoulder’ approach. It could take a lot of these to really let you into our heads, but it should be well worth the effort. As we review each one, I’ll try and highlight the particular lesson(s) I see in each example.
Let’s just start with one of our recent trades from our ‘In The Money Options’ service.
Back on August 9th, we entered a call option (bullish) trade on Overstock.com (OSTK). At the time, OSTK was trading around $21.00, and had been trending higher (though quietly) for a few months.
The chart below is the very same chart we use to ’scan’ for new trading ideas. You can see for yourself the automated signal that was generated during the week ending August 10th. You can also see it was based on a weekly chart.
Overstock.com - Weekly
As a new trader - or even an old one - I think there are two immediate questions I’d be asking. The first one is, why a weekly chart? The second is, is it really that simple…just a little momentum? Let’s just address those one at a time.
Why a weekly chart? A lot of you might be surprised that a ‘trading’ newsletter like ours is looking at anything longer-term than a daily chart. As we’ve seen over and over again though, daily charts still tend to be too erratic to use very well. It’s not that we can’t use them. It’s just that there’s a lot of intra-day and daily ‘noise’ that we have to weed out. The weekly chart is just mush less erratic than the weekly.
Also, the longer you stick with a trend, the more money you can make. This idea actually goes hand in hand with the first idea. Why do you think traders tend to hop in and out of trades fairly quickly? Ultimately, it’s about efficiency. Once a trend on a daily chart stops, it’s dead money…and the trader has to move on. However, I can guarantee you that even a pattern day trader would be thrilled to stay with a trade for weeks (or even months) if it continued to make good daily progress.
By the way, had we been using a daily chart, we probably would have never seen (or believed in) the bigger-picture uptrend…until we had missed most of it. Also, on the weekly chart, it was clear something had drastically changed. 2005 and 2006 were terrible for OSTK, and shares couldn’t get above their 200 day line (red) or longer-term resistance. When they finally did, we knew something was very different. This paradigm shift was a factor in our selection.
The second question…is this just a momentum-based system? That’s the basic idea, but no, there’s a lot more going on here.
The system we use for In The Money utilizes several factors, like volume, short-term and long-term momentum, the rate of change in momentum, and a ‘control’ to prevent us from buying (or shorting) stocks that have already worked their way past the bulk of their move. None of that legwork shows up in the little arrow on the chart, but trust us - it’s there.
While you don’t have to mimic our strategy, I feel you do have to have a means by which you receive good trade signals…a source other than the news or Internet. Most good trends are generated by stocks never discussed in the news until well after the fact.
For option traders, you may also be wondering why a December call (that’s a lot of time), and why a call with a $15 strike price (that’s fairly deep in the money)? I’ve got answers there too.
Basically, I believe you should let the style and system dictate the option. Had we been using a daily chart and expected a short-term trade, we probably would have used a September or October option. They move a little more responsively than a December option would. With this system though, timeframes are more often measured in weeks. That’s fine though, as the system also tends to find very efficient trends that allow us to make sustained progress for weeks on end.
As for the strike of $15, yeah - we could have gone with a $20. But, this game is more about controlling risk than maxing out a potential reward.
With one bad day, a call with a $20 strike could have been pulled out of the money. In fact, the $20 calls were temporarily pulled out of the money on August 16th when OSTK fell to $19.00. Fortunately they started to rebound the very next day (and how!). Now be honest - when that happened, would you have had the fortitude to stick it out even though you were well in the hole? Or, would you have flinched and taken the trade out?
Truthfully, I’d hope you have enough self-imposed risk control to make your exit at that point. The thing is, with the $15 strike, we never even had to make that decision. We controlled our risk by going deeper in the money.
What you didn’t see on the chart:
Confession time, Yes, there was a little more going on here than just the chart. Short interest. It was phenomenally high at the time, but also going lower by the day. The buzz was all the short sellers were being forced to cover as the stock went higher. Of course, they had to ‘buy’ to cover, which only compounded their problem…and benefited the OSTK bulls.
While a short squeeze may only help you with 1 in 100 trades, it never hurts to have it in your favor.
OK, here are the take-away’s from today to put in your mental file
1) Don’t be afraid of longer-term (weekly) chart settings, and…
2) Look for micro-opportunities (entry and exit) within macro trends
3) Incorporate volume into your analysis/picks
4) In this case, short interest played a huge role in the gain
As for the trade, so far so good. We were up about 80% as of Monday. I suspect we’ll give up a little ground soon, since OSTK has been red hot. However, the bigger uptrend is still going strong, and I expect to hit our 100% target within two or three more weeks at the most.
We’ll study some other object lessons in a future TrendWatch as we try and collectively define the perfect trade. In the meantime, do you have any lessons learned or questions worth answering in a Daily TrendWatch? Send them in.
Also, if you’d like to learn more about our In The Money Options trading service, call 1-800-244-8736. The basic trading system we used for the OSTK example above has done pretty well lately, and the service would be a great chance for you to learn more by watching us.
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Price Headley, Trading
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