Quiz
CHAPTER 7 Who You Do Business With 107
(d) providing their broker with all the facts needed to open an account.
(e) all of the above.
(f) none of the above.
4. A clearinghouse performs which of the following activities?
(a) It matches up all buys and sells.
(b) It collects debts owed brokerage firms.
(c) It helps maintain the integrity of the markets.
(d) It is the lender of last resort for retail clients.
5. Clients can
(a) ask for arbitration if they feel they have been unfairly treated by their broker.
(b) sue their broker.
(c) trade any way they please because in the final analysis, it is their money that is at risk.
(d) refuse to provide information to their brokerage firm.
(e) fire their broker at any time.
6. The Mahoney Act
(a) closed the bars during trading hours in Chicago.
(b) created the SRO system.
(c) outlawed securities fraud.
(d) created a government-owned insurance company.
7. Leverage makes trading more (a) risky.
(b) profitable.
(c) volatile.
(d) exciting.
(e) all of the above.
(f) none of the above.
8. Which investment provides the most leverage?
(a) Stocks (b) Futures (c) Options (d) Leasing 9. Margin is
(a) a down payment on the purchase of stock.
(b) a performance bond.
(c) currently 50 percent on stocks.
(d) either initial or maintenance.
10. Which of the following are regulators?
(a) New York Stock Exchange (b) NASD
(c) NFA (d) SEC (e) CFTC
(f) All of the above (g) None of the above
Answers
1. e; 2. c; 3. f; 4. a and c; 5. a, b, and e; 6. b; 7. e; 8. c; 9. b, c, and d; 10. f.
Fortune Telling 101
109
CHAPTER 8
Fundamental Analysis Technical Analysis
You might be wondering about the title of this chapter. I used it not to denigrate the art and science of analyzing and projecting upcoming economic cycles, trends, or the prospective prices of various securities. Instead, I chose it to alert you to the most important and probably only truth there is when it comes to picking winning trades, and that is no one can do it successfully and consistently without suffering losses. Not me. Not you. Not any analyst you pay attention to on television, on ca- ble, over the Internet, in the Wall Street Journal, at the top brokerage firms—not anybody!
The reason is that at many times unexpected information—beyond the ability of any analyst to detect in advance—hits the trading pits. It is like driving in Iowa in the early summer with everything under control. As you reach the peak of a grad- ual incline, you are confronted by a tornado. You panic—your fight or flight re- sponse kicks in—and you do the first thing that comes into your mind, no matter how stupid. The same thing happens to traders. They have a market outlook in their heads, a trading plan, a sound strategy, and a visualization of exactly how the
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trade should unfold. Then a jobs report hits the floor with a number half of what is in the market. The exchange floor looks like a Chinese fire drill as every trader tries to get out of his or her positions at the very same time and at the very same price. If it were not for human nature, just about every trader would be as comfort- able as George Soros.
Before the mysteries of securities analysis are revealed, give some thought to your philosophy of life. How do you look at and react to the world around you?
How do you manage your career, your personal relationships, and your family? Are you religious? Do you believe in an afterlife? Do you have a plan for your life? How much control do you have or think you have over the major events of your life? Take a moment to answer these questions.
Your answers influence how you will use, interpret, accept, and apply various analytic tools. More importantly, they influence how successful an option trader you are going to be. There are two distinct schools of thought regarding how the price discovery process works. One group, mostly composed of academics, be- lieve it is impossible for anyone to get an edge on the market. They believe that the market is random in nature and efficient.
If markets are completely random and there are no patterns to find, then analy- sis is bogus. This argument is articulated by Burton G. Malkiel in A Random Walk Down Wall Street. He argues for randomness and declares that a broad portfolio of stocks selected by chance will perform as well as a portfolio carefully chosen by the industry’s top analysts. He presents a strong case for buying index funds and leaving the rest up to fate.
Then there is the efficient market hypothesis espoused by Eugene Fama. This simply states that at any given time all the information on an individual stock is in the market and is reflected in the price of that stock at that specific time. Therefore, since it is impossible for an individual trader or investor to have all that information at that specific time, no trader or investor can possibly have a trading edge on the market, and thus no trader or investor can consistently beat the market. Think about all the possible news, political events, economic announcements, social upheavals, and to- tally irrational acts, like terrorist attacks, that have drastic and unforeseen impacts on the market. Worse yet, there are thousands of more mundane occurrences, like gov- ernment reports on employment, income, consumer confidence, and so on, tugging and pushing the markets every day. To boot, this information is often misunderstood and/or misinterpreted. Too much of it can be manipulated by political factions at- tempting to influence the public’s perception of the country’s economic condition.
These two professors and many other very intelligent people have come to the conclusion that attempting to beat the market is futile. If you accept these arguments and your philosophy of life tends toward determinism, please do not attempt to make money trading options. You will shortly be exposed to the two basic analytic disciplines—fundamental and technical analysis. Both assume that you can get an
edge on the market and that you have some control over how much you can take out of the market. People who invest or trade actively believe in self-determination to some degree. Granted there is a plethora of events that sweep down on the markets, like the barbarians on Rome, disrupting well-planned trades—wars, major depres- sions, diseases, natural catastrophes, and so on.
Then there are others times when we seem to have more control over our lives.
Plans for a career, marrying, choosing to be religious or not, spending leisure time—
things like these. Additionally, I believe you can have some control over your invest- ments and your trading. Not complete. Not absolute, but some. There are many well-known investors, like Warren Buffett, who rely on fundamental analysis. There is also a Traders Hall of Fame filled with individuals who beat the market on a regu- lar basis using technical analysis. Accounts of many of these great traders are avail- able in the “Market Wizard” series of books by Jack Schwager.
My point is that fundamental analysis makes you a value investor or trader by mak- ing sense of the key financial data, giving you a trading edge. Technical analysis re- veals patterns that human beings make repeatedly as they trade. Both disciplines help traders read human nature, which is unforgivably repetitious. What makes analysis so interesting and challenging—which also accounts for the losses that investors and traders sustain—is the variety of ways in which humans do the same thing differ- ently over and over and over again. To become an option trader, you must accept that you have some control over your environment and that human behavior, and thus price trends, is repetitious. You must then develop or adapt a trading system that di- vulges the future, at least occasionally. The first step is to learn the pros and cons of fundamental and technical analysis to assist you in your search.
The trading enigma even becomes a puzzle when you give some serious thought to what drives the prices of stocks and commodities up and down. It is earnings for stocks, supply versus demand for commodities—or at least the perception of the strength or weakness of these forces. Any company stock that increases its earn- ings each quarter, year in and year out, in good and bad economic conditions, will see its stock price rise just as steadily. Any commodity futures contract with an un- derlying commodity that is always in short supply or always enjoys high demand will set new highs. But there is rarely any entity that always performs perfectly for any substantial period of time, and that’s what makes this business so stimulating (or challenging). Additionally, there are many successful traders and investors who are doing something right using either technical analysis or fundamental analysis, and even some who use a combination of the two. There are plenty of winners out there, but most do it quietly less they attract too much unwanted attention. Plus, it is bad luck for a trader to brag.
Let me diverge for a second before I cause too much confusion between the use of the words commoditiesand futures contracts. Commodities are physical entities of commerce, that is, corn, oil, gold, silver, coffee, sugar, pork bellies, shrimp, and
CHAPTER 8 Fortune Telling 101 111
so on. They are real, physical things that you eat, drink, heat your home with, or stick under your mattress for a rainy day. They are the entities underlying the origi- nal futures contracts. When new contracts on things like T-bills, the S&P, insurance rates, interest rates, indexes, bonds, and so on, were added, the terms financial fu- turesand just plain futures contractscame into vogue. Futures contracts is a more inclusive term than commodities because it represents both financial futures and physical commodities. So when you see the words commodities or futures con- tracts, they refer to the futures markets as opposed to the stock markets. I will get much deeper into this in the chapter on trading options on futures.
Therefore, what do you know for sure about all the markets, and what is your challenge? The first thing is, prices go up and down most of the time and sideways occasionally. Next, the more profit a corporation makes, the higher the price of its stock goes; the scarcer a commodity becomes, the dearer it is. To make money buying or selling options, you have to have a way of predicting the velocity and di- rection of price moves in order to exploit them. If you have done any research on the subject, you know that there are an incredible number of systems, strategies, pundits, books, trading schools, software programs, newsletters, Web sites, news- papers, radio shows, cable commentators, e-mail services, brokerage firms, bro- kers, friends, associates, coworkers, and other ready sources of information and trading tips. All of them seem to be willing to show anyone who is ready to pay or to listen how to make a fortune in the markets with little effort or risk.
Well—what do you say to all these people? How about balderdash? My answer is, if they can do it, why aren’t they? The people that I know who are making money in the market keep it to themselves. If you knew what horse was absolutely going to win in the fifth race at Pimlico, would you put it on your Web site? Would you want thousands of other people to take the same bet and reduce your odds?
Obviously the answer is no.
Successful traders are usually the same way. Giving someone a tip on a trade you are going to do is bad luck. Most traders are very superstitious about sharing specific trades. If someone else knows about, it does not work. They feel bad when someone loses money on one of their tips, which often happens, so they avoid of- fering them. But most important, trading is a very personal enterprise. No two traders trade in exactly the same way, nor do they both see the exact same thing when reading price charts or interpreting data. A very competent option trader could share an idea with you. You could both enter the trade at the same time, and one of you could make a nice profit and the other take a dreadful loss.
There are two and one-half schools of thought on the best way to predict price trends. There is fundamental analysis, and there is technical analysis. Additionally, many investors and traders combine both into a hybrid analytic approach. Let’s look at each type of analysis separately and then the crossbred version.