We used Intuitive Surgical, Inc. [NASDAQ:ISRG] to illustrate the Seven Steps to Better Stock Trading during Day 4 of our free Open House on January 13, 2011 and set up an options play with a potential 45% return with limited downside risk. You can also download the WMV file.

45% Return With Limited Downside Risk

At the time, our RMI studies showed ISRG potentially making the transition (yellow price bars) from underperformance (red price bars) against the S&P 500 Index to ourperformance (green price bars) again the benchmark index.

Since the future is never certain, we demonstrated how to use Smarter.Stops (from the Daily Worksheets or as an add-on for TradeStation/eSignal) to decide on which Bull Call Spread was best to maximize the upside and minimize the downside.

Based on the trading price ($279-ish) at that moment and the pink dot below at $266.42, we evaluated the following bull call spread that would establish a long position:

Buy 1 February 260 Call = -$27.10
Sell 1 February 280 Call = +$13.40

CLICK TO VIEW LARGER IMAGE

The net debit of the spread would be $13.70 (+$13.40 – $27.10) before commission. Since one call covers 100 shares, the cost would be $1,370 before commission while the maximum intrinsic value of the bull call spread would be:

$280 – $260 = $20.00 x 100 = $2,000

The maximum return would be:

+$2,000 – $1,370 = $630/$1,370 = 45.99%

ISRG moved up on an earnings announcement on January 20, and as of the close on Friday, January 21, 2011, the net value of the bull call spread was:

Sell 1 February 260 Call = +66.70
Buy 1 February 280 Call = -48.70

The net credit of the spread would be $18.00 (+$66.70 – $48.70) before commission. Since one call covers 100 shares, the proceeds would be $1,800 before commission to produce a paper gain of:

+$6,670 – $4,870 = $1,800 – $1,370 (cost of spread) = $430/$1,370 = 31.39% “up”.

Since the bull call spread does not expire until mid-February, a trader could decide to take the quick windfall or wait to liquidate, hopefully at the maximum intrinsic value.

Uninformed traders often look for volatile markets because of their potential for large price gains and often attempt to enhance returns using margin. Eventually, they learn that the most important job of a trader, investor and portfolio manager is to manage risk, and the first rule to learn is that volatile markets are dangerous because wild price swings also mean larger potential losses.

Each day, we publish information to gauge the underlying condition of the markets. We measure correlation of various asset classes to construct the Correlation Heat Map. We identify Volatility Clusters. Statistics are transformed into Market Barometers.

And now, let me introduce the Market Turbulence Index. This indicator was inspired by Skulls, Financial Turbulence, and Risk Management, a paper by Mark Kritzman and Yuanzhen Li of Windham Capital. The company stopped providing their version (click image below to enlarge) of the index to the public last week. Many thanks to my friend, portfolio manager Sam, for bringing their research to my attention.

After reading the paper, it occurred to me that their method is good but the results could be much improved using different inputs. After all, if we are interested in turbulence, it makes sense to use a better proxy for volatility than simply price change. Since the Mahalanobis Distance handles multiple variables, why not incorporate market statistics as well? That’s exactly what I did, using data going back to January 1978.

By combining several inputs, the MTI becomes a multidimensional tool for detecting and measuring a stylized fact of asset returns: the volatility clustering property, namely, “large changes in prices tend to cluster together, resulting in persistence of the amplitudes of price changes.” (Volatility Clustering in Financial Markets: Empirical Facts and Agent–Based Models, Rama Cont, 2005) In other words, there is never just one cockroach. When we see one on the kitchen floor, we have to assume there are more and act accordingly.

To take a closer look, we will review historical data by the decade followed by a closeup of recent market conditions. Continue Reading →

After Seven Steps to Better Stock Trading, Part 1, I presented a webinar to expand on the topic. It was good to see so many old friends and members attend on a busy weekend.

Teresa…Thanks for the seminar…I remember your teaching the ES trading from about 10 yrs ago…. I’m still at it because of you….THANKS
– Hal E.

The video is 167MB and may take several minutes to buffer over a slow connection. For the best viewing experience, click the full screen button located on the right side of the control bar, next to the volume button. You can also download the WMV file for Windows Media Player.

CLICK TO LAUNCH VIDEO

References

The PowerPoint presentation is available for DOWNLOAD HERE. The following articles, books and sources were mentioned during the presentation:

• Fischer Black and the Revolutionary Idea of Finance
• Office for National Statistics: Time series estimation and forecasting
• Cleveland Fed: Mirror, Mirror, Who’s the Best Forecaster of Them All?
• The New Market Wizards: Conversations with America’s Top Traders
• The Analysis of Time Series: An Introduction, Sixth Edition
• Introduction to Time Series Analysis
• Webinar: Day-Trading E-mini Stock Index Futures
• Modelling Financial Times Series
• Justin Mamis Investor Sentiment Cycle
• The Magic of the Moving Average (for members)
• How to Measure Range and Volatility
• List of Discretionary Technical Trade Setups (for members)
• Thoughts on Position Sizing (for members)
• Options: Bull Call Spread and Bear Put Spread (for members)
• Treynor On Institutional Investing
• Beta vs. Volatility Ratio (for members)
• Position Sizer for Stocks (for members)
• The Stock Roulette for Monday
• The Short List for Monday
• Stops Cannot be Eyeballed
• Bill Miller Explains His Annus Horribilis
• Explaining the Favorite-Longshot Bias: Is it Risk-Love or Misperceptions? [DOWNLOAD PDF]
• The Favorite/Long-Shot Bias in S&P 500 and Ftse 100 Index Futures Options
• CNBC: Man vs. Machine

Questions and Answers

During the webinar, there were a few questions that I said I would answer later.

Dan asked, “Is there a technical advantage you have found for scaling in or out of positions?” I’ll let William Eckhardt answer this one:

There was also a question about how Smarter.Stops compared to Welles Wilder’s Parabolic SAR. Here, a picture (click image to enlarge) is worth a thousand words.

For more, please see Evaluating Buy and Sell Signals.

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