A little over a month ago, I wrote an article posted on Seeking Alpha about how I trade CF Industries (CF) on a daily basis using stock options. Please read that article as it will give you a nice head-start on what I will be going into for this article.
To expand on my previous article, I am of the opinion that it is easier to spot a bottom with a stock daily than it is to spot the top. While put options work great with this strategy, I would say my overall ratio of placing calls to puts is 5:1. This strategy takes advantage of the large daily price swings, while also recognizing the bottom or top in a stock price in the short-term. It is also cognizant of market conditions and current volatility.
Since the article was released, I have received more e-mails and questions on this article than any other. While I briefly mentioned other stocks this strategy works well with, I did not go into any great detail on any of them. This article should clear up a few of those questions.
This is a good opportunity to elaborate more on this strategy and mention the other stocks you can use this strategy with. I also provide an image of how the streaming chart with all five indicators should appear.
I am always looking for "new" potential stocks to place this trade with. Although time consuming, I do many trial runs on a particular stock to see if they work. In the future, I will add to my list and make them known on my InstaBlog. You may even know of certain stocks that I haven't tried with this strategy that may work. If so, let me know via the comment section or e-mail, and I will definitely check it out.
I have been trading this strategy for years. Over time, some of the stocks have changed. A great example is Potash, Inc. (POT). This was formerly a great stock to use this strategy on. When it did a stock split, it took out all of the "juice" that it had. It simply doesn't move enough anymore. In other words, Potash got kicked out.
For the most part, the criteria that a stock needs to qualify it as a trade possibility follows:
- The stock should at least be $100/share or more (There are exceptions, which I will mention later in the article).
- The options for the underlying stock must have liquidity.
- The underlying stock has large price swings daily (i.e. volatile daily)
The stocks that I currently use with this strategy with are the following:
- CF Industries (CF) - strategy works great with this stock.
- Apple, Inc. (AAPL) - is right up there with (CF) as a favorite.
- Google (GOOG) - Google works extremely well, too.
- Baidu (BIDU) - while I don't trade (BIDU) as frequently, I have always had success when I do.
- Wynn Resorts (WYNN) - another stock that works very well.
- Netflix (NFLX) - haven't used it much since it fell below $100/share. A bit too risky now.
- Sina Corp. (SINA) - even though it's under $100/share right now, this is one of the easier stocks to spot a bottom with on a daily chart. Very volatile, which is perfect for this strategy.
- Chipotle Mexican Grill (CMG) - is lacking in liquidity at times, causing the bid/ask spread to be wide, so be careful. Easy to spot a bottom, however.
- Intuitive Surgical (ISRG) - similar to (CMG) in that liquidity can be a issue, but this stock is a serious mover that consistently makes money for me.
Often, too many traders rely on only one indicator to tell them when to buy or sell a stock or option, such as the Relative Strength Index or the SMA/EMA. While I like these indicators and use them, this is simply not enough information to go on. Having only one or two indicators can easily send a false buy or sell signal. My strategy uses five indicators, all independent of one another. I will never place a trade until all five of my signals are reached at my set criteria and at the same time.
When two or three indicators signal a buy signal, this is a good confirmation. However, when all five hit the mark, this is very significant. It doesn't happen as many times daily on a given stock.
It takes a lot of discipline to not make the trade until all five indicators reach their buy point. On some days, you may get four buy signals a day on a single stock. Other days, there is only one. CF on Monday had one buy signal all day, at 11:28 a.m.
Also important to this strategy is that I will not make any trades until one hour has passed since the markets have opened. You really need to let your streaming chart form and to see a trend. This will also avoid false signals that large, early price moves can bring. I also try to avoid trading in the last hour of the markets being open. This is more of a personal choice because I do not like to hold a position overnight if I don't have to. The only exception is Apple (AAPL), which sees a lot of movement in the last hour of trading.
Current market conditions also play a role. For instance, if Ben Bernanke is scheduled to speak at 11:00 a.m, I will wait to make a trade until I see how the markets have reacted to it. Also, always be sure to be on top of any news that is related to the stock you may be trading that day. An example would be if a report came out earlier in the day mentioning something that might be detrimental to a stock in the short term. You don't want to be holding call options only to find out there is little chance the stock is going to move up during the day. Basic stuff, really.
I would like to touch on just a few more things before I get into the indicators and stocks I use for this strategy. I really can't stress enough how important a good trading platform is. Depending on your broker, the quality really varies. It is necessary that your platform has all of the indicators I use. I've received so many questions from readers asking if they can use this strategy without the Full Stochastic Indicator or the Intraday Momentum Index because their broker or platform doesn't offer it. My answer is no. I cannot give my endorsement on a strategy if what I consider a key component to it is missing.
Whichever platform you use, be sure they have the following indicators. I am copying my parameters and details of each indicator from my previous (CF) article to make this easier to understand:
- Bollinger Bands - I use the 12,2,2 as my parameters, i.e. (12) as the Simple Moving Average (SMA) and Standard Deviation, (2) as the standard deviation of the top band, and (2) as the standard deviation of the bottom band. As a personal preference, I will not begin to even consider making a trade until I see the current price action move below the bottom band (calls) or above the top band (puts), but this is only one of the indicators needed out of five (5) total.
- Relative Strength Index (RSI) - I use a length of twelve (12). The RSI is an indicator that shows when a stock is at overbought and oversold levels. It has a range of 0-100. A reading on the RSI of 70 indicates overbought levels, while 30 is considered oversold. Some traders like to go even below the standard 30 level for a buy confirmation, but it is ultimately the trader's choice.
- Intraday Momentum Index (IMI) - The IMI is invaluable as far as I'm concerned for an options trader who gets in-and-out of positions quickly. The Intraday Momentum Index is similar to reading the Relative Strength Index, in that both of them have a range of 0-100. Again, 70 indicates overbought, while 30 is considered oversold. I also use the range of twelve (12) to correlate with the RSI. Again, it is the trader's preference as to what length works and what he or she likes to use. The Intraday Momentum Index is a very powerful technical indicator to use for any type of trader.
- Money Flow Index (MFI) - follows the IMI as the next indicator. The MFI is a momentum indicator that is used to determine the conviction in a current trend by analyzing the price and volume of a given security. The MFI is used as a measure of the strength of money going in and out of a security and can be used to predict a trend reversal. The MFI is range-bound between 0 and 100 (like the RSI and IMI) and is interpreted in a similar fashion as the RSI and IMI. The fundamental difference is that the MFI also accounts for volume, whereas the RSI only incorporates price. It is also different in the fact that instead of the number thirty (30) indicating oversold levels, the Money Flow Index uses twenty as oversold and eighty as Overbought.
- Full Stochastic Oscillator (Do not use only the Fast or Slow Stochastic) - Used by many Forex traders, I find the FSO tremendously helpful in my trades as another indicator that confirms what the previous four have already done. Combining all of these indicators together really validates when it is an opportune time to buy. The FSO is a combination of the Slow Stochastic and the Fast Stochastic and is more advanced and more flexible than the Fast and Slow Stochastic and can even be used to generate them. Readings above 80 act as an overbought signal while readings below 20 act an oversold signal. The parameters I prefer to use are (10,6,6) for daily trading.
My broker is OptionsXpress.com. I've been with them for years. They have all of these indicators and more. They are a little bit more expensive, but well worth it. I always get my trades executed quickly.
I have two screens of streaming, real-time charts. The first (main) screen will have the chart with Bollinger Bands where the line chart (my preference, it's more clear) or candle is moving with the price of the stock. Underneath the price and movement chart, the four (4) other indicators will be below, all separated from one another. This is how your chart should look (or close to it):
(Click chart to expand)
As you can see, I use the 2-minute, one day chart setting. I do not recommend implementing the 1-minute stream. It will send off too many false buy/sell signals. It does work, but you will find yourself really missing on some good ones because you bought in too soon.
One of the more impressive things about this chart you see above is that even though (CF) was down all day, and kept moving down, there was only one complete buy signal where all five indicators hit their requirement. But here's what's most important: it recognized the downside (CF) was facing early on.
Besides my main screen, I then have the other screen that will have a "tab" view, which can show nine charts all at the same time on the same page. These charts will only have the Bollinger Bands visible.
This works great and makes it easy to view because all I simply do is keep an eye on the screen showing the nine stocks, wait for the stock price to come close to the top or the bottom of the Bollinger Band, and then put that stock symbol on my main chart (above example) to look closer at where the numbers are for the RSI, IMI, MFI, and the FSO. Keeping it simple.
Finally, it's time to talk about the most important part of this strategy. Always, without even thinking about it, place a sell order immediately after placing your order once it is filled. I always set my sell order at least $0.60 above what I paid for it. However, there are situations where I will increase that amount to $1.00.
For you to be successful trading this strategy, you need to take out all the emotion of the trade. Yes, there will be times when you could have held onto the trade longer and made a lot more money. I can't even tell you how many times this has happened. On the flip-side of that, there will also be many times when you should have sold the options when you had the chance to. It works both ways.
If you are the type of trader who constantly looks back on trades and then wonders to yourself "why did I sell it then" or "I could have made so much more," then scratch this strategy off your list immediately. This strategy is based on consistency. Whatever the amount of contracts you buy at a time, this strategy will do very well for you. On average, I buy between 10-15 contracts. I personally like to only make one trade a day, profit between $600-$1000 on it, then relax for the rest of the day.
I highly discourage trailing stops with this strategy and here's why: the stocks we're dealing with aren't utility companies that move in tiny penny increments by the tick. These stocks are big movers. In a span of two minutes you will sometimes see the stock move in dollar amounts. When you set a trailing stop right away, the likelihood of you being stopped out and losing your position is about 50/50. I knew this one guy who always insisted on using trailing stops, even with this strategy. Of course, he kept getting stopped out frequently (for a loss, obviously) and kept asking why he was losing money. Finally, the headlights came on and he realized the mistake he was making. I didn't even think to mention this to him initially because I thought he knew better. Trailing stops are great for stocks like Cisco (CSCO), Intel (INTC), and so on, where you can gauge how the stock will move in the very short-term. My advice: don't even bother using trailing stops with this strategy. They work great on long positions when you are up a lot or when you cannot follow a stock for a while. Think of it this way: only you know at what price you're happy exiting the trade with, so place the sell order immediately and move on to the next trade.
As I mentioned earlier in the article, there are a few exceptions of stock that are priced under $100/share. SINA works extremely well, and Las Vegas Sands (LVS) had had success. However, I would be extremely cautious adding any new stocks.
Also of utmost importance is that you are able to execute the trades quickly. If you have a slow trading platform or computer find one that is fast. From the second all of the indicators signal a buy you need to place that trade as soon as possible.
It should also be noted that this strategy works regardless of market conditions. It performed great before the 2008 financial crisis and continues to do well now.
If you have any questions you can e-mail me at Seeking Alpha or in the comment section. I usually try to respond to questions as soon as possible.Additional disclosure: