Options Trading For Dummies
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Here’s a hypothetical scenario that a trader might encounter. The market is trying to begin a new bull market by entering a bullish transition phase. At this time, your $100,000 example portfolio is sitting 100 percent in cash. Your goal: Establish ten positions by the height of the bull market, which means that you plan to allocate an average of $10,000 of your initial capital for each position.

When you begin seeing signs of a bullish transition, you’re likely to be champing at the bit to start taking positions, even though you haven’t yet found stocks that fit your trading criteria. Still, you’d like to participate in the new bull market, and you’re willing to risk a small loss if the bull market doesn’t materialize.

In this case, you may want to start by taking a small position, perhaps a half‐sized $5,000 position, using exchange‐traded funds (ETFs) for the broad market indexes and perhaps for a sector fund or two as they break out. For example, you can take a $5,000 half‐sized position in the NASDAQ ETF (QQQ), with a similar commitment to the S&P 500 ETF (SPY), and similarly sized positions in the cyclical and technology sector ETFs (XLY and XLK, respectively).

In all, you’d have positions totaling $20,000, which is 20 percent of your capital, committed to the market. That kind of commitment is appropriate for a relatively risky bullish transition phase.

As stocks break out of their trading‐range patterns, you may add positions, but you need to continue taking small positions until you’re certain the market has changed to a bull market. You also need to set an upper limit to the amount of capital that you’re willing to commit during a bullish transition phase, perhaps no more than 40 percent or 50 percent of your total trading capital.

If market conditions turn to a bull market, you then can start taking full positions and become fully invested. You may also want to reallocate your positions from the ETFs into leading stocks showing high relative strength. If you plan to use margin as leverage, a bull market is the time to do it.

In this case, you could leverage your $100,000 of trading capital into a portfolio of stocks and ETFs worth up to $200,000 or more as your portfolio grows. You can either add to existing positions or add new positions in leading stocks as they break out of trading‐range patterns. Whatever you decide, keep the number of positions small.

When the market consolidates into a bullish pullback phase, you need to tighten your stops and consider hedging your positions. Doing so enables you to use your stops to get out of underperforming stocks. If you’re stopped out of a position, forget about it. If it’s a profitable trade, pay your taxes and be pleased with your profits. If you’re leveraged, you want to get out of your margined positions quickly whenever they move against you so you don’t give up your profits.

During a bullish pullback, you first must decide whether to hedge the portfolio and then decide whether you want to hedge each individual position or the portfolio as a whole. In general, you’re probably concerned more about a marketwide downdraft than you are about a major stumble in any single position. If that’s the case, then hedging the whole portfolio with index options makes sense. However, the larger the number of stocks in your portfolio, the more sense it makes to hedge your individual positions.

As a bullish pullback reverts back to a bull market, reallocate your capital into the new leaders as they break out. After each bullish pullback, becoming a bit more conservative is prudent. For example, you may tighten your stops, use less leverage, or continue providing a hedge against a significant downdraft.

When the bull market transitions to a bear market, you need to exit your long positions when your stops are hit. You may continue to hold your positions as long as they’re not losing money, but don’t let your bull market profits evaporate. If you want to sell short, the bear market is the time to do so.

Making profitable trades is significantly easier if you buy during bull markets and sell or sell short during bear markets. Again, don’t try to fight the dominant trend. Of course, subtleties may exist. You may, for example, take long positions in defensive stocks, such as utilities and financial companies, during bear markets. Some traders find it profitable to hold a two‐sided portfolio, where the best‐performing stocks are purchased and poorly performing stocks are simultaneously shorted, even during a raging bull market, but our advice is to keep it simple. Become proficient by trading with the dominant trend before trying to fine‐tune your strategy.

About This Article

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About the book author:

Dr. Joe Duarte is a financial ­writer, private investor and trader, and former money manager/president of River Willow Capital Management. In addition to Options Trading For Dummies, he is the author of Trading Futures For Dummies and Market Timing For Dummies. Visit his website at joeduarteinthemoneyoptions.com

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