Option Purchasing Rules

It's human nature to want to buy a market when the media and brokers are positive, or bullish, and likewise to sell a market when they are negative, or bearish. This response is reflexive and characteristic of most inexperienced traders. However, by dissecting the dynamics of the market, it becomes apparent why the antithesis of this response would be more profitable, especially when day trading. With the majority of markets today, price fluctuates rapidly, leaving little time to enter at important price reversals. Oftentimes, a high or low is established and quickly followed by a price vacuum, as floor traders and other traders scramble to quickly reverse their positions. If one were to enter at this point, that individual would likely suffer considerable price slippage and experience terrible order fills, particularly if one were day trading. That is why we prefer to buy before a market low is recorded and price is still declining and why we prefer to sell before a market high is made and price is still advancing. If the crowd is buying, we are looking for a place to sell, and vice versa, if the majority is selling, we are looking for a place to buy. This way, we can enter the market and, oftentimes, actually enjoy positive slippage, realizing better fills than if we were attempting to participate in the market's trend. Therefore we realize a greater profit potential for our trades by participating in a larger portion of a market move. This practice is similar to the role played by both market makers and floor specialists. Someone must assume the opposite side of a transaction, as difficult as it may be at the time, both psychologically and emotionally.

We are not encouraging you to ignore fundamental analysis or common sense. After all, it is foolish to immediately take a trading stance against the direction of a news announcement, crop report, or earnings release—doing so is akin to stepping in front of an express train or catching a falling dagger. However, we are suggesting that traders view these announcements as opportunities to anticipate and identify key areas of price exhaustion, particularly when day trading. And because these important news releases are often followed by sharp price retracements, anticipating trend reversals can create sizable trading profits.

Our recommended practice of buying into market weakness and selling into market strength is an important trading lesson we learned early in our careers. This approach is applicable to all markets and is particularly valuable once a market's volatility, or intraday price movement, increases. More often than not, news serves as a catalyst causing a security's price volatility to increase. The increased public interest and participation in the market is reflected in the expansion of volume and wider price swings in the underlying asset. If the underlying security undergoes a transformation in its trading profile, a similar change becomes apparent in any related option activity since the accompanying option premium will expand to adjust to the increased volatility. Generally, if the news or market's perception of the news is tilted toward the positive, the premium attached to the calls is greater than that assigned to the puts. Conversely, all other factors being equal, if the outlook or traders' expectations are perceived negative, then the put premium is greater than that of the call premium. Regardless, the impact of news upon a security reverberates and resonates throughout its respective derivative markets as well.

Again, to reiterate, markets usually record trend reversals at a bottom when the last seller, figuratively speaking, has sold and at a top when the last buyer, figuratively speaking, has bought. Also, contrary to popular belief, the release of negative news generally coincides with and exhausts the downside of a market just as the release of positive news coincides with and exhausts the upside of a market. Obviously, as price declines, the ultimate low draws closer in terms of both time and price; and as price advances, the eventual high draws closer in both respects as well. Sooner or later, a down close signals the final low of a decline as does an up close signal the final high of a rally. By applying this concept to option price activity, the initial rule for trading is formulated. In other words, by requiring that the closing price of an option be down versus the prior period's closing price for a low-risk call buying opportunity and by requiring that the closing price of an option be down versus the prior period's closing price for a low-risk put buying opportunity, a distinct trading advantage can be established. One could also require that not only the option adhere to this trading qualifier, but also that the underlying security conform similarly by closing down for a call and up for a put. Additional layers of requirements can also be introduced to further filter short-term trades. By applying these concepts to both long-term and short-term trading, investors can realize greater trading success.

To take advantage of these observations we have outlined, we have devised a set of rules to determine the opportune environment in which to buy call and put stock options. Similar rules can be applied to futures options but since the homogeneity among contracts is lacking in this market, the prescription must be altered somewhat. Ideally, each of thèse trading rules should be aligned before entry into a market occurs; however, in the real world this requirement may be less restrictive. These rules stand well on their own and help prevent one's emotions from running rampant in the market, but the addition of other indicators, such as TD Percent Factor (TD % F) and the interrelationship between call and put volume and open interest, can be utilized to further fine-tune a trader's entry.

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