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Sharpen your Skills

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This document has been brought to you in partnership with Scotia iTRADE. All thoughts and opinions are of Pro Market Advisors and do not necessarily reflect the views of Scotia iTRADE. All research, analysis, charting, reports, estimates, commentary, information, strategies, data, opinions and news (collectively, the “Research”) are provided to you for general informational purposes only and do not address the circumstances of any particular investor. All Research has been prepared and supplied by independent third parties that are not affiliated with Scotia Capital Inc. or any of its affiliates, and accordingly may not have been, and no representation is made that such Research has been, prepared in accordance with Canadian disclosure requirements. Neither the Research nor the profiles of the third party research providers have been endorsed or approved by Scotia Capital Inc., and Scotia Capital Inc. is not responsible for the content thereof or for any third party products or services. Nothing in the Research constitutes a recommendation by Scotia Capital Inc. to buy, sell or hold any security discussed therein and does not constitute an endorsement of any of the information contained therein. The Research neither is, nor should be construed, as an offer, or a solicitation of an offer, to buy or sell securities by Scotia Capital Inc. Scotia Capital Inc. does not make any determination of your general investment needs and objectives, or provide advice or recommendations regarding the purchase or sale of any security, financial, legal, tax or accounting advice, or advice regarding the suitability or profitability of any particular investment or investment strategy. You will not solicit any such advice from Scotia iTRADE and in making investment decisions, you will consult with and rely upon your own advisors and not Scotia iTRADE. You are fully responsible for any investment decisions that you make and any profits or losses that may result. Any opinions, views, advice or other content provided by a third party are solely those of such third party, and Scotia Capital Inc. neither endorses nor accepts any liability in respect thereof. No endorsement or approval by Scotia Capital Inc. or any of its affiliates is expressed or implied in connection with this book, any third party product, service, website or information is expressed or by any information, material or content contained in, available through, included with, linked to or referred to in the Research, or in any Scotia iTRADE communication. Neither Scotia Capital Inc. nor its affiliates accept any liability for any investment loss arising from any use or reliance of the Research or its contents.Options involve risk, are not suitable for all investors and are intended for sophisticated investors.Copyright © 2016 by Richard H. Swope and W. Shawn Howell. All rights reserved.Scotia iTRADE® (Order-Execution Only Accounts) is a division of Scotia Capital Inc. (“SCI”). SCI is a member of the Investment Industry Regulatory Organization of Canada and the Canadian Investor Protection Fund. Scotia iTRADE does not provide investment advice or recommendations and investors are responsible for their own investment decisions. ®Registered trademark of The Bank of Nova Scotia, used under license.”

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Table of contents

Chapter One : Stock Selection Strategies

3 Things to Consider

3 Familiarity

4 Fundamental vs Technical

5 Price

6 Industry/Sector

7 Volatility

8 Volume

9 Market Capitalization

10 Option-ability

11 Analyst Coverage (SoL)

12 Timeframe

12 Appreciation vs income

13 Trend

Chapter Two : Entry and Exit Strategies

14 Key Candle Patterns

15 Candle Basics

16 Bullish Engulfing

17 Bearish Engulfing

18 Shooting Star

19 Hammer

20 Doji and Spinning Top

21 Candle Wrap

22 Support and Resistance

Chapter Three : Risk Management

25 Are You Out of Your Mind?

26 Gambling With Losses

27 Accepting the Loss

29 Mental Preparation for Managing Risk

Chapter Four : Bull & Bear ETF Strategies

30 Exchange Traded Funds

30 Hybrid Vehicle

31 Advantages

36 Disadvantages

39 ETF Types

Bonus Material : Intro to Options

44 Why Options?

45 Option Myths and Misconceptions

47 Terminology

49 Option Approval

Chapter One 3

Chapter One

Things to ConsiderWhen it comes to selecting stocks from the North American stock market investors have over 10,000 stocks to select from. Having a general idea of what you want and what you don’t want will prove helpful in narrowing down the choices to a manageable lot. Below are a few things to consider when you’re starting to build a stock selection strategy for yourself.

FamiliarityInvestors that are new to the markets often focus on stocks that they are familiar with, believing that this familiarity will lead to a better understanding of the price action of the company’s stock. This may or may not be the case but investors tend to feel better investing in what they know. This can often be a good starting point for selecting a stock. For example, if you are

loyal to a particular coffee provider and you feel you would like some “retail” type stocks in your portfolio, you might consider choosing your preferred coffee provider for your portfolio and then begin a further analysis of the fundamentals and technicals of the stock. “Liking” a company’s products alone should not be the sole reason for investing in the company stock although it may be a reason to purchase the company’s products.

Stock Selection Strategies

Chapter One 4

Fundamental vs TechnicalTypically the longer term an investor’s time horizon is the more important a company’s fundamentals are. Fundamentals are the data points provided to shareholders and the general population that reveal the financial health of the company itself. In theory, the more profitable the company becomes the stronger the company’s stock will be. Fundamental data can be overwhelming for a non CPA investor to analyze and they often will look to a few key data points in their stock selection. For example, old school investors often looked

for a stock that had a PE (price/earnings ratio) of less than 15, which suggested that it was a “good” stock. If a PE increased to >25 this was “bad” and a stock might be sold off. During the tech bubble of the late 1990’s some of the fastest growing stocks did not have earnings and therefore no PE ratio or extraordinarily high PE ratios making this fundamental benchmark useless. Technicals are all the data points that reflect the performance of the company’s stock. Technicals involve the analysis of price and volume over a period of time. The primary tool used in technical analysis (often called TA) is a stock chart/graph. Short-term traders place a greater emphasis on the technical aspects to

select stocks such as timed entry and exit points and usually don’t focus on the fundamentals. For example, day traders rely exclusively on technicals for the myriad of trades they make throughout the day. For “swing” and “position” traders that typically take a position for a few days to a few months, they might rely mostly on technicals for their trade decisions but utilize some fundamental data points to select the stocks in which they will trade. Investors that consider themselves “buy and hold” will usually rely on fundamental data to select and buy their stocks and then may use a long term technical indicator to suggest an exit point.


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PricePrice is an important psychological consideration and companies will often try to keep their stock’s price within a certain range. For example, stocks that are below $1 are often considered to be “cheap” and from a low quality company. These stocks are usually called “penny stocks” and don’t attract serious investors. Stocks that are priced over $100 are usually considered to be “expensive” and attractive only to large investors and institutional clients. The sweet spot for most stocks seems to be between $20 and $50. This tends to be

driven by the fact that for decades, investors could only buy in “round lots” of 100 shares. This is no longer the case but it has still affected investor mentality. A “round lot” of 100 shares of a $25 stock would be $2500 and that size of an investment generally appealed to the typical investor. Of course companies do not want to see their stock price capped by a psychological barrier and that’s where a “stock split” comes into the picture. If an investor buys 100 shares at $25 and over the next few years the stock price increases to $68 a company may consider a stock split. The most common stock

split is a “two for 1”. In a 2:1 stock split the price of the $68 stock is halved to $34 and the number of shares is doubled. There has been no actual change in the net value of the position but the share price is now back down to a psychologically comfortable level and it may again attract more mainstream investors. Investors might use a range of stock price as part of their selection criteria based on this market behavior or even seek out a stock that has recently announced a stock split.


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Industry/SectorIn the markets there are groupings of stocks which are based on the nature of the business of the company. Here are a few examples of stock market sectors: energy, healthcare, technology, basic material, utilities, consumer staples, consumer discretionary, precious metals etc. I’m sure we’ve all seen over time, changes in the attractiveness of different sectors over others. As an example, in the period from 2000 to 2006 the “housing sector” was a very “hot” sector with housing related stocks of home builders and hardware stocks soaring as did commodity prices for lumber and other raw materials used for construction. During the housing crisis the money that had flowed into these sectors now flowed out of the

sector causing the prices of the stocks within the housing sector to plummet. Although the money left the housing sector it did not leave the market. While the funds were coming out of the housing sector, they may have been flowing into the oil and energy sector as oil and energy related companies were enjoying record prices from 2008-2014. When the oil sector became “yesterday’s news,” funds began to flow out of oil/energy into other sectors. This flow of capital from one sector of the market to the other is called “sector rotation”. Part of stock selection involves looking at a variety of sectors, charting those sectors and trying to ascertain where is money flowing in and out.


Chapter One 7

VolatilityNot all stocks prices move in the same direction at the same time or to the same degree. Volatility is an important element to consider when selecting a stock as historic volatility might offer a general idea of future stock behavior. Investors who don’t want to see larger price swings from their position will want to focus on stocks that have displayed lower historic volatility while those willing to “ride the roller coaster” might be willing to consider stocks with higher volatility. One of the tools to measure historic volatility is Beta. Beta helps to quantify the stock’s price behavior relative to a

benchmark. Usually the benchmark in the stock market is the S&P 500 index. A stock that has perfectly followed the movement of the S&P 500 would have a Beta of 1. This would mean that if the S&P 500 moved up 5% that stock also moved up 5% over the same period. A stock that has a Beta of 1.5 is one that historically moved up/down 7.5% when the market moved up/down 5%. Tech stocks often have high betas. A stock like a utility company typically have lower beta under 1.0.


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VolumeVolume is an important factor for short term traders as higher volume stocks trade more “efficiently” than lower volume stocks. The word “efficiently” refers to the ability to buy and sell quickly and at a minimum cost to complete the transaction not including commissions. Stock prices are quoted with a Bid and Ask. The bid is the current price at which buyers are willing to buy shares. The ask is the

price at which sellers are “asking” others to pay for their shares. Stocks with higher volume tend to have very tight bid/ask pricing. For example, a stock trading at $20 with a usual volume in the millions, may have a bid of $20.00 and an ask of $20.01. If I buy 100 shares at $20.01 and change my mind the very next second and go to sell the 100 shares, I can sell them back at $20 losing one cent per share to the bid/ask spread. Let’s take another example where a stock only trades on average 50,000

shares per day. For this particular example, the stock last traded at $20 but the bid is $19.95 and the ask is $20.05. If I decide to buy 100 shares at the current asking price of $20.05 and then immediately change my mind, I will only get the $19.95 price to sell back my shares. A $0.10 loss to the bid/ask spread alone is a ½% loss in just market inefficiency. Searching for higher volume stocks is one of the ways to reduce this.


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Market CapitalizationThe size of the company is also something to be considered. Stocks are generally broken out by their “market capitalization” or market-cap. Market cap is calculated by the value of a share of the stock multiplied by the number of shares outstanding. Large Cap stocks are the largest and most common stocks investors trade. They tend to be household names of multi-national corporations. Large Caps stocks generally have access to inexpensive

capital through high quality bond offerings, a solid history of growth and often pay a dividend. Large cap also tend to display average to volatility and trade in line with the general direction of their sector or market in general. The S&P 500 stocks are all large cap. On the other spectrum is Micro cap. Micro cap stocks are small publicly traded companies. Their share value is usually very low often under $1 and considered “penny stocks”. These are often companies just getting started, have almost no name and

brand recognition, seldom have any profitability and tend to borrow money at the highest rates with heavy debt loads. The hope of every micro cap stock is that it will grow into a large cap. This is often the most volatile area of the market with high risks and large potential rewards. This is also the area of the market where a few companies have emerged from but where thousands of other companies vanished from the markets entirely.


Chapter One 10

Option-abilityAs your knowledge and skills grow and you want to explore other strategies, stock options may become an important part of your investment selection strategy. Most large cap and mid-cap stocks have listed options while only a few small and micro-cap stocks do.


Chapter One 11

Analyst CoverageMuch like option trading, large and mid cap stocks often have multiple analysts that cover them and provide important commentary and data that aids investors in making informed decisions about their positions. It’s unusual for analysts to cover the smaller cap stocks since

analysts are typically compensated for their research and opinions by large institutional investors that tend to only invest in large and mid cap stocks. When an “analysts” covers a small cap or a micro cap stock and you receive that analysts’ report unsolicited in your email, mail or across your fax machine, it may actually be a marketing piece and

the “analyst” may be nothing but an employee of a company trying to “pump and dump” the stock on unaware investors. Large cap stocks will have dozens of analysts providing long term and shorter-term ratings on stocks which allow investors a consolidated opinion to consider.


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TimeframeAs discussed earlier in the Fundamental vs Technical section, the time frame in which an investor anticipates holding on to a position can be important when deciding how much to weigh the fundamentals of the company versus the technicals of the stock. In general, the shorter the timeframe, the more technicals matter and the longer the timeframe the more weight and emphasis that is placed on the balance sheet of the company itself with the assumption that the stock’s price will reflect health or sickness over time.

Appreciation vs incomeSince buying a share of stock is really buying a piece of a company, it’s important to understand there are two ways to profit from this partial ownership. The first way is price appreciation. Even if a company does not pay out a portion of its profits to the shareholders in the form of a dividend, the price of the stock may be rising as the company invests back into itself. This can be reflected in the appreciation of the stock’s price. Let’s say you bought 100 shares of a $40 stock. A year later the price has appreciated to $50 and you have a $1000 unrealized profit in the position. If you want the money you will need to sell your shares in order to have access to the $1000. This is price appreciation and most traders are looking JUST for this. The other way to profit is through a dividend. Let’s say you bought into an oil pipeline company trading

at $50/share with a 10% dividend. You bought 100 shares and over a one year period the stock price increased to $55/share but during that year the company paid out $250 of dividends. You’ve enjoyed a 5% return on your investment from the dividend but you also have some price appreciation. You didn’t need to sell the stock to enjoy some of the benefits of ownership. In stock selection you’ll need to decide how important price appreciation potential is versus income in the form of dividend. Companies that are paying out much of their profits to shareholders as a dividend have less capital to work with to grow their business.


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TrendThe “trend” or cumulative price behavior of the stock should be one of the most important considerations when selecting stocks. Back in the early 1900’s Charles Dow wrote his six basic tenets in his “Dow Theory”. Number three is “The stock market discounts all news”. The idea here is that the markets are efficient in processing all the KNOWN information about a particular stock. In other words, all the news stories and all the analysts opinions and ratings are already being factored in to the price of a stock as people influence a stock’s price through the buying and selling

shares. If a stock’s price is trending higher day after day and week after week then the idea is that buyers are processing all the information and coming to the decision to buy. Their action drives prices higher. Assuming the information being received continues to drive this opinion then the buying should continue and price should trend higher. If/when news is released or information discovered that adversely effects that opinion then the buyers will cease to buy and may turn into sellers and send the stock in a downward trend. It’s based on this concept that we look to trend to observe the trend of the chart over several period of time as a way

to visualize the collective opinions and actions of the millions of market participants trading billions of shares for trillions of dollars. Price is the one absolute in the market as price determines if a position is a winner or a loser. This is why there are some many clichés’ associated with trend “The trend is your friend”, “Don’t fight the tape”, “Follow the money”, “Go with the flow” “Don’t mistake a Bull market for brains” etc. When it comes to selecting stocks the trend of the overall market, the trend of the industry/sector and the trend of the individual stocks are all very important considerations.


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Chapter Two

Key Candle PatternsCandlestick charts form the foundation of much of our technical analysis. While there are many various chart styles, we find candlestick charts to be the best at representing the story being told by the market. They are nothing more than a graphical depiction of the activity of buyers and sellers. When you recognize that they tell a story, you’ll be better prepared to apply the various patterns to your trading and investing.

There are scores – perhaps hundreds – of candle patterns, and entire books have been written about

them. In fact, we suppose that entire patterns have been created for the sole purpose of filling some books. For that reason, you should always apply this sanity check to any pattern that you’re considering: What’s the story that’s told by the pattern? If you can’t make sense of the story behind the pattern, then you should consider eliminating that pattern from your toolbox. You’ll find that those patterns that do tell a story about what the traders are doing and how they’re doing it, will add to your understanding of how the market is behaving and which strategy is best applied.

Entry and Exit Strategies

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Candle BasicsCandles are like Lego pieces. Each piece gives you information, albeit very limited. You can see the shape, color and size. But if you look at a single Lego piece, it doesn’t tell you a story. It’s not until you take multiple pieces and fit them together do you begin to see the big picture.

Candles are the same way. A single candle will tell you what happened during that trading session. But its real value is recognized when you fit that single candle together with the sequence of candles that preceded it and you start to see the story unfold. Two candles with the same basic shape may tell entirely different stories when placed in different sequences.

For starters you need to know the characteristics that make up the Lego piece. Every candle has four data points:

1. Open

2. Close

3. High

4. Low

Figure A.1 illustrates the basic building block of the candle chart. Typically, most trading software will use the red/green scheme but a black/white scheme is often used in print. Just keep in mind that black and red are the same, while white and green are the same.

Let’s start with the candle on the left. Since it is white, we know that the bottom of candle body is the open and the top of the body is the close. The open is the first trade of the market session and the close is the last trade as the bell rings. Many trading platforms allow you to modify the open and close to any time you choose. For example, you may be able to set the open as the first trade at 9:00 am EST in order to capture 30 minutes of pre-market trading on your chart. We’re not fans of this type of adjustment. There is a real value to benchmarking the actual open and close and any adjustments to the time detract from your ability to read the market through the open/close prices.

The lines above and below both bodies are called shadows. The top shadow marks the high water mark for the trading session. We don’t know

specifically when it occurred, but we do know that the buyers were able to push the price to the top of shadow at some point during the day. Likewise, the bottom shadow indicates the lowest trade price for the trading session. By observing the shadows, you can get a good idea of relative volatility by simply comparing shadow lengths for various periods in the market.

The candle to the right is a black candle, telling you that the price opened at the top of the body and then traded lower throughout the session. The bottom of the black candle body tells you where the price finished at the end of the trading session.

With these basic definitions in hand, let’s look at some bread-and-butter patterns and the story they tell. If you start by learning to recognize these patterns in your charts, you’ll have a very good foundation for your technical analysis and charting. Think of these as the hammer, wrench and screwdriver for your toolbox. You’ll almost certainly add more as you go along but these will serve you well and often.

Figure A.1 Candle Chart Basics

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Bullish Engulfing

The Bullish Engulfing pattern shown in Figure A.2 is considered a self-confirming trend reversal pattern. It is self-confirming in the sense that it does not require an additional trading day to confirm that the reversal has started. When you observe a Bullish Engulfing pattern, you may enter a bullish trade at the close of the pattern day or at the start of the next trading session. The key characteristics of the Bullish Engulfing candle are as follows:

• The first day of the pattern is a down day, as evidenced by a red or black candle. The black candle tells us that the short-term downtrend is still controlled by the sellers, who are pushing the stock to lower levels.

• The second day’s candle should be green or white, indicating that the buyers are in control for that day.

• The second day’s body must completely engulf the first day’s body. The open of the second day should be lower than the first day’s close. Likewise, the second day’s close should be above the previous open. A bonus to the pattern is if the second day’s body completely engulfs the first day’s body and shadows.

• Care should be exercised if the engulfing day has weak volume. Typically, you should expect to see stronger volume confirming the reversal. A significant drop in volume on the engulfing day would be cause to pass on the pattern.

Now consider the story that is told by the Bullish Engulfing candle. First of all, the stock is in an initial downtrend. Since this is a trend reversal pattern, you need to begin with a trend. No trend, no pattern. The price is in a downtrend and you’ll typically see lower highs,

lower lows and predominately black candles. The strength of the downtrend is evidence that the sellers are firmly in control of the trading. When the price reaches the level that has been a floor in the past (support), the sellers appear to have continued strength by virtue of the gap down on the engulfing day. How do you know the stock gapped down? Because the only way you can have an engulfing candle is if the engulfing day opens lower than the previous black candle’s close. However, this gap occurs at or near a support level – a price level where the buyers have previously been able to rally against the sellers. This time, the buyers come in with such strength that they’re able to completely erase the sellers’ gains from the prior day. The resulting long white candle tells you that the buyers advanced the price from support to close above the previous day’s open. As noted, if the white candle has no top shadow then you know that the buyers were still buying right up to the closing bell. At that point, it’s likely that the market didn’t run out of buyers but rather the buyers ran out of time.

Figure A.2 Bullish Engulfing Candle

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Bearish Engulfing The Bearish Engulfing candle pattern is the bear equivalent to the Bullish Engulfing candle. All of the same key points apply, except that you have to adjust them for a reversal from an uptrend.

• The first day of the pattern is an up day, as evidenced by a white candle. The white candle tells us that the short-term uptrend is still controlled by the buyers, who are pushing the stock to higher levels.

• The second day’s candle should be black, indicating that the sellers are in control for that day.

• The second day’s body must completely engulf the first day’s body. The open of the second day should be higher than the first day’s close. Likewise, the second day’s close should be below the previous open. A bonus to the pattern is if the second day’s body completely engulfs the first day’s body and shadows.

• Just as the Bullish Engulfing candle gaps down on the engulfing day, the Bearish Engulfing candle gaps up in order to create the engulfing day.

Figure A.3 Bearish Engulfing Candle

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Shooting Star

The Shooting Star candle pattern is considered an initial trend reversal pattern that requires confirmation. You need to wait one more trading session to ensure that the pattern will complete before acting on the signal. As you’ll see in the story, the Shooting Star only indicates that the buyers are weakening; it doesn’t tell you that the sellers have taken control. If the pattern gets confirmation, then you can proceed with the confidence that the trend reversal has started. Confirmation for the Shooting Star would be a black candle with a lower close. Ideally, volume would be higher, adding further confirmation to the trend reversal.

• The body must be small relative to recent candle bodies. Since the body is small, the color of the body is of no importance to the pattern.

• The top shadow should be at least twice as long as the body. With the shooting star, we’re not as concerned if the top shadow is relatively long. This tells us that the sellers pushed the stock down from much higher levels. If you have a technical background, a word of caution: Don’t measure the shadow! If it looks about twice as long, then for all intents and purposes, it’s twice as long. These characteristics are based on visual analysis, not hard quantifying. Too many traders calculate inconsequential metrics like the ratio of body to shadow and, in doing so; they develop a false sense of confidence in the pattern. These are stories – not formulas.

• The lower shadow should be nonexistent or at least less than the body length.

• What’s the story? First, recognize that you have to start with an uptrend in order for this to serve as a trend reversal pattern. The stronger the uptrend, the better the pattern will fit. If you’re having trouble deciding whether or not you have an initial uptrend, then move on to the next trade. There are too many good trading opportunities out there for you to waste time trying to squeeze a trade out of a pattern that hasn’t developed properly.

Next, the price reaches a level that had previously acted as a ceiling (resistance). This is a level where the sellers have pushed the buyers back in the past and moved the stock lower. As the buyers run the trend higher toward resistance, it would appear that they have continued strength. This is apparent by the length of the top shadow. Recall that the top shadow shows you the highest trade price during the day. With a long top shadow, you can see that the buyers had the price much

Figure A.4 Shooting Star Candle

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higher at some point. However, the sellers came in at or very near resistance and drove the buyers back from the high. Ultimately, the stock closed very near where it opened, forming a relatively small candle body.

Notice that the small candle body does not indicate that the sellers are in control. In only tells you that the buyers relinquished control at the highs. That is weakness of the buyers, not strength of the sellers. It is quite possible that the buyers may take that opportunity to regroup, only to resume their buying strength the next day. We have seen many occasions where a Shooting Star is followed by a strong breakout above resistance. That’s why confirmation is so important. If you see a black candle with a lower close the day after the Shooting Star, then you can safely assume that buying weakness has yielded to selling strength. That’s your trading signal.

Hammer

The Hammer candle pattern is the bull equivalent to the Shooting Star pattern. The Lego piece is exactly the same. The difference is the location and orientation. The Hammer occurs at the bottom of a downtrend as opposed to the top of an uptrend. The long shadow of the Hammer points down, the long shadow of the Shooting Star points up. A good way to keep these straight until you have them memorized is this: Stars are in the sky and the long shadow always points in the direction of the initial trend. Hey, it works with a lot of our students but if that doesn’t work for you, come up with your own!

Figure A.5 Hammer Candle

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Doji and Spinning Top

Dojis and Spinning Tops are two candle patterns that indicate market indecision. Any given market may be controlled by 1) buyers, 2) sellers or 3) nobody. These two patterns tell you that nobody has a firm grip on the trading direction. As with the Shooting Star and Hammer, you need to wait for confirmation before acting on these candles. Dojis and Spinning Tops may occur at either resistance as an uptrend reversal signal or at support as a downtrend reversal.

The definition of each candle is fairly simple. The Doji is shown in

Figure A.6 as the candle on the right that forms at support. The Doji is characterized by the fact that the body is simply a horizontal line. That tells you that the open and close are the same price. As always, this is a visual assessment. If you look at a chart of a $400 stock, an open that is $0.50 off the close will look like a Doji on most charts. For your purposes, that’s a Doji. The horizontal body line may appear anywhere along the shadow line and still count as a Doji.

The Spinning Top is characterized by a relatively small body. Of course, as we’ve pointed out already, the small body means color is unimportant. With the Spinning Top, the top and bottom shadows should be approximately equal. Any significant difference between the shadows and you’ll have a different candle. For example, if the top shadow is much longer than the bottom shadow and the candle is at the top of an uptrend, then your candle is a Shooting Star

rather than a Spinning Top.

Dojis and Spinning Tops both require that the price begin with a trend, either up or down. If an uptrend, then the candle must occur at or near resistance. If the initial trend is down, then you need support with the candle. Confirmation is required and has the same criteria as we’ve previously discussed. Bearish confirmation is a black candle with a lower close and bullish confirmation is a white candle with a higher close.

The story starts to take shape as you realize that these candles are indecision. In the face of an initial trend where one side of the market is firmly in control, the price reaches a key support or resistance. At that level, the side that had control pauses and momentarily (at least) loses control. The loss of control is represented by the Doji or Spinning Top – price closes at or near the open. If the pattern completes through confirmation, then you take action.

Figure A.6 Doji and Spinning Top Candle


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Candle WrapCandle charts are powerful tools and we use them regularly as part of our approach to technical analysis. However, they are tools that need to be used with an appreciation of what they can and can’t do. We use them to help draw the story out of the market, but we recognize that sometimes we miss the story. Sometimes a candle pattern looks like it came right out of a textbook and then it fails entirely. When that happens, manage risk with strict discipline. Other times, the story plays out well and you enjoy the profits from choosing a strategy in line with your analysis.

Occasionally, a trader will approach us and inquire about the winning percentage of one candle pattern

versus another. The problem with assigning a winning percentage lies in definitions. What constitutes an uptrend? Is it three white candles? What level of volume confirms the trend? How close should the candle be to support or resistance? How much of the shadow is allowed to penetrate through support or resistance? With just these few questions you can appreciate that it would be difficult to set a strict definition by which to compare various candle patterns. And to suggest that candle pattern X is successful Y percent of the time is both arbitrary and meaningless. Fortunately, you don’t need that information. Learn to draw the story from the totality of your analysis and then protect your position. That’s the foundation of trading success.


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Support and ResistanceThe patterns in a chart are constantly telling us a story. The story is all about the actions of the buyers and sellers and knowing who is in control at any given moment. Because our eyes are trained to pick out patterns, it is critical for the trader to develop the skill of pattern recognition. This is even more important than learning all of the advanced technical indicators and applying them to every trade analysis. When we refine this skill of identifying patterns, we are better able to know when the buyers are in control and we should be buying, also. Likewise, the subtle clues that tell us when the sellers gain control will be important for us as we manage risk or employ bear market strategies.

Some price levels appear on a chart as a battleground between the buyers and sellers. We identify this from points of inflection on the trends. If you were to view this on a simple line chart, it would have the appearance of a “V” for the support level. This is the price where the sellers are stopped by the buyers and the downtrend reverses to an uptrend.

Candlestick charts help to identify support levels because the colors give the added dimension of telling us who is winning the day. Green candles indicate that the buyers controlled that day since a green candle is formed when the stock closes higher than it opens. Conversely, the red candle is formed when the stock closes at a lower


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price than it opened. Sellers win on the red candle day.

Some traders have difficulty deciding where to draw the support line. Should you use the lowest point on the candle – the bottom of the lower “shadow”? Maybe you’ve heard that you should draw the line across the bottom of the candle body. Others will tell you that you should always use the closing price, regardless of the candle body color. We like to take the “best-fit” approach. Since this is NOT an exact science but rather a subjective assessment of the support line, we may use a combination of all three. What we’re looking for is the level that “best-fits” a horizontal price level.

Precision is not necessary and, in fact, is not realistically attainable.

When drawing resistance, you would take the same approach. However, instead of defining a “floor” you’re

looking for a “ceiling.” Resistance is the price where buyers are stopped by the sellers after a period of up-trending prices. Candle patterns may be useful for helping to identify resistance levels as uptrends reverse and form the inverted “V” shape as shown in the illustration.

Your goal with support is to pick a line which defines the expected range of trading. If the price drops below that expected range, you can

assume that the trade has moved against you and you will exit your position. Support levels ultimately help you pick your sell stop protection price. So find support, drop below it a reasonable amount and be sure to exit if it reaches that level. Then assess your results and decide on any adjustments for the next trade.


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Chapter Three

Risk Management

How many times have you looked at your trading diary and realized that you’re missing a simple key to success: if only you had bought when you sold and sold when you bought, you’d be showing a handsome profit?

There are some people who can best be described as reliable contrarian indicators. Watch what they do and then take the opposite position. While we laugh at the irony of this

example, the fact is that we often find that we’re working against ourselves when we take a close look at our trading style. This article will explore the psychological aspects of managing trading risk and how we can accommodate our own limitations.

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Risk Management

Are You Out of Your Mind?Research has shown that our own minds work against our financial best interest. For that reason, when we develop a plan to manage trading risk, it is imperative that the plan be designed in such a way as to minimize our interference in the execution of the plan.

Simply, we need to create a foolproof plan and recognize that it is ourselves that we’re protecting against. To illustrate this, we can look at a popular experimental economics game referred to as the “Ultimatum Game”. In the Ultimatum Game, two players are given the opportunity to divide a sum of money and there is no reciprocation. That is, each player only has to make one decision and the game is over.

To start, player A is told to divide an amount, say $10, between player A and player B. The split can be any ratio with one exception: player A cannot keep the entire amount. The

worst case split for player B is that player A will choose to keep $9 and give $1 to player B.

The next step is for player B to decide whether to accept or reject player A’s offer. If player B accepts the offer, then both players get the amount of money set forth in the offer. If player B chooses to reject the offer, then both players walk away empty-handed. Here’s the key question: When is it advantageous for player B to reject an offer? The answer, of course, is never! In the worst case scenario, if player B accepts the offer, he will still receive $1 that he otherwise wouldn’t have.

However, experimental results show that offers of less than 20% ($2 in our example) are often rejected. Subsequent investigation reveals that there is an element of “fairness” that’s considered by player B and if the offer is perceived as “unfair” then the offer is rejected. Player B would choose the defense of perceived fairness rather than improve his financial condition if they appear to be mutually exclusive choices.

Before you think that you’re the exceptional trader who can overcome this propensity through sheer determination, consider this: A research study scanned the brains of Ultimatum Game players as they responded to fair and unfair proposals. The results were published in a 2003 article in Science magazine entitled “The Neural Basis of Economic Decision-Making in the Ultimatum Game”. It was shown that unfair offers elicited activity in brain areas related to emotion which suggests an important role for emotions in decision-making.

The conclusion for the trader is that we have to recognize that our emotions are an integral part of our financial decision-making and then take the necessary steps to ensure that we don’t harm ourselves in the process. Of all professions, the trader must take care to address this point since financial decisions are made every trading day.

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Risk Management

Gambling With Losses

Figure 1.

An extension of the concept of perceived fairness was developed by Daniel Kahneman and Amos Tversky, in their landmark research into Prospect Theory. The short description of Prospect Theory is that people are much more willing to gamble with losses than with profits. This concept is actually quite familiar to traders because we are quick to lock in a profit while allowing losses to continue, in the hope that our patience will be rewarded by a rebound in the stock price.

Gambling with a loss is known as Loss Aversion: the tendency for people to strongly prefer avoiding losses over acquiring gains. On the other hand, when we quickly lock in our profits, we’re exercising Risk Aversion: we shun any risk when we have a profit in hand. Some studies suggest that losses are as much as twice as psychologically powerful as gains. This phenomenon serves to dramatically increase the level of risk that a trader will accept with a losing position. We don’t want to

accept the negative emotions that come with a loss and will go to great lengths to avoid a loss.

However, many times the losses are not avoided but rather deferred. When we practice Loss Aversion and watch the unrealized losses continue to grow, we’ll eventually reach a point where even the unrealized loss becomes untenable and the position is closed. In the markets, the movement that occurs when masses of traders finally realize a loss that has become unbearable is known as capitulation selling. The rapid downward drop in price with a corresponding spike in volume is often the result of emotional decision-making rather than a thoughtful, well-executed risk management plan.

Figure 1 illustrates the imbalance between the value that we assign to losses and gains. As gains increase, there is a “joy” value assigned to the gain. However, if you move the same distance on the loss scale, the “pain” value is much greater.

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Risk Management

Accepting the LossA key difference between a successful, experienced trader and a novice is the ability to accept a loss. One might even go so far as to suggest celebrating a loss if the loss is small and within the defined risk plan. As a trader, logging losses into your trading diary is the surest evidence that you have a plan that is working to protect your positions. If your trading success rate is exceptionally high, you should be concerned about your Loss Aversion.

A warning flag in any trading plan is a low loss rate coupled with high drawdowns. This is nothing more than a manifestation of the age-old belief that a loss isn’t really a loss until the stock position is closed.

Traders are some of the best players of this game. While that belief may hold true from a profit/loss analysis of closed positions – and the possibility exists that your position may yet recover – a loss exists any time your position moves against you, regardless of whether or not you close the position.

The biggest fear for most traders is that they’ll get caught up in seller’s remorse. This occurs when you decide to close your position for a loss, only to watch the stock turn around and move in the direction you wanted it to go initially. The trader regrets selling the stock at the wrong time and vows not to make that mistake again. The proper response to that situation is to congratulate yourself for accepting a

loss according to your trading plan. The next step is to reevaluate the trade based on the current technical setup and, if the conditions warrant, open a new position.

Many traders have trouble accepting a new position in a stock that they just took a loss in because of the concept of perceived fairness. They think to themselves that they were unjustly robbed of a profit by the volatility in the stock price and they refuse to be beaten by the stock again. An even worse response to the same scenario is to try to exact some form of revenge from the stock that just dealt them their loss.

In the same manner as a warrior going into battle, the trader will persistently attack the same stock

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Risk Management

with the goal of finally extracting a profit and proving to themselves and any observers that they were right after all. This process may yield many losing trades in the pursuit of the one winning trade that satisfies the need to be victorious.

It’s not surprising that this condition exists since most of us come to trading from other professions. Due to the technical nature of financial markets and the challenge of pitting oneself against the ranks of highly intelligent and worthy traders, the trading profession especially attracts successful individuals from such fields as engineering and the sciences.

For an example, let’s look at the case of a medical doctor specializing in the field of obstetrics. Throughout his education, internship and practice, he’s taught to exercise his profession at a level that permits no failures. It is beyond consideration to accept a “loss” in the sense that we’re describing. To reason that there is an acceptable loss level and that the successes will offset the losses on balance doesn’t even enter into his thinking.

Furthermore, by continued study and practice, this doctor will only raise his expertise and the likelihood of a “loss” diminishes to virtually zero. Now this same doctor, after years of practicing medicine, decides

to take his accumulated earnings and trade his personal portfolio. His experience has taught him that a loss is unacceptable and now he begins to apply that logic to his trading. In short order, he realizes that his self-imposed requirement of a zero-loss strategy is the very recipe for his failure.

When he discovers that it is possible to lose on seven out of ten trades and still be a successful trader, he has to shed the mindset that brought him to his initial level of success. If his first profession accepted only a 30% success rate, he would certainly not be welcome in the delivery room!

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Risk Management

Mental Preparation for Managing RiskThe goal for the trader entering the markets is threefold:

1. Recognize that risks exist which will result in losses;

2. Accept the fact that the risks are neither fully identifiable nor quantifiable and;

3. Develop and execute with discipline a plan to protect against these risks.

Nassim Nicholas Taleb, in Fooled By Randomness: The Hidden Role of Chance in Life and in the Markets, has the following observation:

There is nothing wrong with a risk taker taking a hit provided one declares that one is a risk taker rather than that the risk being taken is small or nonexistent. Characteristically, blown-up traders think that they knew enough about the world to reject the possibility

of the adverse events taking place: There was no courage in their taking such risks, just ignorance...They all made claims to the effect that “these times are different” or that “their market was different,” and offered seemingly well-constructed arguments (of an economic nature) to justify their claims; they were unable to accept that the experience of others was out there, in the open, freely available to all, with books detailing crashes in every bookstore.

Of the three points listed, the second is the most difficult for traders to reconcile. We convince ourselves that with sufficient analysis and training, we can fully quantify the risks that we’ll face in the markets. With our biased perspective, we come up with technical and fundamental reasons why a stock will not move beyond a certain level, or at least not at this time. After the position begins to move against us, we justify continuing to hold the position with more wellconstructed arguments.

These arguments include all sorts of good logic such as the strength of the company’s management team, the history of the stock price in the same quarter of previous years, the convergence of the perfect candlestick pattern with a major support level, and so forth. These are nothing more than tools of the trade for the trader who is practicing Loss Aversion.

To close the first article in this series, make no mistake that taking risks is good. Every trader is, by nature, a risk taker. But you need to enter your market with a realistic assessment of the risks that you’ll face and a plan to deal with them as they arise. In the final article of this series, we’ll explore the technical tools for managing risk and how they can be incorporated into a specific plan. For now, take heart in knowing that you are not out of your mind…but that might not be such a bad thing after all!

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Chapter Four

Exchange Traded FundsExchange Traded Funds, more commonly known as ETFs, have been around since the mid 1990’s when the S&P 500 (SPY) was first introduced as a more efficient way to trade this index. The original ETFs were created as a tradable mutual fund allowing investors the ability to enter and exit positions like a stock while remaining diversified like a mutual fund. Since then, the ETF market has exploded with well over 1400 ETFs from which to choose. With so many to choose from it’s imperative a trader acquires the knowledge and strategy to better utilize ETFs as both an investment and trading vehicle.

Hybrid Vehicle

Since the ETF is a hybrid vehicle it naturally comes sharing many advantages of both stocks and mutual funds alike. Fortunately for us, this “cross breeding” of a mutual fund and stock has bred out many of the disadvantages of the parents while leaving the attributes more valued by a trader intact. We have outlined a few of the key advantages you should be aware of to better appreciate the value of this relatively new investment vehicle.

Bull & Bear ETF Strategies

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AdvantagesTradable:

Since the “T” in ETF stands for “Traded” this is one of the most significant advantages. An ETF trades just like a stock. This means that an investor can buy or sell an ETF at a moments notice in the same way that he would with a stock transaction. Since the mechanics of buying and selling ETFs mirror those of a stock transaction, the associated fees (commission) are the same. If, for example, your broker charges a flat rate of $7.99 for a stock trade, the costs to you would be the same. ETFs have become so popular that several brokerages have created their own proprietary ETFs. Many of these can be traded free of any commissions. We all know there’s no such thing as a free lunch. The brokerages might not be charging a commission, but that doesn’t mean they aren’t making money. ETFs come with management fees that

are included in the value of each share. These fees can vary greatly with some fees as low as .09% per year to over 1%. If your broker has a proprietary ETF that you can trade without fee, take a few minutes to research the management fee and compare it to a like-kind ETF with a commission to determine your true costs. Even with fees, many ETF’s are an extraordinary value. Consider the fact that purchasing just one share of the SPY (S&P 500 tracking ETF) represents ownership in 500 unique companies. The SPY has an annual expense ratio of .09% or $9 per year for every $10,000 invested, a tremendous value to say the least.

Volatility:

As a result of ETFs being comprised of a basket of stocks, they tend to be less volatile than individual stocks and we say that ETFs will “gap” less. Gapping is a technical term associated with a candlestick chart in which there is a visible gap from the closing price of the

period to the opening price of the next period. Gapping goes hand in hand with volatility. If the opening price is higher the stock is said to have “gapped up”, if the opening price is lower the stock has “gapped down”. Gaps are most common when information about the company is released after the markets have closed. Information such as an earnings release, an analysts’ opinion, a product release, litigation, management changes and many others can have a dramatic effect on the stock’s opening price the next day. Since the market is not open when the information is released, the price cannot react until the opening of the next sessions. Buy and sell orders build while the market is closed, the opening gap is often the most dramatic move of the day. Gapping indicates a lack of efficient information dissemination and although a gap can work in the favor of a trader, taking a trade after a gap has occurred is best left to experienced traders.

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Order Types:

Another significant advantage of the tradability of the ETF is the ability to use various order types common to most online brokers. Being able to automate and mechanize entry and exit is an important factor in becoming a skilled and disciplined trader. We encourage the use of various order types including: Market, Limit, Stop, Stop Limit and Conditional Orders for ETF and option strategies. Having an understanding of various order types will help to automate trades, protect positions and help lock in profits.

Diversification:

ETFs are one of simplest and most cost effective ways to diversify a portfolio. When Shawn’s children were just infants, he and his wife opened and funded an educational

account for each child. At the time the maximum amount a parent could contribute to these accounts in a given year was $500. $500 did not allow much room in the way of diversification and many index mutual funds had minimum purchase limits of $500 or greater, therefore limiting the choices and ability to be diversified. Instead of using mutual funds or outright purchasing a variety of individual stocks, Shawn and his wife were able to utilize ETFs like the SPY (S&P 500), QQQ (NASDAQ 100) and IWM (Russell 2000) to diversify. Using these ETFs diversified their portfolios into 2600 different stocks for under $30 in transaction costs. Prior to the creation of the ETF this was impossible. Both small accounts and large accounts can benefit from utilizing ETFs to diversify portfolios.

Technical Analysis:

The vast majority of traders and investors utilize some form of

Technical Analysis (the visual interpretation of charts that measure historical price and volume movement to better anticipate price movements). The fact that ETF trades are plotted on a chart the same as a stock means that all the traditional forms of technical analysis apply with some exceptions to volume analysis.

Non-emotional:

In all our years as investors, brokers and investment educators, we have seldom seen a more dangerous pitfall than becoming emotionally tied to a stock. Creating an emotional attachment creates a biased opinion and the biased opinion blurs and distorts the trader’s better judgment, thusly bringing forth bad decisions. Bad decisions create financial losses, something we all want to avoid. Since ETFs are “funds”, they are comprised of a basket of various stocks. It is unlikely that an investor

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would form an emotional bond with this basket unlike a stock in which they: work for the company (Enron), love the company’s products (Apple, The Gap), utilize the company’s services (UPS, Verizon) or have a family history (my family only buys Ford trucks). All these emotional bonds are dangerous to the trader and bias his better judgment and are to be avoided. Human emotion is hard to avoid when being a stock picker, with ETFs it’s much easier. As a technical trader you will soon discover certain chart patterns that you’ll trade with confidence and discover success with. In this case, it’s OK to fall in love with “Ascending Triangles”, “Bearish Engulfing” patterns and a chart that just blew through its “Resistance” level on heavy volume.

No news is good news:

Along with being an emotional investor, the attempt to interpret the news about a particular stock

is another pitfall of being a stock investor. Each day the media machine spits out tens of thousands of news headlines related to individual stocks. For the sake of knowing, we monitored the number of daily articles related to some of the most widely held stocks from the Industrial Goods, Services, Healthcare and Technology sectors just to see how much “noise” was coming across the wire. On average, EACH of these stocks had about 20 news articles or headlines EVERY DAY. Not only would it be near impossible to monitor all these stories, the interpretation of each story will force each investor to make 20 decisions per day for each stock based on their interpretive opinion. News, therefore, is not only a distraction, but also a hindrance and a waste of time. We have the trading motto “no news is good news” and “news is noise”. This does not mean we search for stocks without news. It simply means we prefer investment

vehicles like ETFs that are essentially without news. Not having news means we are not forced to read or interpret every nuance of every story released around the clock. It also forces us to rely on the technical analysis to make our decisions. This is a key concept for you to embrace. We invest in order to make money and assume you do, too. No hiring or firing of a CEO, no new product release, no new phase III drug trial, no new earnings estimate or release and no gurus’ comments will make us money by themselves. What will make us money is the movement of the stock or option in the direction we anticipated as the market reacts to this news. All these things and all the other “things” that make up the stock’s news MIGHT make the stock move, but until they do, they are simply noise. Price is the only reality we should focus on. We’re sure you’ve watched companies release earnings that beat their estimates and listened to the CEO’s

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glowing comments about future earnings. Common sense would dictate that the stock should rally, pop, move up based on this new information. To the angst of millions of novice investors, the stock drops like a stone. To be even more direct, our opinion on what we think the news means to the stock’s price is meaningless, as is yours, as is your neighbor’s, and so is the talking heads on CNBC. In reality, no one person’s opinion matters to me. What does matter is the collective opinions of the institutional investors that drive enough shares through the market to affect the price of the stock to move with their ACTIONS, instead of their opinions. Since individually we cannot move the market so we sit back and watch what the market thinks of the news. We watch what shows up in the chart in the form of price and volume and technical analysis. We want to avoid noise and with an ETF, this noise is muted.

Void of fundamentals:

Back before the information age and the internet, investing was simple. It went something like this: buy a stock in a company you know with a product you trust and have faith that your children and grand children will feel the same. This is why so many portfolios ended up with shares from well-known fast food restaurants, multinational retail, oil and gas, and consumer packaged goods companies. For the sophisticated investor they might also add a PE filter. Provided the price to earnings ratio was below 20, and it met all the other criteria, it was a stock to buy and hold. Simple, and back then it worked. That was then, this is now. In an age where CEO’s say what they want you to hear, The “Street” looks for earnings to beat the infamous ‘Whisper Number” and accountants and insiders discover “new and creative” ways to make losses look like profits and debt to look like income. The

traditional approach to fundamental valuation of a stock has mostly vanished. For the technical trader this is a good thing. You will not be relying on fundamental analysis when trading ETFs. The reason for this is because the computation and analysis of an entire basket of stocks from 30 to 2000 is impossible. This forces the trader to concentrate his analysis on the one thing that matters to your success, price. This is not to say that a good story is no longer relevant. In fact, the genesis of a good ETF trade set up is more often found in a good story that is supported by a technically significant move in the chart. Fortunately for us, ETFs being void of classic fundamentals further removes the confusion and adds clarity to our trading.

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Always a trade somewhere:

For your average stock and mutual fund investor, there is only one profitable market and that is the bull market. As we all know, the market is not in a constant state of going up. In fact, the market spends more time either going sideways or down versus going up. There are numerous ETFs that are designed for bear market strategies. Hundreds of ETFs also have option contracts associated with them. We rely heavily on ETFs with options to utilize various strategies that produce returns in bull markets, bear markets and range bound markets.

Dividends:

Many of the stocks held in these ETF baskets pay dividends. Since your purchase of an ETF represents ownership of these dividend paying stocks, you are entitled to and will receive your share, as the trustees will pass along the dividends. This is usually in a quarterly payout to the shareholders.

Various account types:

ETFs can be held in virtually any type of account from the standard brokerage account to RRSP, TFSA, Custodial Accounts, Trust Accounts, Corporate, and Partnerships etc. Typically it is the broker that determines if you have access to ETFs. Over the years, Shawn has always taken advantage of any company sponsored 401K plans (also known as locked-in plans in Canada), as has his wife. Back in 2000 Shawn’s 401K became self-directed, allowing him to invest in mutual funds, stocks and ETFs. Up until that point he was limited to a short menu of around 12 mutual funds. Unfortunately for Shawn’s wife, the company she worked for continued to house their 401K plan with a mutual fund company and to this day the only choices for their employees are mutual funds. Outside of a 401K plan, you should have access to ETFs. If you do not, it might be wise to consider a broker that provides more options to their account holders. If

you have an old 401K from a former employer, you can discuss with your broker transferring it to a Rollover IRA. This would allow you to best utilize your inevestment education.

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DisadvantagesWe always strive to provide balance of opinion. This is no exception. Although there are numerous advantages to ETFs, there are also some disadvantages. We believe you will agree that all things considered, the advantages far outweigh the disadvantages.

Complexity:

With the recent creation and popularity of leveraged ETFs complexity, risk has increased. Some of these ETFs seek returns that are double (200%) and triple (300%) the move of an underlying index or commodity. As an example, the S&P 500 has seen a 20% drop in value, an investor that utilized a double leveraged ETF would now be down more than 40% for the double leveraged ETF. Remember, just because these are diversified investment vehicles does not mean they are without risk. Another example of the increasing complexity is the bearish ETFs, which will increase in value when their underlying index/commodity drops. A double inverse bearish ETF might be appropriate for some investors but probably best avoided by novice investors. Leveraged ETFs like the

QID, double inverse NASDAQ 100 (PROSHARES ULTRASHORT QQQ) are simple to trade but the vehicles that make up their “basket” are complex. Without getting into the mechanics of how leveraged ETFs work, just know that these vehicles were designed for short term traders. A double inverse leveraged ETF does an excellent job of replicating a move equal to an inverse that is twice the DAILY movement of the index. A position that is held for more than one day will begin to experience a divergence of returns. To clarify the point, your profits diminish and your losses increase with time using leveraged ETFs.

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Fees:

The original ETFs were created largely in response to the often hidden and always complex fee structures of the mutual fund industry. Many investors were unfamiliar with industry terms like 12B1 fees, front end load, back end load, Class A, B, C, STR Fees, AOE Ratios etc. ETFs like the original SPY are very cost efficient. The last time I checked, the SPY had a fee of .09% or $9 for $10,000 per year held. That’s very inexpensive. Contrast this to a newer, more exotic ETF triple inverse ETFs with expense ratio of 1.15% or $115 for $10,000 per year held. Granted, this is still far less than what many mutual funds charge but something to be aware of if you intend to use a vehicle designed for short-term traders as an investment.

Volume/Liquidity:

With so many new ETFs on the marketplace the volume is being spread thin in some cases. Light volumes are best avoided. With light volume, spreads (the difference between the buy and sell price being quoted) increase, which in turn eats into your profit or increases your loss when the position is closed. Another concern about light volume is “slippage”. Slippage occurs when the price changes adversely as a buy or sell order executes. For example, you placed an order to buy 1000 shares at the Ask price of $20.00. 200 shares executed at 20.00 then the price changed to $20.01. You changed your order to buy the remaining 800 shares at 20.01. This time you were able to buy 400 shares at 20.01 and the price changed again to $20.03. Not only is the slippage costing you more but also many brokers will treat each change to the order like a new

order increasing your transaction charges. As a general rule of thumb we don’t consider anything with an average daily volume of less than 500,000 shares. There are exceptions, of course, but generally speaking for orders of up to 1000 shares this has served us well. We modify this general rule for smaller and larger orders as we see fit.

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Risk and Reward:

We have all heard the saying “No pain no gain”. With a diversified investment vehicle like an ETF there is theoretically less risk than in an individual stock. The risk is spread out over the stocks that make up the ETF. Well, the inverse is also true. The reward is also spread out over the stocks that make up the ETF which has a tendency to “water down” both the profits and the losses. Take, for example, the NASDAQ 100 ETF the QQQ. The QQQ is made up of 100 NASDAQ stocks. Currently, the largest holding in the QQQ is Apple Inc (AAPL) at approximately 11.5%. Although Apple is just one of a hundred stocks, it is weighted at over 10%. In one three-week period AAPL stock moved higher by 29%. An investor in AAPL stock would be up 29% in just three weeks. An investor in the QQQ (that is invested

11.5% into Apple) through the ETF is also up, but he is up just 10.5% as the QQQ moved from $28.43 to $31.43. Although some see this as a negative, I do not. The diversification value of an ETF has been especially valuable in the face of many stocks that have simply vanished as a result of market meltdowns. Stocks like AIG that previously ranked in the top 5 holdings of the S&P 500 that are down 98% from where they were in May of 2008, have done far less damage to the owner of the SPY than to the owner of AIG stock itself. In extreme bear markets, having a diversified portfolio sometimes is the difference between surviving to trade another day and not.

Boring:

Although we do not consider this to be a disadvantage at all, we are surprised at the number of people we know that do. There are plenty of stock junkies in the business for “the rush”. These folks often enjoy the anticipation of earnings announcements, watching CNBC from market open to close, and the intrigue of an opening gap of a stock that missed earnings. Although this level of excitement can be “fun”, we don’t often find people that make money with it. To them, it’s a hobby. There’s nothing wrong with it as a hobby, but just don’t expect to make money.

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ETF TypesMost common ETF’s:

Now that you are aware of the characteristics of ETFs , we will start to introduce a few ETFs that are more common and useful as you get started with trading. The list below is in no way comprehensive, but it will provide a strong basis for getting started.

Index ETFs:

The growth of the volume of the most popular ETFs is a classic success story. When ETFs were introduced the investment community quickly realized the benefits outlined above and embraced these products. As of today, ETFs are usually the most active of all securities. The NASDAQ 100 ETF (QQQ) typically trades of 100 million shares EACH day. Let’s take a look at a few other popular index ETFs.

1. S&P 500 = SPY a. Short S&P - SH

2. NASDAQ 100 = QQQ a. Short QQQ - PSQ

3. S&P 400 Mid Cap = MDY a. Short Mid Cap 400 - MYY

4. Russell 2000 = IWM a. Short Russell - RWM

5. Dow Jones Industrial Average = DIA a. Short Dow - DOG

*Short ETFs will change in a way that is inversely correlated to the movement of the underlying index. A one day drop of 1% in the S&P 500 would approximate a 1% increase in the SH.

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Sector ETFs:

The S&P 500 consists of 500 of the largest companies that represent 9 various sectors of the US market. By investing in the SPY you would technically have ownership in all 500 stocks across all nine sectors. If in your analysis you’ve determined one or a few of these sectors presents a better opportunity for you, then you could utilize one of the ETFs below. The Sector ETFs will allow you to more strategically target these sectors with Bullish, Bearish and Neutral strategies.

1. Material - XLB 2. Energy – XLE 3. Financial - XLF 4. Industrial - XLI 5. Technology- XLK 6. Consumer Staples - XLP 7. Utilities - XLU 8. Healthcare - XLV 9. Discretionary - XLY

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International:

The borders of the United States do not limit opportunities in stocks. There are many thousands of terrific publicly traded companies across the planet. Utilizing international ETFs allows a trader and investor to tap into these markets just as easy as they would buy a domestic ETF. Although buying and selling an international ETF is just like a domestic ETF, it’s important to remember that the basket contains foreign stocks that are subject to political, social, economic, and natural forces that are often different that what a US based investor is accustomed to. Exchange rates will also have an effect on the value and volume tends to be light. Don’t let these dissuade you from considering these. It just means a little more diligence and education on your part. Below is a selection of various international ETFs for you to explore. These happen to be a product of Ishares but there are several others.

1. Canada - EWC 2. Hong Kong - EWH 3. S. Africa - EZA 4. Malaysia - EWM 5. India - EPI 6. Mexico - EWW 7. Brazil - EWZ 8. Japan - EWJ 9. Xinhua China 25 - FXI 10. Germany - EWG 11. France - EWQ 12. Italy - EWI

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Specialized:

Recently, a class of ETFs have emerged that is best categorized as “specialized”. In this category you will find everything from ETFs that seek to replicate the double inverse relationship of the NASDAQ 100, to ETFs correlated to commodities like Gold and Crude oil. Another reason we are placing these under “specialized” is that we believe these are best utilized by seasoned traders. Seasoned traders may fully understand the added risk associated with leveraged and/or inverse related ETF relationships and risk management of leveraged vehicles. The specialized ETFs will continue to grow in response to the ever-changing market. Option trading is a more tactical approach to utilizing leverage and bear market strategies. You will have plenty of time to build your skills in this direction. For the time being, enjoy these as a novel approach to market speculation.

1. Ultra QQQ - QLD* 2. Ultra-short QQQ - QID** 3. Ultra-Dow - DDM* 4. Ultra-short Dow - DXD** 5. Ultra-S&P - SSO* 6. Ultra-short S&P - SDS** 7. Ultra-Midcap - MVV* 8. Ultra-short Mid Cap - MZZ** 9. Ultra-Russell - UWM* 10. Ultra-short Russell - TWM** 11. Ultra-short Gold - GLL** 12. Ultra-short Crude - SCO**

*Ultra shares seek a return that is 200% the daily move of their underlying index/commodity.

**Ultra-Short shares seek daily investment results, before fees and expenses, that correspond to twice (200%) the inverse (opposite) of the daily performance of the underlying Index or commodity.

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Conclusion:

One of the elements of ETFs as an investment vehicle is that of trader accountability. One of our favorite market words of wisdom is “don’t mistake a bull market for brains”. In bull markets it seems everyone is making money and they attribute their profits to “being good stock pickers” or “having the Midas touch” and even having the “trading gene”. Contrary to what some might think, no one is born with the “gift” of trading. This becomes painfully evident when the bulls vanish and the bears appear. Being consistent and making money in a variety of market conditions will always come

down to a trader’s skill, not luck. Yes, luck will be a factor in your short term trading success but over time luck will play a minor role. Trading ETFs forces accountability because profits and losses are all on you. No CEO’s or analysts to blame, and no hot tips or news alerts to distract you. One of the primary objectives for us is to force the trader to rely less on his ears and start to rely on his eyes for trading. What a trader hears is noise, what he sees in the chart is reality. The chart is where money is made or lost. ETFs are one of the best ways to focus on your technical trading skills and block out the noise. Becoming a technical

trader can be liberating but it will take some time. Developing a solid foundation as a technical trader is the starting point. The next logical step will be option trading strategies. A large majority of ETFs have accompanying options. With options comes the ability to utilize leverage, profit in any market, generate income, hedge portfolios and speculate with less money at risk. It is our hope and goal that you will go on to apply what you have learned and reap the benefits of your commitment to improving your market skills. Congratulations on making the investment in your financial education.

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Intro to Options Why Options?At some time in every investor’s career he will be exposed to options and ask himself the question “Why Options?” To many, it would seem that starting down a path of trading options will bring with it increased risk, confusion, additional fees, complexity and account maintenance. After all, option trading is for the “big boys and girls” on Wall Street that manage billion dollar hedge funds or those crazies on the Chicago Board Options Exchange yelling at the top of their lungs and waving their hands around wildly transacting trades. In some ways, this is true, but the same reasons these professionals trade options are the same reasons you will trade options. Options serve three basic purposes for the retail investor and professional investor alike:

1. Risk Management 2. Income Generation 3. Speculation

Most investors would agree that all three of these are important to their own situation. With options, you dramatically increase the ability to manage risk, generate income, and speculate using smaller sums. Leverage is one of the defining characteristics of options. Leverage is simply the ability to do more with less. In the case of options, leverage means smaller accounts can control more stock, produce more income, or hedge more risk. Options strategies run the range from basic to complex. In this chapter, we will start with basic strategies of buying Calls and Puts. These one-legged directional strategies will form the basis of more advanced strategies involving multi-legged options. This quick introduction to options chapter is designed to start you off with the right information and basic terminology to help you better understand the options trading world.

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Option Myths and MisconceptionsOptions are surrounded by a number of misconceptions that are best categorized as “myths”. These myths come about because the population of investors that truly know how to trade options is relatively small and they prefer to use this knowledge to trade instead of break down misconceptions. Here’s just a few of the most common ones and the reality behind the myth:

Myth 1:

Trading options means you can lose more than what you have in your account including your home, car, and first born child!!!

Reality:

There is some truth in this myth. It is possible to lose more than the original investment and more using “naked” option strategies. Brokers limit naked strategies to their most sophisticated traders. There is simply never any reason to expose an account to unlimited risk, ever. Using a multi-leg option strategy will always define risk. Defined risk is a strategy in which there is a finite amount of money at risk and no more. This finite money is usually the cost of the option itself as in the case of buying an option. In trading there is a time to be aggressive but never a time to be reckless. Each strategy taught in this chapter has defined risk so the trader will know exactly what the maximum loss potential is prior to entering any option trade.

Myth 2:

Options and other derivatives are too complex for the average investor and designed for professionals.

Reality:

Options are derived from stock and index movements. “Derivatives” is a fancy term for options. The professionals like to use fancy terms to discuss options the same way some doctors like to call Aspirin acetylsalicylic acid. The simple fact is that options come with their own language. Once the trader learns the language, options themselves are not all that complex. The language is just another way to describe the three purposes of options, risk management, income generation and speculation.

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Myth 3:

I like to stay in control of my portfolio and trading options is all about giving up control.

Reality:

Trading options is not about giving up control. In fact the buyer of an option contract is actually increasing his control. A buyer of an option always has the RIGHT, the seller of the option always has an OBLIGATION. Each side of the equation has its advantages and disadvantages and an educated options trader is able to decide which strategy is right for him.

Myth 4:

The options market is the wild west of the stock market in that anything goes and the prices are all manipulated by the floor traders!

Reality:

In the past 15 years the options markets have undergone tremendous change. The vast majority of that change has greatly benefited the retail option trader. As a result of some of these changes, the options market is now a highly efficient, orderly and economically sound way to transact trades. In the strategies taught in this chapter I’ll take a vantage of the modern options market that looks very little like it did 20 years ago.

Myth 5:

Once you get into an option contract, you can’t get out of it or if you can, you’ll suffer a huge loss.

Reality:

Myth number five and myth number four go hand-in-hand. Back when the options market was open outcry (non-electronic) and retail traders’ orders were treated like second-class, the spreads (the difference between the buy price and the sell price) were much larger. A retail buyer might buy 10 contracts for $500 and find that as soon as he bought it, the contract was only worth $400. That spread would represent a 20% loss just to close out the contract. Now that many options have penny-wide spreads, that same contract bought for $500 could be sold for $499 or just 2% loss to close out the contract. The modern options market is highly efficient and retail orders now enjoy priority over most other orders, including institutional and other professional traders.

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Myth 6:

Options are only suitable for gamblers. I’m conservative so I stick with stocks where there’s far less risk!

Reality:

This is one of the most common myths. The assumption is that options are vehicle for engaging in risk. With an option, there are always two sides of the transaction. One side of every transaction is taking on risk, while the other side is transferring risk. A stock trader is always taking on risk. The more stock they own, the more risk they take. Since an option will allow the investor to take on or transfer risk, many of the strategies discussed in this chapter have a lower risk. When we say lower risk, we mean less money is at risk of being lost. Don’t mistake lower risk for probability of loss or profit. Both of these concepts will be explored more thoroughly later on in this chapter.

TerminologyLet’s get down to the basic components on options by exploring the language of options. The language of options is different than the language of stocks but there are parallels to bridge the gap. Most investors are already familiar with stock terminology prior to their first investment. The general public is exposed to stock language in everyday life, such as what they hear on the news, in popular movies, books and magazines, conversations amongst friends, around the dinner table, or at work. Options language is really no more difficult. It’s just new. Like any new language it will take a while to build fluency. Here are a few of the most common terms that make up the nuts and bolts of options.

Contract

Just as a share of stock is the smallest increment an investor can purchase, a contract is the smallest option increment. A standard option contract represents 100 shares. Therefore, any transaction in an option will be represented by a number of contracts. If the transaction is for 10 contracts then that transaction represents 1000 shares. Since a contract is quoted on a per share basis, the cost of any transaction must be multiplied by 100. For example, an option contract being quoted .47 on the Ask would cost $47 per contract, an option being quoted at the bid price of .45 could be sold for $45. The spread is the difference between the bid and ask. In this example the quote spread is .02. Two cents on a contract represents two dollars. Based on this quote at this point in time, a buyer would pay $47 per contract, it would then show up in his account as worth $45 due to the two penny wide spread or $2 per contract.

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Call

As discussed above, options are contracts. Every contract has definable characteristics. Within the contract, the rights and obligations are defined. This includes the price (strike/exercise price), time frame (expiration month), and deliverables (number of shares, cash, etc.). In the case of a call option, the buyer of 1 call has the right to buy 100 shares of a specific stock or ETF at a defined price forward to the final amount of time specified in the contract. For this right, the buyer of the contract will pay an amount called the premium to the seller.

The seller of the call has an obligation to deliver/sell 100 shares of a specific stock or ETF at a defined price for defined amount of time as specified in the contract. The

price that is specified in the contract is called the strike price or just “strike”. The seller of the call option will receive the premium into his account. The premium is payment for his obligation and he can now use the money as he sees fit.

Put

A put contract is in many ways the exact opposite of a call option except that the buyer of the put still has rights and the seller of the put still has obligations. The buyer of 1 put contract has the right to sell 100 shares of a specific stock at the strike price for the life of the contract. For this right he pays a premium to the seller. The seller is obligated to buy 100 shares of the “underlying”, at the strike price for the life of the contract.

Strike Price

The strike price or strike, is the price that is specified in the contract. It is often referred to as the exercise price as well. When selecting a strike price of an option to buy or sell, it is done from the table called an “option chain”.

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Option ApprovalBrokerage houses are in the business of providing investors and traders access to the various capital markets. They make money from many sources including commissions, margin interest, market making, payment for order flow, management fees, inactivity fees, transfer fees etc. They don’t make any money if a client destroys his account through poor trade decisions including options. Since the options market is more complex than other markets and historically most uneducated traders lose money trading options, the brokerage houses require additional information, documentation and approvals prior to permitting option trading in an account.

Most brokers use a system of option approvals, often from 1 to 4, to define which strategies the account holder may employ. Typically the lowest level allows covering call writing. As the levels increase so does the complexity, risk or both. An individual that wishes to trade options should contact his broker and inquire about the options approval process.

The investor should understand the levels in which they will be permitted or not permitted to use various strategies across all their accounts that they wish to trade options in. Option approval can take several weeks as only certain individuals within a brokerage are permitted to approve option eligibility on behalf of the firm. This time can be used to review strategy and mock trade using your new skills.

Practice, Practice, Practice!

An important step in developing your skills and preparing yourself to be a successful option trader is “mock trading”. Although you may be excited to put your new skills and strategies to the test with real money and real trades, it’s best that you slow down and ensure you have a handle on the details. A practice account is the next best step. There should be no discernible user difference in your mock trading and your real life trading, so practice as often as you can until you have a good understanding of options trading. Options are suitable for all investors willing to commit to the time and energy to learn how to use options to manage risk, generate income, and even occasionally speculate.

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This document has been brought to you in partnership with Scotia iTRADE. All thoughts and opinions are of Pro Market Advisors and do not necessarily reflect the views of Scotia iTRADE. All research, analysis, charting, reports, estimates, commentary, information, strategies, data, opinions and news (collectively, the “Research”) are provided to you for general informational purposes only and do not address the circumstances of any particular investor. All Research has been prepared and supplied by independent third parties that are not affiliated with Scotia Capital Inc. or any of its affiliates, and accordingly may not have been, and no representation is made that such Research has been, prepared in accordance with Canadian disclosure requirements. Neither the Research nor the profiles of the third party research providers have been endorsed or approved by Scotia Capital Inc., and Scotia Capital Inc. is not responsible for the content thereof or for any third party products or services. Nothing in the Research constitutes a recommendation by Scotia Capital Inc. to buy, sell or hold any security discussed therein and does not constitute an endorsement of any of the information contained therein. The Research neither is, nor should be construed, as an offer, or a solicitation of an offer, to buy or sell securities by Scotia Capital Inc. Scotia Capital Inc. does not make any determination of your general investment needs and objectives, or provide advice or recommendations regarding the purchase or sale of any security, financial, legal, tax or accounting advice, or advice regarding the suitability or profitability of any particular investment or investment strategy. You will not solicit any such advice from Scotia iTRADE and in making investment decisions, you will consult with and rely upon your own advisors and not Scotia iTRADE. You are fully responsible for any investment decisions that you make and any profits or losses that may result. Any opinions, views, advice or other content provided by a third party are solely those of such third party, and Scotia Capital Inc. neither endorses nor accepts any liability in respect thereof. No endorsement or approval by Scotia Capital Inc. or any of its affiliates is expressed or implied in connection with this book, any third party product, service, website or information is expressed or by any information, material or content contained in, available through, included with, linked to or referred to in the Research, or in any Scotia iTRADE communication. Neither Scotia Capital Inc. nor its affiliates accept any liability for any investment loss arising from any use or reliance of the Research or its contents.Options involve risk, are not suitable for all investors and are intended for sophisticated investors.Copyright © 2016 by Richard H. Swope and W. Shawn Howell. All rights reserved.Scotia iTRADE® (Order-Execution Only Accounts) is a division of Scotia Capital Inc. (“SCI”). SCI is a member of the Investment Industry Regulatory Organization of Canada and the Canadian Investor Protection Fund. Scotia iTRADE does not provide investment advice or recommendations and investors are responsible for their own investment decisions. ®Registered trademark of The Bank of Nova Scotia, used under license.”

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