A Psychological Index of Stock Market

A Little Secret

The psychological power in the stock market is bigger than we think. Any action in the stock market has to go though peoples’ mind one way or another. If most people believe a stock will go up, then it probably will. If you know other people’s thought, your chance to win will be enlarged.

The option trader is more experienced then regular stock trader in general. Their judgment of a stock’s future movement would be a good reference. The question is --- How can we get such information?

The easiest way is to check the call/put ratio. For a particular stock, if its volume of call is significant higher then the volume of put at the same expiration date, you can know that a numbers of people think the stock will go up; otherwise go down.

You could watch the number change of the open instruction and the volume change of both call and put option for a few days. If you recorded the changing numbers, you can sense the change of expectations. The dynamic changed information can draw a clear line about the market speculation. It is reliable and helpful.

The option price supposed to be in synch with its stock price change. If you see an abnormal situation without a reasoning explanation, then it is a very useful hind. For example, if the stock is down a little, but its call option is stable or little bit up, then you can assume it is a positive sigh for that stock.

In many cases, not always, the option market acts earlier than its stock market. If you can trace the changes, you can catch the pause of the stock market.

Please note:
1. This theory would work for stocks that have bigger option market. Please do not apply it to any stock that has limited option available.
2. Some hedge funds are using the option to hedge their stock investment. There is a possibility that a large volume of option indicates an opposite direction.

The Gift from Chinese President --- TEX and FLEX

TEX (Terex Corp.) and FLEX (Flextronics International Ltd.)

The Chinese President will visit US and sign some contracts with US companies soon. Among the top companies, TEX will get a 150 million contract and FLEX will get a 1 billion one.

Even though the impact of the contract won’t show immediately on those companies’ balance sheets, the big promises can still attract some attention to them right now.

TEX is heavily accumulated by institutions. It has good fundamentals. It is a good choice for conservative investors. Its closing price is $82.94. Its support is at $80.

To any company, 1 billion is not a small number. This number will make FLEX’s fundamentals looks better sooner or later. The market will welcome this change. An analyst said its current quarter earning will be better than expected for another reason. If it is true, the two good news will move the stock up. Its earning date is 4/27/06. It is good one for short and mid term investor. Its closing price is $10.78. Its support is $10.

My suggestion:
TEX: Buy (7)
FLEX: Buy (7)

Check the Earning and Bet on the Potential

The Best Time for Option Players

The earning season has come! It is a good opportunity for option traders. An option trader should not miss this big game.

Here is our strategy:

1. Check the incoming Earning Calendar for stocks that you know or you believe would be hot at the earning.
2. Study those stocks and see whether it can release a better then expected earning.
3. Watch the stock for a while and see if there is any positive sign for a possible up.
4. Buy some call options in the nearest expiration date 2 or 3 days before the earning announcement
5. Sell a portion of your calls when the option price up before the announcement. (optional)
6. Wait the earning announcement.
7. After the announcement, sell all your options.

You should separate your investment into pieces. For each stock, you only invest one piece.

In general, a good earning will move the stock price up a few percents. To option player, it means over 100% margin. In case you were wrong, if you sell your call quickly, you should limit your lost to 50%. Suppose you got a 50:50 chance, you would gain at the first for 100% and lost the second at 50%, when you invest in even, you should have a 25% margin for all. If your judgment is all correct, you will get a much better return in less a week.

For the whole earning season, you can play it several rounds. You can imagine how much will be your return!

Wish you all good luck!

Option Basics --- Option Price

What determine the price of an option?

Like buy anything else, you need to know whether the current price of an option is fair or not. The factors to determine a stock option’s price are:

1. The price of the underlying stock and the strike price
It is the most important factor. When the stock price goes up, calls should gain in value and puts should decrease. Put options should increase in value and calls should drop as the stock price falls.

The price of an option is determined by the difference between the option strike price and the current stock price. The bigger the difference is, the cheaper the option is (at the same expiration date).

For example, if the current price of stock ABC is $10 and you want to buy a call expire in 3 month, the price of the option at strike price $15 would be less expensive than the one at $12.5. If you want to buy a put, the price of $5 would be cheaper then the one at $7.5.

2 .Time and the expiration date
The option's future expiry, at which time it may become worthless, is key factor of every option strategy. Ultimately, time can determine whether your option trading decisions are profitable. To make money in options over the long term, you need to understand the impact of time on stock and option positions.

With stocks, time is a trader's ally as the stocks of quality companies tend to rise over long periods of time. But time is the enemy of the options buyer. If days pass without any significant change in the stock price, there is a decline in the value of the option. Also, the value of an option declines more rapidly as the option approaches the expiration day.

An important concept in option trading is the time value. The option buyer is actually buying time. A longer expiration date is always means higher option price.

3. Volatility
Volatility is considered into the option price. If a stock is volatile, its option price will be higher.

There are some option pricing models available. They require you to put in what the future volatility of the stock will be during the life of the option. Naturally, option buyers don't know what that will be, so they have to try to guess. A common way to make the guess is to check the stock’s history.

4. Supply and demand
The market controls the price. If there are more buyers than the sellers, then the price will go up; otherwise the price will go down.

The option market is very small market. For some unpopular stock, the number of available open contract is very limited. The demand or the supply will drive the market dynamically.

An option trader has to consider this factor. Sometimes, the option trading is not a choice simply because its market size is too small. A big buy or sell might heavily impact the price and reduce the trader’s profit.

5. Interest rate and dividend of the underlying stock
The two impact the option price also. If you use an option price formula, you have to provide such information. For regular people, we might not care them much.

Option is different from stocks. Learning how to use options properly requires a little effort; however, once you knew it, you'll quickly find that options give you more flexibility to tailor the risk and provide you bigger potential of reward.

If You Were Interested

Question and Answers

I have received some excellent and interesting questions from readers regarding the article “What a Wonderful World”. Instead of reply them individually; I would like share those questions and answers with everyone.

Q: “I don’t agree with you. What you described is some kind of coincidence. Even you said in your article ‘Once in a blue moon’”.
A: I would like to explain it from two angles:
1. There are some well known and well accepted relation between the weather and stock market. Because they are well reasoned, people treat them just like any other common knowledge without question.
For example, a cold winter will increase the demands of heating oil and increase the oil or gas price; then the oil price will impact the stock market very much…
And we all know a serious hurricane or winter storm would badly change our economy, and the stock market underneath…
From the above examples, we can clearly draw a line between the weather and stock market. They are strongly related and not a “coincidence”.
2. A coincidence cannot have the two characters: repeatable and predictable. In our case, we have the two. Therefore, what I described is not a “coincidence”.

Q: Does NASDAQ follow the same rules?
A: Yes, the similar rule can apply to NASDAQ also.
If you using the Closing number of NASDAQ and divided by the daily high temperature, you will get another sequence nicely. They are “41, 45, 49, 43, and 39”. It is 2 up of the sequence that we got from Dow.

Q: Why did you use daily High temperature, but not the low or both?
A: Usually the low temperature is at about 5:00 AM; the high temperature is at about 3:00 PM. Because we are using the summer time, the high temperature is at 4:00 PM New York time which is our market closing time. Therefore, I am trying to use the two data at almost the same time to ensure a more accurate result.

Q: “If the 5 is for spring, what is for summer?”
A: In fact, there are two factors for spring: 5 and 4; two for the summer: 3 and 8; two for the fall: 2 and 1; one for the winter: 6.
If you have time, you could try it yourself. I think there will be some funs.

Q: Can I use your formula to predict the market? How reliable it is?
A: Please don’t. There are a lot of factors to consider. If you try to use one factor to cover all, you just went too far.
You can definitely discover some interesting fact by summarizes the past data during certain time frame. But I am not sure how confident you will be to predict the future, unless you want to gamble.

Thank you for your support!

Weekly Review (4/3/06 - 4/7/06)

Wait for News

When the market stopped dancing with the weather on Friday, its weak balance was crushed by the selling power.

On Friday morning, the NASDAQ had a years’ new high at 2375.45. (It tried to reach that 53. Ha-ha!) It did not stay there for too long, and then slipped down almost 40 from the top to the bottom.

Even though it was caused by news, but I rather translate it in this way: There are someone believes the market has potential to growth; there are someone else are anxious about the current market position and are afraid the market going down. The first group is the potential buyer; the second is the potential seller. From Friday’s result, we know the second group is more powerful then the first one.

The situation is always changing dynamically. When the market is down too much, someone in the second group would think to buy something for cheap, and then join the first group. When the market is up a lot, someone in the first group would like to take profit and leave, then join the second group. Besides, any group will stop or slow down its action if the opposite seems too strong. For example, if the potential buyer sees the market is going down, he probably will stop buying and wait for a lower price.

The market is driven by the two dynamic groups. If the first group, the buyer, stronger, then the market will go up; else, it will going down.

Because of Friday’s down, the buying power stronger and the selling power weaker then before, but the buying power is not strong enough to advance the market! The current balance level is just at 11195 (Dow). Apparently, for next week, the market needs some external force to lead its direction.

If the weather is good, --- woops! I am sorry, a typo! --- If there is good news, the market will move up. If it is up too much, it will be pushed down again. If there is bad news, then another way around. The both parties are waiting for news, to give them a reason, to go forward.

The most possible scenario for next week is: Up in Monday and Tuesday; down in Wednesday. How will be Thursday? Not sure.

Our strategy of this week is still the same: Don’t run after the up, but buy at the low.

*****

The Friday’s down is a good examiner for a stock. Please review your holdings.

If a stock was strong on Friday, you should see an up, or a jump, during this week.

If a stock was down more than the market percentage wise, you should double check its reason. If you cannot find a good explanation, you should reduce your position when the market back. If that stock is sensitive (when market up, it up more; when market down, it down more) to the market, you should sell it first when the market up, or use it as a market index.

If a stock was down about the same as the market, you don’t need to pay attention to it.

If a stock was down at the beginning and keep flat in the afternoon, probably it got some support at that price level. You should consider buy a little.

Today I don’t have much to say about the suggestion list:
1. SUNW.
You need increase your holding. I feel the next up is on the way.

2. CSCO
A sector bad news made it very disappointed for this week. I think it will back to $21 this week. Its chart does not look good. You should pay attention on it this week.

If you are a short term player, there are opportunities in the coming week; if you are a mid or long term investor, I suggest you hold your stocks and enjoy the spring.

I am still optimistic about the market.

Invest on the Natural Resource, Invest on the Biggest Market --- ACH

ACH (Aluminum Corp. of China Ltd.)

ACH engages in the production and sale of alumina, primary aluminum, and ancillary products primarily in China and internationally. Its closing price is $107.99 as of 4/7/06.

It is a good choice for both long term and short term investment. This is a low risky investment. It is the one that moves slow and stable.

My suggestion: Buy (8)
Instruction:
1. It seems have a resistant at $110 and support at $105 and $100. You should buy at lower. Once it crossed $110 firmly, you should buy more.

2. On 4/10 5:00 PM, The AA (Alcoa) will release its earning announcement. I guess its earning would be a good one. It will impact this sector. If you play short, it is a good chance.

3. Its fundamental is very good. If you are a long term investor, you should hold it longer. Whenever there is a market down, you should increase your holding.

4. For short term player: it has not had a big adjustment yet since Nov, 2005. When you see a negative sign, you should get out.