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February 2, 2006

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My Biggest Trading Secret

Name: Ryan Jones



Learn More About Today's Author
Years Trading: 19

Favorite Movie: Gladiator

My Biggest Trading Secret

The 1990ís saw a major shift in how individuals traded the markets. I remember getting weekly paper charts in the late 80ís, early 90ís and filling in each dayís market action until the new charts came in the mail. The 90ís saw a boom in trading tools created for the computerÖand everything was suppose to change.

What actually happened was a lateral shift. Before the computer, a great deal more than just the majority lost money trading. The computer was supposed to equalize the playing field, allow traders to back test systems and give us an edge for becoming successful. That didnít happen. The shift to technology did not shift the success rate.

So what gives? Do you really have an increased probability of success because of technology? Iím going to stick my neck out on this one and say no, you donít. I realize, I have some of the most convincing numbers to back my statement up, but people are going to disagree. And that is fine. But I think that after this article, you will agree that the difference between success and failure can be attributed to some much more obvious problems that face traders than technology.

Pick up any magazine, read any article, look at most trading ads and a solid number more than the majority, if not every single one of them, will focus on one thing. Can you guess what that is?

Profits, and lots of them. And, why do they focus on profits? Because it is proven that it is what you will respond to. We are all intrigued by how we can obtain profits, and for most, any profit will do. But the bigger the potential profits are, the more we are intrigued. Now, granted, you and I are in this for exactly that, profits. Iím not trading for my health, that is for sure. We want to be smart and make our money work for us instead of us work for our money. There is nothing wrong with that. Both take work, but one has a far greater potential return.

The problem is that when you and I focus on profits and profits alone, we are ignoring probably the biggest thing that will keep us from achieving profitsÖrisks. Oh, we address risks because we realize our limited account size, but that is about all we do. We focus on the profits and the risk is just one of those things we have to at least acknowledge out of necessity.

Do you want to know what my biggest secret in trading is? I focus first on the risks. That’s it. That is my secret. Want to know how this works? Let me explain by giving you an example of a trade I recently provided to my Truth About Trading subscribers. (by the way, the Truth About Trading is a COMPLIMENTARY daily email covering all sorts of different topics in trading. You can subscribe by going to http://www.smarttrading.com/MPPInfo.asp).

On January 12 th, 2006, I sent out an email letting my subscribers know about an opportunity that existed in OJ. I gave the order, it was hit the following day. Just 3-trading days later, the profit target was hit and 120% profit was achieved on the trade. Intrigued? Why? I’ll tell you why, because I told you about the profit on the trade, and nothing more.

But do you really want to know why this trade was profitable? Because in creating the trade, I addressed all of the what ifs of being WRONG. In fact, had I not addressed the what ifs of being wrong, it is likely I would have presented a different way of trading this opportunity and the trade would have probably been a loser.

Here is the trade opportunity I presented:

Buy May OJ 115.00 put options for 1.70 or better.
Exit at 3.75 or better.

IMPORTANT NOTE – This was presented on January 12 th to a different group, this is not necessarily a valid opportunity at the time of this writing (or reading).

There are several aspects to this trade, all were focused first on the potential risks, not the potential profit. Here are the questions associated with this trade and opportunity:

Why OJ?
Why Buy options?
Why buy puts and not calls?
Why go out to May?
Why use the 115.00 strike?
Why buy for 1.70 or better?
Why exit at 3.75 or better?

With every single question, the answer is focused on the risks associated not just with the market and direction of the market, but on options as an instrument as well. And that is what I want to focus on with this example. If you would like to see why I chose OJ and why I had calculated a probability of OJ moving to the downside at the time, you can go to the following link and take a look at the video explaining the trade.

http://www.smarttrading.com/MPPInfo.asp

In the meantime, suffice it to say that I determined that based on the pattern that was setting up in the OJ market, a quick move down to about the 105.00 area was a solid opportunity. This is not why we chose the OJ market though. There are many patterns in many markets that setup all the time. For example, there was a similar setup around the same time for heating oil to move higher by about 30 cents, but the risks that were associated with the underlying options in this market were simply too great. Understand, it is not all about the market, or for that matter, market direction.

Nonetheless, the first focus in this particular trade was not the fact that OJ looked like a great selling opportunity, but because the options were relatively cheap compared to the average volatility of this market. I have a specific formula for determining whether the options are a good buy or not and had the options not been undervalued, it didn’t matter how good the pattern looked.

This is almost completely opposite of more common approaches to trading. If most would have looked at this pattern and saw the potential down move in OJ, they would get in at all costs. Why? Because the focus for most is the profit potential, not the risks involved.

As it turns out, both puts and calls were undervalued at the time. I could have gone either direction if I would have based my decision on the options alone. So I don’t want you to think I ignore the direction altogether, or the profit potential altogether. I want you to understand that I simply focus on risks first, and then move forward from there. If the risks are too great, I don’t move forward, I look for the next opportunity.

Why options? Well, beside the fact that they were undervalued in this market, I want you to consider what I call “staying power”. Again, focus on the risks. One thing that traders need to know about technical analysis, patterns and price action is that it is far more GENERAL than most think. Traders are constantly trying to force price action into this little box of preconceived limits of what it can and cannot do. This is a major no no.

The pattern I was looking at, based on my experience, pointed to the probability of the market moving down relatively quickly. But knowing that price action is general, had I sold a futures contract, I obviously would have had to put a protective stop order in place to address the risk to the upside. But where? How much would I be risking? What if the market moved higher, stopped me out and then moved lower? Ever had that happen to you before? If it did, then I would be faced with making a decision of whether to re-enter and place another protective stop on the second entry. But what if the market moved higher after the second entry too and handed me my second loss?

Yes, there is a more immediate and bigger profit potential if the pattern works out perfectly, but “what if”. I focus first on the risks.

To the credit of many traders, on some decisions, the risk is the main focus. Many may take a look at the situation and conclude that buying an option is a better choice based on the defined risks associated with options. But then, they move away from this focus when picking the option. Again, many may pick options regardless of how expensive they are based on the fact that they see the profit potential of the underlying market moving. If the options are expensive compared to the average volatility of the market, I will pass on the entire opportunity altogether or look for better ways to take advantage of it.

Nonetheless, buying a put option in this situation would allow me to have the staying power if the market moved in the opposite direction by several points relatively quickly. I would not be stopped out and if the market came back down, I would still have the profit potential. But what if the market took some time to move down. Instead of moving down relatively quickly, it waited 6-weeks.

The most common approach for option buyers is to buy options with less than 6-weeks until expiration. The pattern I was looking at is normally associated with the market moving within one to two weeks after the pattern is completed. So why wouldn’t a 6-week option work in this situation. I’m not saying it wouldn’t. But what if the market took longer than 6-weeks to move? The option would expire, most likely worthless, and you would have a decision to make. Or, the market might move higher first, then start to move down. If it moves higher for a week or two, not only does it have further to move down, but it also has less time to make a bigger move to the downside.

Let me explain something about options…but it will have to wait until Part II of My Biggest Trading Secret. In Part II, I will explain a couple of very important facts every trader needs to know about how options work in the context of addressing risks first. I will also finish up the information about this OJ trade I provided, as well as give a few more examples of how focusing on risks first can literally change the way you trade.

If you would like to view My Biggest Trading Secret, Part II, you can go to http://www.smarttrading.com/MPPInfo.aspand it will be sent to you via email.

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