Harvard Financial Analysts Club (HFAC)
By Connor Haley

Regis Corporation (RGS) owns, operates and franchises low-end hair care salons and hair restoration centers around the world, including well-known brands such as Supercuts, MasterCuts and Magicuts, with a market capitalization of roughly $1 billion. Their core business is resilient in even the most difficult of business climates (hair needs cutting no matter how the economy is doing), which has allowed the company to produce decent results despite poor management. A recent power play by activist investing firm Starboard Value, however, has the potential to unlock the value in this stable, low risk business by cutting excessive costs, making Regis an attractive investment opportunity for value investors.

To begin, the stock is cheap at current valuations even before potential catalysts are considered. It trades at an enterprise value of less than 6 times EBITDA, all while yielding 1.5%, and produces substantial free cash flow yields, averaging over 15% of the current market cap over the past five years. The free cash flows are primarily a result of the cash flow friendly industry model, with low capital requirements and few shifts that require large capital expenditures. A likely reason for these attractive valuation levels is the company’s poor management history, with billions of capital expenditures yielding paltry returns for shareholders (ROE for the ttm is negative and ROA is a miniscule 3.68%), a suspicious history of related party transactions and egregious management salaries despite chronic underperformance.

For example, the former CEO, Paul Finkelstein, earned $15 million in compensation from 2008-10 despite a 30% share price decline, and has a beyond-generous retirement plan entitling him to $800,000 per year for life, despite delivering negative same store sales growth during his tenure. In addition, the company maintains multiple regional management teams for its brands despite the similarities between their business models, presenting an easy avenue to lowering costs that has somehow not been taken.

These management faults were an impetus for the involvement of Starboard Value LP, a New York based investment advisor that specializes in unlocking the value in deeply undervalued and poorly managed small cap companies. This past fall, Starboard sought and received three positions on Regis’ eight member board, vowing to force cost-cuts and sell of non-core assets (the hair restoration centers, to be precise). Since then, they appear to be successfully changing the company’s trajectory.

Randy Pearce, a veteran Regis executive seen my many investors as too much of an insider to enact the needed change, has announced his retirement instead of becoming the CEO as previously planned. Regis also recently cut staff, including 110 workers at its corporate headquarters. These are encouraging signs that Starboard’s investment and advice are having positive impacts on Regis’ operations, and we expect their influence to remain strong for the foreseeable future.

To measure the potential increase in shareholder value should Starboard be successful, it is useful to consider Regis’ operating margins, which have plunged to 2.5% ttm from 7.1% in 2007, largely due to 3.3% increase in SG&A expenses relative to revenue. Returning SG&A to historical levels as Starboard has vowed to do would result in annual cost savings of almost $80 million, raising Regis’ expected EBITDA to roughly $250 million. A 6-8X EBITDA multiples, the company would be valued at $32-$43 per share, leaving RGS grossly undervalued at its current share price of $17.62.

We believe the cost cuts proposed by Starboard will be enacted, and that other changes spurred by their activism, including the divestment of non-core businesses, will be beneficial to shareholders. As the company exits its current state of transition, we expect margins to improve to historical levels and the share price to reflect the positive changes wrought by Starboard’s shareholder-friendly influence, thus we recommend buying RGS at current prices with a target price of $25/share.

Disclosure: I am long RGS.

Position management involves the decisions you make after you enter a trade. The main
question is: When to sell? On the surface it sounds simple, but anyone with trading experience
knows it can be a very difficult question. You need a plan to follow before the heat of the
moment arrives.

Once you are in a trade, only one of three outcomes can be the result:

1. Sell for a profit
2. Sell for a loss
3. The trade just sits there

A major theme for trading is that we always want to have two potential spots to exit in place: the
profit target and the stop. No matter what your strategy is, you should have an idea what your
risk is compared to the reward you are attempting to capture. Except for scalpers, traders want
the biggest possible reward possible for the risk they take. The very least the ratio should be
is 2:1 / reward-to-risk, but I want 10:1 if I can get it. This very often forces me to improve my
entry points until it meets good risk-to-reward parameters or not place the trade at all.

As traders, of course we always want option #1 – to make money. The real issue here is how to
maximize the profit. The answer depends on your trading strategy. In many ways, managing a
successful trade is the hardest because inevitably traders hold on too long or not long enough.

The answer is easy for Scalpers, who seek income by taking a quick profit with tight risk
parameters. They are more likely to place lots of trades with the risk being about the same or a
little less than the potential reward. They aren’t holding trades for long anyway, so entry points
with an edge tend to be a more important issue for them and to have as low commissions as
possible. To be profitable, scalpers generally have to have a much higher percentage of winners
vs. losers in order to profit if they are risking about the same as the reward. Managing the
position is mostly a mute point – they either get stopped out or hit the target and quickly exit.

Intra-day trend followers are trying to ride the trend as far as possible before it reverses in order
to maximize profits. They should not try to guess where the top is and sell. True trend followers
should let the market tell them when the trend is over in order to catch as much of the trend as
possible. They should not play the position so tightly with a trailing stop or they could see a
profit of 20 ticks when they could have made 50 or 100.

The other option is to sell when the profit target is hit, which can still be a profitable strategy;
you will miss the big moves at times but other times you will hold on to your profits before the
market reverses on you.

As an intra-day trend follower, after entering the trade I already know where my stop and target
are. If the position goes some distance toward my target, I won’t take a loss and will move my
stop up to break-even. Once the position goes a significant distance in my direction, I won’t give

back more than 50% of my profit. After working hard to gain a profit, I just hate giving it all
back. I would rather lock in my profits and decide later if I want to re-enter a trade.

Option #2, selling for a loss, is a necessary evil that comes with trading. As long as your reward-
to-risk ratio is properly in place, a trader can have an equal number of winners and losers and
still profit. The stop should give “wiggle room” for the position to move before heading in the
right direction. How much that room should be depends on the volatility of the security you
trade. This is where knowing how your security moves based on studying charts proves helpful.
Don’t rationalize, don’t feel bad – just take the loss and move on to the next trade.

As a day trader, I don’t mind option #3 although it bores me to death when my position just sits
there. As long as it does not move against me, I will stay in the position with stops in place, or
get out before the close, and look for other markets to trade that are moving. For longer-term
traders, don’t let your position waste too much of your time when you can be making money
with something else.

One of the best things a trader can do to improve is to know his/her tendencies, to analyze them,
and decide what actions will receive the best outcomes for his/her trading style.

Many Profitable Returns,

Trader Gregg

Team Trading for Intra-Day Traders                                               

By Fred Decker

All traders are looking for an edge to help them be consistently profitable in the markets. With so much information available for the trader to process and act upon and so many trading ideas and hypotheses racing through the trader’s mind each moment of the trading day it’s easy to be overwhelmed. Which trading ideas are the right ones? Have you ever told yourself, “I knew the market was going to go higher, why was I short?” or, “I knew I should have stopped trading.  I wasn’t seeing the market well. Why did I continue to trade?” If you’re like me you’ve asked yourself these questions and others like them many times.

These thoughts can be the enemy of the trader—undermining confidence and starting the snowball of negative self talk rolling down hill. Soon the questions can become, “What made me think I could ever do this?” From there thoughts can naturally turn to giving up on the trading opportunity.

What traders need is a way to prioritize their thoughts while they are trading, find a source of encouragement and support, and a better way to analyze and hold themselves accountable for their actions. They need a trading teammate.

Prioritize Trading Thoughts

Thoughts race through the trader’s mind faster than he can verbalize them. Some thoughts are probable and others are only possible. For a passing moment an idea can seem so compelling it requires immediate action. The trader clicks the mouse. Then—too late—realizes he has made a mistake.

The trader can’t talk as fast as he can think. Describing thoughts to a teammate requires the mind to filter out the less likely ideas and only focus on thoughts which seem more probable. The trader reexamines his thoughts as he speaks them. The trader thinks, “Does this idea still make sense when I hear myself explain it?” “Does this idea fit with my purpose and what I am trying to accomplish in the markets?” The teammate can react, agree or disagree, and the trader can check himself. If the idea is a good one, the challenge won’t hurt. The trader’s actions become more deliberate by working with a teammate. He has a chance to prioritize his market ideas and get a better feel for his own identity in the markets.

Finding A Source Of Encouragement And Support

No one can fully understand the obstacles and challenges of trading as well as someone who is fighting the same battle. Have you ever thought your mistakes must be unique, because no one else could be stupid enough—or stubborn enough—or crazy enough to keep making the same error again and again?  Guess what? Almost every mistake you have ever made has been made many times by others. You are not alone after all.

Working with a teammate fosters camaraderie and places the trader’s mistakes into a context of shared experience. Whatever the specific mistake may be the teammate is likely to respond, “Oh yeah, I’ve done that too.” The shared experience can even become a joke—not in a way which belittles the mistake, but in a positive way that understands that we all make mistakes and have to work hard to correct them. Even if the teammate is only a person to vent frustration to, having an outlet allows the trader to avoid bringing trading problems home to his family.

There is something inherent to the task of trading which lends itself to talking with a trading teammate and working out the thoughts and feelings of the day. Without an outlet for examining these thoughts and feelings the trader is left feeling isolated and vulnerable to negative thoughts.

Analyzing Mistakes And Holding Traders Accountable For Fixing Them

There is an education in every market the trader sees and every trade the trader makes. Working with a teammate naturally allows the trader to make the most of this education; by reviewing performance, developing strategies for improvement and being accountable for planned changes.

A formal approach isn’t needed—only regular conversations with the teammate. The conversations will tend to cover the most appropriate topics automatically. The trader will be accountable to the teammate for carrying out the strategies discussed—not in a disapproving “did you eat your vegetables?” way—but in knowing he will talk to the teammate and describe his trading day. The trader won’t want to tell the teammate that the same mistakes were repeated. The teammate will recognize the small victories when the trader implements his planned strategy and avoids the mistake. Once again positive momentum is built and progress is encouraged.

Conclusion

Each trading teammate relationship will be different depending on the individuals involved. I am fortunate to have several teammates I talk to regularly, and I am open to talking to anyone about markets if I have the time. If a trader is inexperienced this should not be a deterrent from seeking out a trading teammate relationship. The willingness to help others is more important in my opinion. Remember, no one is asking for charity. Each trader is offering mutual help.

Any contact with other traders could be a potential resource for finding a trading teammate. I offer to exchange phone numbers and ask if the potential teammate wants to talk about markets sometime.

I think working with a teammate could help all traders. I hope you will try it. You might be surprised by how much you enjoy the experience and how much your trading will improve.

Trading by the Rules
By Dan Giovannetti

Most of the things we do and encounter in life often come with a set of rules, laws, instructions or guidelines we must follow. Whether you’re driving a car, playing baseball, assembling a bicycle or even working a corporate job, your actions are limited by the rules, laws or other guidelines imposed by a higher authority for the purpose of order, safety, efficiency or any other number of reasons. However, when it comes to trading, there are almost no rules to follow when putting on a trade (other than qualifying for an account, any margin requirements and any applicable laws.) What I mean to say is that as long as you have the capital, you can trade almost anything, at anytime. The market provides every trader with endless possibilities and unlimited opportunity.

Now, even though trading comes with almost no rules, that doesn’t mean you shouldn’t follow a set of rules in order to be successful. I believe the phrase “Those that fail to plan… plan to fail” applies to everything in life, and trading is definitely no exception. Think about it for a minute. I recently bought my eight year old son a very complicated 600 piece Lego© kit that resembled a semi‐truck when properly assembled. The instruction manual was more than 40 pages long. If the kit did not come with instructions, what do you think the chances are that my son or I could assemble the kit exactly as the manufacturer intended? The answer is slim to none. The same could be said about almost anything out there. Therefore, I believe a trader will only become successful when they follow a set of common sense rules.

Here are some of my rules that I believe are crucial to becoming a successful trader:

• Devise a trading plan and follow it. I believe the best trading strategy is the one you’ve been able to review, back test and fits your trading style and risk tolerance. It is important that you know all vitals of the trade (the entries, possible exit targets, and where your stops may be prior to placing your trade orders.) By having a concrete plan, you assist in removing the emotion out of the equation.
• Use good money management principles. Don’t over leverage your account. I trade futures and Forex and even though the margin on the ES S&P Emini is only $500 per contract with the broker I use, there is no way I would ever max out my position to that level. I like to trade one contract for every $5,000.00 in capital I have in my account. That way, one bad trade will not blow out my account.
• Make sure your risk to reward ratio is solid. If you find you are risking 20 ticks to make 6, you are destined to fail. I believe that your R/R ratio should be between 1:2 and 1:3.
• Stick with the trend! There’s a reason why the cliché “The trend is your friend” exists. It’s because it’s true! Successful traders will always tend to follow the trend when trading. Remember, if you trade with the trend, you have the majority of the market on your side.
• Control your emotions. This by far is the hardest thing for any trader to do. After all, it has been said that emotional control is 90‐95% of trading and the rest is your strategy. Therefore, I can’t say it enough times… Figure out a way to trade without emotions. To help with this matter, I believe it’s vital that you trade only with capital you can afford to lose. If you are using money that you need to pay your bills, you will almost certainly get emotional about every trade you make. In addition, I found that the more confident you are about your trading strategy, the better the chances are that you can trade with little emotional stress.
• Record your trades in a trade journal. When I first started trading, I was a bit lax about this concept. But once I started doing recording my actions, I found that I was able to identify my strengths and weaknesses. I take about 30‐45 minutes each day after I’m finished trading for the day to review my trades and to analyze any disconnect from my original plan. This helps me strengthen my conviction of my plan.
• Never trade unless the signal is clear. There are times when the market can confuse you. For me, confusion is a clear cut signal to keep out of the market. I always want my trades to be high probability signals. My signal has generated a winning percentage of more than 70%. So if I’m uncertain about a signal why would I want to take it, knowing that the chance of it winning is more like a coin toss or less? To me, that is gambling… and I do not consider myself a gambler.
• Never make trades because you are bored. Sitting on the sidelines waiting for your next trade signal to line up can be very unsettling. Many traders have learned that trading out of boredom can blow out your account in a hurry. For me, trading out of boredom while failing to follow your trading signal is gambling.

Remember, the day you decided to start trading was the day you opened your trading business. Everyone wants to have their own business. However, the numbers don’t lie. More than 64% of all small businesses fail within the first two years. That’s a tough number to swallow. But there is good news. It has been found that nearly all successful businesses were started with a written plan and the owner followed that plan. Just goes to show that it pays to have a plan.

Good Luck.

Related:

TopStepTrader

Become a Cliché Trader
By Dan Giovannetti

Since I began trading six years ago, I’ve heard lots of so called experts recite plenty of advice. Most of the time the advice offered was nothing more than a typical cliché. After a while, I got to the point that most of the advice I was given was all but useless. I was always looking for someone to offer me that one thing that I was missing that would make me a millionaire overnight. What I didn’t realize was that I had what I needed to be successful all along, I just didn’t realize it yet… well until now.

My trading strategy has changed over the years to where it is today. Recently, I’ve been able to mold my trading edge in such a way that it conforms to my risk tolerance and yet offers plenty of good returns. As I tried to figure out what I was doing that was different from my previous failures, I discovered something very profound. And as I examined the qualities of my strategy, I found that I had become a Cliché Trader. Let me explain.

I bet if I asked you to write down all the clichés you’ve heard over your trading career, the list would be very long. I have found that some just don’t fit my style while others simply don’t make sense. Whenever I hear “Buy the rumor, Sell the fact,” I say HUH??? By the time I hear  rumor, the opportunity is long gone. Moreover, since I’m a technical trader, rumors are irrelevant to me. So there are some clichés that don’t work for me. However, I have found there are some clichés that I believe everyone should apply to their trading. The list includes the following:

• The market is always right.
• The trend is your friend until it bends.
• Buy the dips and sell the tips.
• Buy low and sell high.
• Support becomes resistance and resistance becomes support.

Here are some of my own made up clichés (I’m not sure if they are clichés or not, but they are
relevant nonetheless):

• Never trade with money you can’t afford to lose.
• Never try to be smarter than the market.
• Never fish the bottom or top of the market.
• Never trade countertrend.

Let’s talk about how these clichés and principals apply to my trading edge.

First off, I am absolutely convinced that market is always right. It can’t be wrong. The market is where it’s at during any given moment because two people with opposing views agreed to a price and initiated a trade. This process continues perpetually and the price reflects the market sentiment as time goes by. Therefore the market is always right. It’s our job as traders to get the same mindset as the majority of traders that make up any given market so that we can put on a position that is favorable to the current market sentiment. This brings me to cliché number two; the trend is your friend until it bends. If the market is moving up for most of the morning, why would you want to short it? This makes no sense to me unless you feel charitable and wish to give away some of your money to others in the marketplace. Remember, the market is always right. So until the market tells you it’s going the other way, why would you assume you know more than the market?

I guess while I’m talking about this, I can add three of my four personal clichés to the discussion (Never try to be smarter than the market; never fish the bottom or top of the market; and never trade countertrend). If the market is always right, why would I want to trade against the trend? By doing so, I have decided I am smarter than the market (which is always right!) How can you be smarter than something that is always right? The answer is YOU CAN’T! The same concept applies to fishing for bottoms or tops of the market. To think you know the exact point a market is going to stop climbing or falling is making the assumption you know more than the market does. Sorry, but that simply isn’t true. Whether you are looking at a lagging indicator (MA’s, MACD, stochastics, bolinger bands, etc) that all try to suggest that your symbol is overbought or oversold or simply analyzing changing volumes; I have found that all these indicators are not very effective at predicting when change is coming. In my opinion, only price action can tell you that. I’ve seen and heard of more traders getting blown out by violating these principles than anything else.

So if I say you shouldn’t fish for bottoms or tops, then why do I like the cliché “Buy the dips and sell the tips?” After all, the bottom of the market is a dip right? Wrong. The bottom of the market is the simply the bottom. So then what is a dip or tip? Well, in a rising market, a dip is a pullback from a previous high. Taking a look at a falling market, a tip is a pullback from a previous low. This brings me to my next cliché; buy low and sell high. If I am looking to put on a long position, wouldn’t it make sense to get a value entry? Of course it would. So I tell people, I look to buy on sale, or sell at value. I look for a suitable pullback then enter. Whether I’m right or wrong, I’m in a much better place and will hit my profit easier or minimize my loss. In either case, I’m better off.

The real question then is… where is the right place to buy or sell? This brings me to the next cliché; Support becomes resistance and resistance becomes support. That tells me everything I need to know. If you look at any symbol, you can often see that a previous top has now become a bottom while a previous bottom has become a top. Don’t believe me; look at your own charts. I have my charts set up in a way that gives me clear spots to test. And I have found that most of these spots are high probability entry points. In the event they are wrong, I find out right away and can cut my losses down to a minimum.

Finally, there’s one last cliché I think is vital to any trader; never trade with money you can’t afford to lose. Why is this so important? Well, after trading for six years now, I have come to understand that 90% of trading is the ability to manage your emotions. If this is true, then how do you think you will handle the market conditions when you are constantly in fear of losing your money? I wish someone would have explained this to me when I first started trading. I would have better prepared myself so that I had an edge. Instead, I traded when I wasn’t prepared and struggled for years because of this. Imagine if you had a nice steady income and your bills were all covered. If you had an account that had no bearing on your current finances, how do you think you would perform? Now imagine that your only income is from trading and you have limited resources other than what is currently in your trading account. Do you honestly feel you would perform the same as in the previous example? Not even close. I strongly encourage you to review your personal financial situation. If it’s not where it should be, you may want secure another income source to relieve you of the emotional burden when trading.

So, in closing, I suggest that you take some time to analyze your trading signal. If you find you’re violating any of these principles you may want to rethink your signal. Ask yourself… Am I a cliché trader? If not, you may want to become one soon.

Good Luck

Understanding Economic Reports

by Gregg Killpack, Trading Strategist  

Economic reports can be confusing.  They are couched in professional jargon and technical information that can be difficult to understand.  How do you know what they really mean?

At their most basic level, economic reports help to answer the big question:  Is the economy growing or not?  If so, how fast is it growing?  Or if not, how fast is it contracting?  Each report or indicator is like one piece of a jigsaw puzzle indicating what the future may hold for the economy.

The economy is a broad financial system where consumers and companies are linked and interwoven together.  If that system is growing, then more money is available for all companies to potentially increase sales, from small business to IBM and Microsoft.  Economic reports, data, and news imply how much money may be flowing into that system and at what rate.  They show signs of growth (or the lack thereof) or in other reports, headwinds to that growth.

For example, Initial Jobless Claims is a report for how many new people filed for unemployment benefits.  If fewer people are applying for unemployment, presumably they have found a job, an indication that the economy is improving.  If the number of people applying for benefits has dropped significantly compared to what it had been or compared to what was expected – that indicates a strongly improving economy; markets may jump at that news.  However, if the number comes out in-line with what it had been and what was expected, the markets are probably already priced in-line with expectations and won’t move much.

To us as traders, economic data is critical information because how fast the economy is growing is key to the valuation of markets, including stock and futures markets.  For example, a stock’s price is based on where the future financial performance of the underlying company is expected to be.  No one knows for sure where it will be, so expectations are important.  They represent our best guess about an unknown future of the company’s financial performance.  As the company releases financial data about how well it actually did, that information is compared with what was expected, and the market responds accordingly.

When an economic report comes out, we receive new information about whether the released data is in line with previous expectations about future economic growth for the whole system – the U.S. economy.  Instead of looking at the future prospects of a company or a single market, these reports can affect all companies and all markets; they are systematic reports that can affect the entire economy.  When companies are growing, their stock prices rise.  They will also demand more raw materials; therefore equities and commodities markets tend to rise and fall together, generally speaking.

The 1^st Key

The first key to understanding economic reports is to know how big an effect the data to be released can have on the economy and hence the markets.  Reports and indicators that have large, systematic effects can have huge, instantaneous effects in markets.  Others may have little or no effect.

A change in interest rates set by the Federal Reserve has a tremendous, system-wide impact to speed up or slow down the economy and can instantly cause markets to shoot up like a rocket, or fall off a cliff.  A rate change will increase or decrease interest expenses on debt for every company in the country.  Most of the time the Federal Reserve doesn’t surprise the markets and expectations are built into the prices of the markets, but when the Fed does anything unexpected, the markets move – and fast.

For example, on October 15, 1998, the Federal Reserve ordered a surprise rate cut of 0.25% to help with the bailout of Long-Term Capital Management, a highly leveraged hedge fund that had lost billions of dollars.  In response, the market soared.  The Dow Jones Industrial Average climbed more than 25% over the next year and a half.  It wasn’t just that the Federal Reserve lowered rates – 0.25% isn’t a huge move – it was the unexpected move that Mr. Greenspan and company were easing rates to stimulate the economy… and might continue to do so if needed to aid in the crisis.

The 2^nd Key

Another key to understanding economic reports and indicators means knowing whether the indicator is leading, coincident, or lagging.  Economic indicators are like driving in your car:  some look forward, some look back, and some are like looking out the side window, showing where you are now.

Leading indicators are like looking through the front windshield to see where you’re going as you drive. Coincident indicators are like looking out the side window and lagging indicators show where you have been.  The problem comes when you look at all three images and don’t know which is forward, sideways, or backwards.  Trying to drive while only looking at the rear view mirror would be difficult at best; only looking out the side window would not be much better.  More confusing still would be trying to drive while looking at all three and not know which was forward, side, and behind.

As traders or investors, leading indicators are the most important to us because we need to anticipate future prices in order to profit.  We want to find the earliest and most reliable information that we can find and notice the co-incident indicators to confirm what the leading indicators are telling us.  That will help us enter positions at the right time – when markets are about to make a move and in which direction.  Stock and commodities prices anticipate corporate profits, so we want to find economic indicators that rise before corporate profits.  Lagging indicators aren’t going to help us as traders; we can already see that on the price charts.

Leading indicators include Hourly Earnings, Consumer Spending, and the Consumer Price Index or CPI.

Average Hourly Wages show the wages that employees earn.  Many employees will spend all they make, so as this number goes up there is more money being spent and the economy grows.

Consumer Spending, known officially as Personal Consumption Expenditures or PCE, is similar to hourly wages.  As consumers spend more, the economy improves soon after.  Corporate profits tend to follow average hourly wages and consumer spending, both up and down.

The Consumer Price Index or CPI is a broad measure of inflation.  It breaks down inflation into many different categories that give a solid understanding of where inflation is coming from – if it is across the board or just a temporary reading in one sector.

The CPI is a huge danger signal to warn against coming bear markets.  When inflation gets too high, the Federal Reserve raises interest rates.  All companies with debt are forced to pay higher rates, cutting directly into profits, not to mention consumers.  When the Fed continues to raise rates, a bear market is sure to follow.

One of the best coincident indicators is GDP or Gross Domestic Product for the most recent quarter.  That is the ultimate report of how well the economy has done without showing where it is heading.  Watching the trend for GDP helps us in our analysis of the future direction of the economy.

The most important Lagging Indicator is Unemployment – it is important to ignore.  The Unemployment rate is one of the most commonly reported indicators on the evening news.  Most people look at it (especially if they are among the unemployed) and think that is where the economy is headed, but that is incorrect.  The truth is that companies hire after their financial situations improve, but by then stock prices have already climbed to reflect this rise in profits.  As of this writing, the stock market has been in a bull market for 2 ½ years while the national unemployment rate has not improved much over the same period.  This is clear proof that unemployment is a lagging indicator.

Learn how much effect your economic reports have and keep an eye on the leading indicators to see the big picture.  This will help you drive the vehicle of your trades to where you want to go.

Many Profitable Returns,

Gregg Killpack

All In or Scale In… That is the question!
By Dan Giovannetti

There is a major difference of opinion when it comes to the topic of Scaling In entries when trading. I can say that I’m 100% in the camp that’s in favor of it. Let’s cover the pros and cons of scaling in to see if it can work for you.

First off, what is “Scaling In?” Well simply put, scaling in is an order entry technique where you put on trade orders at various price levels to cover a price range. For the purposes of this discussion, I will talk about the ES S&P E‐mini futures contract even though I believe you can use apply this concept to just about any traded security. So if I was thinking of buying ES and believed a good spot to enter was at 1205.00 while trading 5 contracts, then I would put in 5 Buy Limit orders. The price of those orders would be as follows: (1 @ 1205.00, 1 @ 1204.50, 1 @ 1204.00, 1 @ 1203.50 and 1 @ 1203.00). You could separate the distance of the orders by whatever fits your comfort level or trading system. For example, you could put the same orders in at 1205.00, 1204.00, 1203.00, 1202.00 and 1201.00. Again, it really depends on what your risk tolerance is and what your profit goal is per trade.

“Scaling in” is not discussed nearly as much as “scaling out.”  This is because most traders have not considered it or have been told not to.  Most opponents of the scale in approach argue that you are throwing good money after a bad trade. Although I understand their argument, I think most are missing the point. Using the above example, if I planned to put on a long position on the ES with 5 contracts, but went “all in” at 1205.00, then later when the trade pulled back to 1202.00, went ahead and put on 5‐10 more to try to improve my position, I did it out of desperation and not by plan. This example would support the theory subscribed to by those that oppose this approach. In this example, I’ve exceeded my intended position size and more importantly, I added to a bad trade. This example is not the way to scale in.

Going back to my original example, when I decide to scale in at different prices, I receive the following benefits:

• I lessen my risk from the very first position.
• I lower my cost basis as my orders get filled.
• If my trade fails the original parameters outlined, I can usually get out of the position NET EVEN.
• I improve my win ratio.

Now because of this approach, I will not always get my full 5 contracts filled. But that’s fine with me. In that case, I experience a “heat free” trade and I’m sure we can all get used to those. But in the case where all my positions get filled, my breakeven point (BE) has been lowered substantially. And because of this, I can usually minimize my loss or eliminate it altogether by closing out my position at BE when the trade has failed my original parameters.

You will need to set your profit and stop loss targets according to your comfort level and risk tolerance. For me, I like to take 3 points profit on the ES. With that in mind, I will typically adjust the entire limit order to 3 points from the furthest entry or drawdown. I have found that the ES moves in waves; typically between 3‐5 points in any direction. So, by scaling in my entries, I tend to get the majority if not all of any given move. You will need to figure out what works best for your trading system and style.

There are three styles of scaling in your position: Equally, front ended or back ended.

Scaling in equally is the simplest form of scaling in. By using this method, you simply put on equal positions on at various positions. The above example uses equal scale in orders.

Front end scaling is the riskiest style of scaling in.  By using this method you put on more contracts at the front end of the trade. For example, instead of scaling in at 1205.00 as we did in the above example in 5 equal price points and 5 equal contract amounts, now I would put in the following orders: 3 @ 1205.00, 1 @ 1203.00 and 1 @ 1201.00. By doing this, my BE point would be much worse than by scaling in equally and would have a tougher time getting to BE if my trade failed.  Because of this, I do not use this technique.

Back end scaling offers the lowest risk of the 3 styles.  By using this method you put on more contracts at the back end of the trade.  Using the same example, this time, I would put on the following orders: 1 @ 1205.00, 1 @ 1203.00 and 3 at 1201.00. By doing this, my BE point is at the best place and the easiest to hit in the event that my trade failed the original parameters I set prior to entry.

I tend to stick to the easiest method (equal scale in). Before you decide to use any scale in technique, I strongly urge you to back test your system manually to get an idea of what kind of drawdown you may experience on a regular basis. You may even want to test this approach on a sim/practice account before putting your hard earned money on the line. But in any case, I suggest you remain consistent once you decide to use this approach. Consistency is the key to successful trading, no matter what system you use. I have found that scaling in my trades have increased my consistency and thus has made me a better trader.

Good luck.

The quarterly corporate earnings cycle and market volatility can provide investment opportunities for options traders. During these periods, investors may want to take a closer look at how volatility impacts both stock and option positions before and after earnings announcements.

There are two types of volatility: historical and implied.  Each measurement provides important information for the options trader.

Historical volatility is a measure of movement of an underlying security over a specific period of time. Investors may use historical volatility or past trading ranges as an indication of how much the stock price may fluctuate in the future. It must be emphasized that this is no guarantee that past volatilities will predict future price behavior. The range that a stock’s price has fluctuated in past periods is one of many important factors in determining which options to buy or sell, particularly around earnings periods.

Implied volatility is the market’s forecast for future movement of the underlying. It is reflected in the option premium – puts and calls – of an underlying product. Implied volatility reflects the investor’s positive or negative sentiment about future movements in a stock or index. Like any forecast, it may or may not hold true. Implied volatility is the key element in the time value portion of an option’s premium. When implied volatility goes up, call and put prices go up. When implied volatility goes down, options pricing goes down.

Earnings season is typically a volatile period. This volatility or expectation for greater movement often impacts the price of options. If you notice that overall implied volatility is higher for one option expiration over another expiration, then chances are that month may include an earnings announcement.

Let’s examine how changing implied volatilities can affect options prices. Just prior to earnings, the investor will notice that options tend to be on the pricey side. Let’s assume some investors have an outlook that a stock is going to move higher upon the release of earnings and decide to buy some call options. With the underlying stock trading $30, an investor purchases an at–the-money 30 strike call for $3. Directly after the earnings announcement, the stock moves higher by $2, but the option only increases in price by 50¢. What transpired was a reduction in implied volatility. The unknown is now known, and the uncertainty is taken out of the market, and as a result the lower implied volatility yields reduced time premium.

Vega

Any investor using options should also understand the concept of Vega. Vega is the change in an option’s theoretical value for every 1-point change in volatility. If the Vega on an option is a nickel and the volatility goes up a point, you can add a nickel to the price of the option without any change in the underlying stock. Understand that while theoretically Vega is the same for at-the-money calls and puts, in reality each option’s Vega is affected differently by volatility.

Furthermore, Vega varies depending on each option. There are options that have may have a nickel, 50¢, a $1, or even $2 worth of Vega. The largest Vega is going to be for an option at-the-money with the most time until expiration. So, longer dated at-the-money options have more Vega than short term at –the-money options.

A few things to consider prior to an earnings announcement:

There is no perfect trade and there is no perfect position. If your forecast is for volatility to increase, you might want to purchase options or buy a spread that takes a position of long volatility. A vertical spread is one example of a long delta option position with less volatility risk where the short out of the money call offsets some of the long Vega of the at the money call.

• When you’re buying options, you’re buying volatility and you’re buying Vega.
• If you’re selling options, you’re selling volatility or selling Vega.
• If you feel like volatility is going to decline upon the release of this earnings news, you may decide that you want to sell options, or sell a spread that gets you short volatility.
• Be aware that changing volatility levels can impact the other Greeks in your position, namely Delta and Theta. Also, be aware that the risks associated with naked short option positions are significant and sometimes unlimited.
• Implied volatility changes all the time.

In terms of volatility, there are a couple things that investors can look at going into earnings. A good place to start is to look at the relationship between historical volatility and implied just before earnings over the past 3 or 4 earning cycles. You can find some historical and implied volatility data on OIC’s website at http://www.optionseducation.org/quotes/default.jsp .  Examine the differences between the two volatilities before earnings as well as the relative levels of each.

To learn more about options, visit OIC’s website www.OptionsEducation.org. OIC has a vast collection of educational resources including webcasts, podcasts, multimedia online courses, and interactive tools such as OIC’s Strategy Screener and a Virtual Trading System.  If you haven’t already, register for a free account with OIC Education and get full access to these resources.

The Straddle

The first of a few oddly named strategies we’ll discuss today is the long straddle. In the simplest terms, the long straddle is constructed by buying an equal number of puts and calls at the same strike and within the same series. Typically, straddle strategists will select a strike that’s at or near the money, and will hone in on the expiration month in which the company’s report is scheduled. However, with October-dated options set to expire on Friday, many speculators this week are already turning their attention to the November series.

In order to profit from a straddle, the underlying equity must rise beyond the strike price of the purchased call, plus the initial net debit. Alternatively, you could also benefit if the equity drops below the strike price of the purchased put, minus the initial net debit.

For example, let’s say that you initiated a pre-earnings straddle on XYZ with 10-strike calls and puts. Your total net debit for the position is $1.50. So, you’ll need XYZ to climb beyond $11.50 (call strike + net debit) or fall below $8.50 (put strike – net debit) in order to begin turning a profit. In other words, you’re looking for a move of at least 15% to make money on the trade. Nevertheless, even if XYZ goes nowhere during the options’ lifetime, the most you stand to lose is capped at the $1.50 paid to establish the single-strike trade.

The Strap

Meanwhile, there’s also a way for bulls to modify the straddle to make more money on an upside move: the strap. While both the straddle and the strap employ puts and calls at a single at-the-money strike, the latter strategy utilizes twice as many calls as puts. More specifically, to initiate a strap, you would purchase one put and two calls with the same strike and expiration date, resulting in a net debit.

As we alluded to earlier, the objective behind the strap is for the underlying security to make a monstrous move in either direction – but preferably to the upside, since the strategy employs twice as many calls as puts. In fact, should the equity surmount the upper breakeven rail (strike + [net debit/2]) before the options expire, your profit potential is theoretically unlimited, since there’s technically no limit to how high the security could rally.

What’s more, similar to a simple straddle play, the strap allows you to make money on a significant downside move, too. More specifically, should the stock perforate the lower breakeven rail (strike – net debit), your profit could be substantial, but is limited, considering the furthest the stock could possibly fall is to zero.

What do I have to lose, you ask? Should the underlying stock fail to penetrate either breakeven rail, the good news is that – like the straddle strategist – your maximum risk is capped at the initial premium paid for the options. However, since the strap requires you to purchase three options, as opposed to only two for the straddle, your net debit will typically be higher on the play.

Volatility Plays

The Strip

In similar fashion, bearish bettors can modify the straddle to dangle a slightly larger carrot on the downside. More specifically, the strip allows pessimistic options speculators to gamble on a post-earnings retreat, but hedge their bets in the event of – and even profit from – a significant post-earnings rally.

To initiate a strip, you would purchase one call and two puts with the same strike and expiration date, resulting in a net debit. As we’ve already mentioned, the objective behind the strip is for the underlying security to make a monstrous move in either direction – but preferably to the downside, since the strategy employs twice as many puts as calls.

Should the stock perforate the upper breakeven rail (strike + net debit), the investor’s profit could be substantial, and is calculated by subtracting the net debit from the call’s intrinsic value. However, an equidistant move beneath the lower breakeven level (strike – [net debit/2]) before the options expire would generate even grander gains, due to the double dose of long puts.

Should the underlying stock remain pinned between the breakeven rails, your maximum risk is capped at the initial premium paid for the options. However, since the strip requires the investor to purchase three options, as opposed to only two for the straddle, the net debit will typically be higher on the play.

The Strangle

Finally, the long strangle is similar to its meeker straddle cousin, in the fact that employers of this strategy are rolling the dice on a significant move in either direction. However, while the straddle centers on just one strike in the same series, the strangle is built using calls and puts at different strikes, each one slightly out of the money.

What’s the benefit to spreading out these strikes? In the simplest terms, the premium for slightly out-of-the-money options will be comparatively slimmer than what you’d pay for their at- or near-the-money counterparts. As such, the strangle is typically cheaper to initiate, which translates into fewer dollars at risk.

On the other hand, splitting the strikes means wider breakeven rails (put strike minus net debit on the downside; call strike plus net debit on the upside) than that of the straddle, meaning you’ll need a relatively larger move from the underlying equity to make money on the play.

Returning to our earlier example, let’s assume that XYZ has one-point strike intervals, and the shares are currently right at $10. To build a pre-earnings strangle, you could buy a 9-strike put and an 11-strike call, bringing your total premium to $1. The breakeven calculations are the same — you make money on a move above $12 or a drop below $8. As you can see, the trade-off for the lower cost of entry is that you need a more aggressive price change in the underlying shares than the straddle trader.

Word to the Wise

In conclusion, keep in mind that like you, everyone else in the market knows that earnings season is all about major price moves. As such, the expectation for a significant post-earnings price change will already be priced into your options, thereby hiking your premiums (and making it more difficult for you to capture a profit).

In other words, the more you pay to buy your options in the first place, the greater move you will need from the underlying stock to turn a profit. And here’s the kicker — implied volatility generally implodes post-earnings, as the news is priced directly into the stock itself, rather than being priced into the stock’s derivatives. Lower implieds mean lower premiums… which means your options could actually lose value, even if the shares make an impressively drastic move.

For more options-centered educational content, or to see which stocks are heating up the options pits each day, visit my home base at SchaeffersResearch.com.

In-the-Money Strangle

Also known as a long guts strategy, this two-legged play is constructed by purchasing both a call and a put with the same expiration date but differing strike prices, with at least one of the options in the money at initiation. More specifically, the option that’s deepest in the money – the more expensive of the two – will determine the directional bias of the trade. In other words, those who pay more for the call will have a bullish bias, and vice versa for those who shell out more dough for the put.

Similar to the basic long strangle strategy, the in-the-money strangle requires a significant price swing in order to profit. As long as the underlying stock violates one of two breakeven rails before options expiration, the intrinsic value of the in-the-money option will offset the losses incurred from the out-of-the-money option, resulting in a net gain.

However, the in-the-money strangle is more seductive than its basic counterpart, due to its relatively modest risk. Since one of the two options is guaranteed to finish in the money, the minimum value of the strangle at expiration is equal to the difference between the strike prices. In other words, no matter where the security settles at expiration, the maximum risk is capped at the initial net debit minus the difference between strikes.

Confused? Let’s breathe even more life into this strategy by dissecting a theoretical long guts play on Stock XYZ, which we think is going to extend its recent downtrend.

With the shares of XYZ currently flirting with the $41 level, we’re going to launch our strangle by purchasing the November 40 call, which was last asked at $2.60, and simultaneously buying the November 43 put, which last crossed at $2.90, resulting in a net debit of $5.50 per pair of options. While both of the options are currently in the money, we forked over more cash for the put, pointing to a bearish bias on the play.

In-the-Money Strangle

This skeptical slant is also evident in our breakeven rails. On the downside, we’d need XYZ to fall beneath the $37.50 level (put strike minus net debit) to profit – a decline of roughly 8.5% from XYZ’s current perch at $41. On the other hand, the shares would need to rally atop the $45.50 level (call strike plus net debit) for us to make money – an increase of about 11% from the equity’s current price.

However, even if XYZ remains pinned to the $41 level through the options’ lifetime, the minimum value of our in-the-money strangle at expiration is $3.00 – the difference between strikes. As such, the most we can possibly lose on the play is capped at $2.50 (net debit minus difference between strikes) – or less than half of our initial investment.

In conclusion, by constructing this alternate version of the long strangle strategy, you can maintain your directional view but still capitalize on a move against you. And while the in-the-money strangle will cost more to initiate than its basic counterpart, you’re really only risking a fraction of your initial net debit. As such, the in-the-money strangle is an appealing low-risk/high-reward strategy – especially in the eye of the earnings storm.

For more options-centered educational content, or to see which stocks are heating up the options pits each day, visit my home base at SchaeffersResearch.com.