How to Trade Like a Hedge Fund

• How to Invest in Options
• How to Buy LEAP Options
• Options Intrinsic Value
• ETF Options Trading
• Crisis Investing
• Lockup Expirations

…we now offer How to Trade Like a Hedge Fund: "Secrets of an Options Trader." Enjoy. 

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It was November 11, 2008 when we watched the Financial Select Sector SPDR (XLF) plummet from a $13.50 high to less than $9.50.

Those that shorted it "only" realized a gain of 42%.

But those that bought XLF put options (January 13 put – XJZMM), as we did in Options Trading Pit, realized gains of up to 221% in seven days.

It’s all about leveraging.

It’s the difference between a small profit and a small fortune, something I’ve been teaching traders and investors alike for the better part of 10 years.

But here’s something else you may not know… profiting from technical developments has never been easier.

While there are several ways to screen for opportunities, four of my favorites involve the use of Bollinger Bands, W%R, the news and candlesticks. Using just these four, we can call for tops and bottoms on indices as well as individual stocks.

Let’s take a look at AIG, for example, from November 2006:

And just as we had hoped, AIG fell from about $72 to less than $69, handing us a quick gain.

However, AIG then bottomed out at $70. Again, technically, we had another doji reversal signal… this time at the bottom of the trend (a doji at the bottom of a trend can be used as a bullish reversal signal). Fundamentally speaking, the company (once entangled in investigations that rocked the core of the insurance industry, and whose accounting probes led to the departure of Hank Greenberg) became quite the turnaround story.

We bought again at the bottom, marked by an oversold W%R and rode it back from about $69.50 to more than $72 in a few short weeks.

Or look at what happened with Forest Laboratories (FRX) every time it touched the upper Bollinger Band. We got a bit lucky with the latter portion of the chart with about a $10 dive off a double top on the upper Bollinger Band. But match up the upper Bollinger Band touches with overbought W%R reads and you’ll see the set up for a fall was in the stars.

We’ll get back to the use of Bollinger Bands, W%R, and candlesticks, but I want to point out how the use of news can be used to screen for stocks, too.

In fact, here’s how well the news worked for us…

• Expedia October 22.50 put – 183% gain
• Coca Cola November 20 put – 262% gain
• Masco October 20 put – 60% gain
• Lehman October 20 put – 188% gain
• UBS AG September 22.50 put – 42% gain
• Freddie Mac January 2009 6 put – 44% gain
• Fannie Mae December 9 put – 46% gain
• JA Solar September 9 call – 113% gain
• DryShips January 2009 10 calls – 41% gain
• Chesapeake Energy January 15 call – 57% gain

Take the Masco play, for example.

After seeing its third day of heavy call option buying, we urged readers to buy into lumber and wood producer Masco Corporation (MAS) put options.

October 2008 25 calls were seeing recent interest after the MAS Executive Chairman bought 300,000 shares of the company on May 28 between $17.80 and $17.99. But unless the stock can maintain multi-year support at current prices, it’ll drop even further with the housing slump, which will continue to wreak havoc on the home improvement and home construction markets.

Understandably, investors want to load up behind the Chairman because they believe the U.S. real estate market will bottom this year. It’s won’t happen, though.

If you think the subprime fiasco has been economically debilitating since 2007, just wait until 2009.

When you hear of this mythical housing and credit market improvement, ignore the bulls and Wall Street hot shots that’d have you believe in a housing bottom or the grand illusion of "priced in" credit market weakness.

Subprime mortgage resets may be coming to a near-term end, but Option ARM and Alt-A resets are just around the corner.

What should scare you is this – the coming Option ARM and Alt-A resets are similar to what we saw in early February 2007.

And as you can see above, it turned out to be quite a profitable trade, along with Lehman, UBS, Freddie and Fannie.

Let’s jump back into Bollinger Bands, W%R and candlesticks.

For those of you that aren’t familiar with the terms (doji, Bollinger Band and W%R), here’s a quick tutorial:

• Dojis usually appear at times of market indecision and have called key reversals in indices and individual stocks.

• W%R (or Williams % Range) is the ultimate momentum indicator that signals oversold and overbought conditions. W%R shows an overbought condition with a numerical range read of 0% to 20%. Oversold conditions are measured with a numerical range read of 80% to 100%.

• As for Bollinger Bands (plotted at standard deviation levels above and below moving averages), stock prices tend to stay within the upper and lower bands. So, when the prices (in this case with the Dow) move above the upper Bollinger Band, are coupled with a bearish candlestick read (gravestone doji, for example), and an extreme overbought W%R read is present, we expect a reversal at the top.

Reverse everything you just learned, and you can play bottoms, too.

Using the W%R, the Bollinger Bands and bearish candlesticks, we called the top of CVS before it sold off from a $36 high on Sept. 12, 2006 to less than $31 two weeks later.

Here’s how we found this.

• Step 1: On Sept. 12, 2006, the W%R peaked in overbought territory.
• Step 2: On the same day, a bearish doji made its presence known above the upper Bollinger Band.
• Step 3: We bought puts and watched as the stock sold off to $31.

Okay, but what’s a doji?

The profit stars, more commonly known as dojis, are commanding reversal signals. These are formed when the candlestick opens and closes at the same level, implying indecision in the stock price.

Depending on the location and length of the shadows, dojis can be categorized into four subcategories:

1. Doji

This candlestick looks like a cross, inverted cross, or plus sign. At the top of a trend, it can indicate that a reversal is near.

2. Long-legged doji

Long-legged doji formations occur when the stock opens at certain levels, trades in a wide trading range intra-day, and closes at the same level that it opened. These become better predictors when preceded by small candlesticks. Long-legged doji formations can imply a change in trend.

3. Dragonfly doji

The bearish dragonfly doji can usually be found at the market top or during an uptrend. This candlestick tells us the bulls may be losing their way and casts doubt on the market’s ability to continue north. Confirmation is essential. You can confirm with a gap down or a lower close on the following day.

4. Gravestone doji

Gravestones are the opposite of dragonflies and indicate top reversals when confirmed with a bearish engulfing scenario (which we also use). These dojis look like gravestones and can signal the death of a stock.

As for the bearish engulfing scenario, an engulfing occurs when a candlestick engulfs the preceding candlestick body.

Dojis become more significant when seen after an extended rally (seven or more) of long-bodied candles (bullish or bearish) and are confirmed with an engulfing candlestick (a long candle body).

The Bollinger Bands

Bollinger Bands allow users to compare volatility and relative price levels over a period of time. They consist of three bands:

• A simple moving average (SMA) in the middle…
• An upper band (SMA plus 2 standard deviations)…
• A lower band (SMA minus 2 standard deviations)…

Standard deviation, a statistical term that provides a good indication of volatility, ensures that the bands will react to price movements and reflect periods of high and low volatility. Sharp price increases (or decreases) will lead to a widening of the bands.

For our purposes, let’s make this a bit simpler. When we use the Bollinger Bands, the closer the market prices move to the upper Bollinger Band, the more the stock market is considered overbought. The closer the prices move to the lower Bollinger Band, the more the stock market is considered oversold. We’re not going to get into the scientific structures and Bollinger band calculations with each trade. We’ll be here until New Year’s 2012 doing that.

Using the Bollinger Bands, look at what happened to CVS (CVS:NYSE) after putting in a doji cross above the upper Bollinger Band. (Note: If a pattern is above the upper Bollinger Band, it’s an extremely overbought condition. We view this as a near-term reversal opportunity.) It sold off from its Sept. 12, 2006 $36 high to about $31 two weeks later.

The Williams Percentage Range (W%R)

The third component of the trade is to find an overvalued W%R read, or a chart where the W%R has peaked. According to the W%R, values of 80% to 100% indicate an oversold condition. Values of 0% to 20% are overbought.

Interesting to note, W%R has the ability to anticipate reversals. The indicator will oftentimes peak and turn down days before the stock peaks and turns down. It does the opposite with upside.

And that’s about it for these four indicators. These are only a few screeners that we use. Stay tuned for more from Options Trading Pit.

Good Investing,

Ian L. Cooper
http://www.wealthdaily.com