Why Favor the Stock Market?

Guy Cohen is the creator of The Private Traders Club, Flag-Trader, The OVI Index and OptionEasy. He is also the author of the best-selling trading books “Options Made Easy”, “The Bible of Options Strategies” and “Volatile Markets Made Easy” (FT Prentice Hall). Guy specializes in stock market trading and he has created numerous online applications for stocks and options traders, with his hallmark being his user-friendly approach and liberal use of illustrations. His clients include NYSE Euronext, The International Securities Exchange (ISE) and FT Prentice Hall. To see what Guy is working on now, click here!
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Why I Favor the Stock Market

Alright, I admit it … I’m a stock market fan! Not Forex, not commodities … the stock market is where it’s at.

Make no mistake about it, more personal fortunes have been made in stocks than any other investment vehicle out there. That is a fact. Forex and commodities are highly specialized and the failure rate for amateur traders is higher in those markets than with stocks. As you would expect, the success rate with stocks is far higher than with Forex or commodities trading.

So with that in mind, let me explain why …

• First, to make big money with Forex and Commodities you require immense leverage. This means you can win big … but at the risk of losing big … really big.
• Second, when did you see a currency or commodity double or triple in a matter of weeks? Doesn’t really happen does it?!

But with stocks this can happen quite often, and it doesn’t require leverage.

Furthermore, with stocks, they often “telegraph” their intentions ahead of time, provided you know where to look and what to look for. Stocks offer more diversity, more choice, and typically when something major is about to happen, we have ample warning of an announcement ahead of time (ie. earnings season).

Of course, surprises can and do happen with stocks, and they can be nasty surprises. However, if you’re sensible and aware, you can massively reduce the odds of a catastrophe, and hugely put the odds of success in your favor.

So you can see I might be just a little biased (after all, it’s like home field advantage for me!). Although I began my trading career in the options industry, I was quickly drawn to the stock market. In the stock market, massive fortunes can be made from relatively modest starting pots.

After many years serving my “apprenticeship,” my focus narrowed still further on just one type of chart pattern - a breakout from a consolidation pattern. We can narrow this down even further by calling it a Flag pattern. This is what I specialize in. Breakouts from clear areas of support and resistance.

Why this method? Three reasons:

1. It forces me to use a simple clear trading plan. Therefore, my discipline is in place for each and every trade. I know in advance my entry and exit points (including when to ride a trend).
2. It gives me the opportunity for windfall profits when we catch a trend.
3. It rarely, if ever gives a gapping loss. Furthermore, many losses don’t even materialize if the stock never broke out in the first place.

These points already start to put the odds in my favor.

However, thanks to my grounding in options, I’ve been able to add something very special to my trading arsenal.

But the great news is, you don't need to know anything about options to take advantage of what's happening in the options market!

Over the years, I’ve observed that there are what I like to call "Informed Traders" in the market. And once you get a sense of this, you begin to see a whole new picture. These Informed Traders gravitate towards the options market for 3 main reasons:

1. Their trades are relatively well hidden, and therefore they can trade discreetly.
2. They can accumulate vast positions over a period of time without disturbing the underlying stock price.
3. Leverage – The ability to “control” a lot by investing a little.

It’s one thing to understand options. It’s quite another to simply observe options transaction data. That’s what we do to see what the big money is up to.

For a technophile, I’m looking specifically at options volume, open interest and implied volatility.

For a technophobe, don’t worry about the above sentence! I’ve combined these factors into the simplest of indicators – a line that just goes up and down from +1 to -1. When the line is positive we look at bull flags, and when the line is negative we look at bear flags.

Simple. The line is called the OVI.

The OVI gives you a serious edge when it comes to monitoring what the big smart money is up to. One of my students has recently mentioned that he’s “addicted” to it! That’s some praise … and rightly so.

However, you cannot use the OVI on its own. It must be used in conjunction with a chart pattern – preferably a flag type of pattern. This is where it really becomes special. And remember, because of the pattern, we already have a robust trading plan in place.

Take this recent example for instance – given the bearish market in the last few months until this week, let’s take the example of RIMM:

RIMM - Bear Flag

As you see, RIMM starts to fall in March, and my OVI indicator also turns negative virtually at the same time. All we need from here is a good entry point.

Now, there were several as RIMM stepped downwards. However, I’ve been conservative and avoided earnings season and any gapping just to show you what’s possible.

You can see that a sound short entry point was around $42.50 at the end of May, and from there (within 2½ weeks), the stock had plummeted another $17! That’s a huge profit, for which one of my students claimed they now loved me because I’d been ragging on RIMM for some time!

So, hopefully you see how this works. We’re looking for a confluence of a simple pattern together with the OVI.

It may surprise you to know that the OVI – even though it correlates nicely here with the stock price movement, doesn’t actually have anything to do with the price chart above it, because the OVI is derived from options transaction data. There’s the secret … it’s effectively spying on what the big players are doing.

As you can see, with the right patterns in place, that can be very revealing. With the right trading plan in place, that can be very profitable as well!

Click here to learn more about this OVI..

Cheers and best of luck in your trading,
Guy Cohen