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Ask The Analyst, Sunday, 03/09/2003

The best book on trading stocks and options
by Jeff Bailey

Hi Jeff,
I'm just learning how to trade options and would like to know your thoughts on any good books to read on the subject.

I've given this great thought, and the book I'm going to recommend cost's just a little over $3,000.00.

After you understand the ULTIMATE basics of price fluctuation and understand what truly drives stock and index prices, then I've got a very good technique for learning how to trade, where the price of this education is LIMITED and need not be as expensive as it may have been for some of your friends, when they "learned how to trade."

The second-best book I've ever read on trading is Tom Dorsey's "Point and Figure Charting," which give the trader/investor the ULTIMATE understanding that all that really matters when considering price fluctuation is supply and demand and how to understand and measure MARKET/SECTOR/STOCK risk/reward.

I'm not here to sell books, but OI does offer the book in our bookstore.

The BEST BOOK on learning to trade stocks/options is the one that I've been writing over the years. It's not on paper so to speak. You can read different chapters in the Bailey's Basics and here in the Ask the Analyst section of the site. However, the best book you will ever read on trading is the book that YOU write, or at least learn on your own. You know the saying, "you'll never learn unless you try." This is so true.

For many, "learning" to trade with your own money can be scary. I'm not knocking a college education, or spending money on books, seminars, etc. as I've learned a great deal when I went to college, but no matter how "book smart" we become, it does little good unless we learn on our own when applying all that we've learned.

I dare say, that I've learned some things over the years from books, college education and seminars, that when I've tried to practice them, just haven't worked out like they were supposed to from the teachings. Guess what? I don't use those "teachings" anymore.

I spent a full semester in college going through income statements and balance sheets to try and determine a company's value. What I learned in life, is that the value I might apply to that company may not necessarily be in agreement with what the MARKET places on the company. My value might be too high, or it might be too low. What I did learn is that while I might be able to look at a company's fundamentals and even project how they will look in the future, it was much easier to test that analysis against a stocks price over time, and see if the MARKET thought I was too bullish, too bearish, or was in agreement.

Then I began to learn that it doesn't matter what I think about a stock's fundamentals or valuation. All that matters is what the MARKET thinks. And what the market thinks will show up in a supply/demand chart, or other types of charts.

So lets suppose you've read Tom Dorsey's book on point and figure charting, and begin to believe that even though company ABCDE has a price/earnings ration of 10, and has been growing the bottom line at 20% the last two years, its the excess of supply (selling) that has the stock down 30% in the last four weeks that begins to hint that something is wrong with the stock.

This is a lesson I learned years ago, and it wasn't from a book. It was from personal experience, and being long a stock with "excellent" fundamentals, quality management and superior product that traded at an extreme discount to the broader S&P 500.

For many traders, learning how to trade isn't necessarily a profitable experience when you first start. Yuck! That's a scary thought isn't it. But that shouldn't be a deterrent or an excuse to not begin trading.

When first stating out, "paper trading" is a good way to begin learning. You know, the imaginary type of trade where you write down on a piece of paper how many shares of stock you bought at the price the stock was trading. Then, if the stock hits your target or stop loss, you'd record the winning/losing transaction and move on to the next trade.

However, the one thing paper trading doesn't allow the trader to experience is the human emotions that only come from having REAL capital at risk. Paper trading does not, in my opinion, expose the trader to emotion as you know that you really don't have any capital at risk, and when there's no emotions coming into play, you can easily stop out a paper trade for a loss, don't feel all that bad, and can simply move onto the next trade, try and apply what you just learned to the next trade and try an not make the same mistake again.

For traders learning to trade options, here's a technique that I think will help a trader LEARN on their own how to trade options.

Find a stock that you like or at least believe has a viable longer-term future that trades between $20 and $25. Open a trading account with $3,000.00, then buy 100 shares of the stock. This would have your cash outlay being between $2,000 and $2,500. I paid for my own college tuition and can't remember now what the cost of tuition was for a semester, but I think it was more than $3,000.00.

From this point on (date of purchase) you will never sell this stock. The only way you can keep from losing the $2K to $2.5K is by constantly trying to protect your positions with a PUT option, when it appears the stock is vulnerable to price depreciation. You will NEVER buy a call option, as the underlying 100 shares always has you long the stock.

The reason a trader might want to "learn" to trade by buying a stock and not shorting it, and using call options to protect the short positions, is that with a short position in an underlying stock, your risk can be UNLIMITED, especially when/if you didn't have a call position established.

By being long the stock, you the trader understand the most you can lose in this trade is between $2K and $2.5K or the $3,000.00 you started your account out with.

Believe me. I know a few "investors" that used to be traders that learned they didn't have the discipline or the knowledge of how to trade stocks or options and it cost them MUCH MORE than $3,000.00 to find this out.

If you think about it, lets say you lose on all of your put option trades when attempting to "hedge" the $2,500.00 long position in your account. How could a trader lose the remaining $500.00 in his/her account on put options?

There are two ways and here is where your first lesson would be learned.

You were buying OUT THE MONEY put options and while your underlying stock position may have declined (or stayed unchanged), it didn't decline enough to have the option gaining in value by the options expiration. Lesson learned: Buying out the money options is a lower probability of success trade, especially if near-month expiration is used.

The second way you might lose the remaining $500.00 of the account, is that the underlying stock you chose, was simply a strong stock where demand was always sufficient enough to keep the price rising. A good stock picker (stock you bought for $2,500 and now worth $30.00 or $3,000) may learn ($500.00 loss in put options) that they've got some further learning on how to properly select options. But hey! If I could have only learned to trade options for $500.00 with REAL money, I could have saved myself from stress when first starting out.

Another lesson you will learn is that it is BEST to BUY TIME in a put option. Traders that buy too little time find that their options trading becomes DICTATED to by expiration, in that they are making decisions as it relates to expiration, on not based on the underlying stock's price action. There's nothing worse that holding a put option on a stock that looks to be on the brink of a potential major decline, only to have to close that put option out because the risk of a slight rebound in the stock's price ahead of expiration could have current profits in the option being eroded rather quickly.

When you buy time on an option, it allows the trader to make a decision on closing out the option ONLY as it relates to the stock itself. If the stock looks to have stabilized at a price you had hedged it to, then the option can be close out, but the decision was based on the stock's price and not the options expirations.

At the end of 6-months, you're going to have an idea if you've "passed the course" or not. If at the end of 6-months, the bottom line of your $3,000.00 account is anywhere close to break- even, and the stock you bought at $25.00 is $25.00 or lower, then you've got a passing grade and have probably LEARNED how to trade options profitably. If your account value is ABOVE $3,000.00, the you've graduated at the top of the class! However, if you're account is down more than $500.00 at the end of 6-months, then keep educating yourself and keep learning! Don't give up! NEVER give up! But make the decision yourself if its worth adding another $500.00 to the account to keep learning.

Here's a novel idea for even more experienced options traders. When you look at a stock's chart and begin to contemplate a call or put option on a stock, try putting yourself in the shoes of a trader that owns 100 shares of that stock (for put option buyer) or is short 100 shares of stock (for call option buyers, either at the level it is trading at right now, or a level just before the put option SHOULD have been bought to have provided the ULTIMATE protection from the hedge.

Let's face it, if a stock looks like its already made a substantial move from an IDEAL action point, then this observation could influence just how much money you expose to the trade at a given point.

If you look at a chart and think.... "Ugh! This stock has fallen too far in recent sessions to really have me looking to hedge it at this point," then it may just be that you should either wait for the stock to rally back to the "hedge level", initiate just a partial position in an IN THE MONEY put option (that you could add further to should the stock recover from an oversold level), or just move on to another opportunity.

I'm a strong believer in also knowing or understanding how to trade STOCKS from the short or bearish side. A good way to LEARN how to trade a stock from the short side is to use a CALL option as insurance while you're learning to trade a stock short. Remember, OPTIONS were "invented" as a tool to HEDGE risk. They were not "invented" as a tool for SPECULATION!

I strongly believe in education through books, subscriptions and seminars as there is going to be something that "hits home" with your belief system and can be successfully incorporated into your trading discipline, but the BEST BOOK you'll ever read on stock/options trading is the one YOU end up writing yourself. And to write this book, you're going to need to RISK real capital.

Hopefully the technique of buying 100 shares of a stock that is priced between $20 and $25, and using a put options contract to hedge that positions when deemed necessary will be of use.

As outlined above, the MOST you could lose is a little over $3,000.00, but it the BEST book you'll ever read and learn from on how to trade options. Again, I'm not here to sell books, but here's a link to our bookstore where you can find Tom Dorsey's Point and Figure Charting book.

Jeff Bailey

Please send your questions and suggestions to:
Click here to email Asktheanalyst

This column is an information service only. The information provided herein is not to be construed as an offer to buy or sell securities of any kind. The Ask the Analyst picks are not to be considered a recommendation of any stock or option but an information resource to aid the investor in making an informed decision regarding trading in options. It is possible at this or some subsequent date, the editor and staff of The Option Investor Newsletter may own, buy or sell securities presented. All investors should consult a qualified professional before trading in any security. The information provided has been obtained from sources deemed reliable, but is not guaranteed as to its accuracy.


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