Swing Trading Options

A Complete Swing Trading Option Strategy by Stephen Jeske

The Meatball Effect – A Complete Swing Trading Options Strategy, by Stephen Jeske  2010 Stephen Jeske

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Table of Contents Sharing Is Good!........................................................................................................................................3 Learn To Swing Trade Options..................................................................................................................4 Trading Options With The Meatball Effect................................................................................................5 Stages In The Stock Market.......................................................................................................................6 Stock Trends...............................................................................................................................................8 How To Use Moving Averages................................................................................................................10 How To Find Support And Resistance On A Chart..................................................................................12 Trading Extremes And Reversals.............................................................................................................14 Options Are The Secret Sauce..................................................................................................................16 What We’ve Learned So Far....................................................................................................................18 Trading Strategy – Timing The Market....................................................................................................19 Trading Strategy – Scanning For Stocks..................................................................................................21 Trading Strategy – The Action Zone........................................................................................................22 Trading Strategy – Pullbacks...................................................................................................................23 Trading Strategy – ADX Indicator...........................................................................................................24 Trading Strategy – Stock Scanning Code................................................................................................26 Trading Strategy – Support and Resistance.............................................................................................28 Trading Strategy – Relative Strength And Weakness..............................................................................29 Trading Strategy – Earnings.....................................................................................................................30 Swing Trading Options Quick Reference................................................................................................31 Constructing An Option Position.............................................................................................................32 You Can’t Win If You Don’t Play............................................................................................................36 Swing Trading Option Resources............................................................................................................38



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Learn To Swing Trade Options In this site you will learn a strategy to swing trade options that will put you on the path to success. If you’re new to trading stocks and options, don’t worry. This site was created for you. But learning to swing trade stock options can be challenging without some prerequisite knowledge. Most traders fail and lose practically all their money within the first year. That happens because they: • • •

Lack the right knowledge. Do not have a plan. Do not have the discipline to follow a plan.

The last point can be particularly difficult for some traders. It’s specially hard to be consistent when you’re suffering a loss! It’s at these times that we are the most vulnerable. You’ve got a good chance at avoiding this fate if you read through the information on this site, develop a plan, and have the discipline to follow it. Ultimately, you will succeed where others have failed. But before we get too far…

What is Swing Trading Swing trading is a style of trading that attempts to capture and profit from short term moves in the market. In our particular case, we’re usually looking to hold a position for 10 to 20 trading days. This time frame is great for those who have a job and simply cannot “day trade”… and it’s a lot less stressful! Swing traders don’t care about the fundamentals of the company, what products they sell, or even what their name is! There are only two things that are of concern: • •

Is the money flowing into the stock, or is it flowing out? How can I structure an option position to profit from this viewpoint

That second point is unique to option traders. Stock traders have no choice, they either buy the stock if they expect it to go up, or sell it if they expect it to go down. But we have more choices.

Using Options In Swing Trading I like trading options. I like them even better when used in swing trading. Here’s why: • • •

Options make efficient use of trading capital. I can control how much capital I have at risk. I can structure my trades so that I can make money even if the stock goes nowhere.

If you’re just trading stocks, you’ve got to pick the right direction in order to make money. In order to make good money, you’ve got to consistently find stocks that make explosive moves in the right direction. Trading options gives us a lot more leeway to be wrong. Generally I like to structure my option trades so that I make money whether the stock goes up sideways, or even a little down. Later on you’ll learn how to structure option trades for the stocks that meet our criteria. In the next post, we’ll explore the stages that every stock (and the market in general) go through.



Trading Options With The Meatball Effect So… you’re probably wondering. What is the meatball effect? Is it some kind of marketing hype? No. I don’t think so. I’m an option trader, not a marketing guru. Is it a code name for some top secret stock market research? That’s classified information. I could tell you, but then I’d have to kill you! Seriously though… here’s the true story behind the meatball effect. You see, I like to cook… But sometimes I don’t… and sometimes I don’t have the time. Anyone with four kids will know exactly what I’m talking about! Anyway… one day I’m in my local grocery store picking up ingredients to make some meatballs. As I’m getting the stuff together, I notice there’s some meatballs already made. I realized that for the same price as the ingredients alone, I could buy them fully cooked. Same thing, same price, but I didn’t need to make them myself. Then it hit me. Why couldn’t I do the same thing with my option trading strategy? I could put together a complete report with everything needed to execute the strategy. Anyone that wanted could get the same software that I have, and use the information in here to generate their own trading candidates. Kind of like open source software. Or… for about the same cost of subscribing to the software and services, they could get those option trading candidates already pre-screened and delivered to their email inbox. Same thing, same price, but they wouldn’t need to do the work themselves. Thus, The Meatball Effect was born. A complete swing trading option trading strategy that you can use. All the details are included. If you like it, please by all means use it. If you like it, but don’t have the time to generate your own option trading candidates, then try my service. It costs about the same as getting a subscription to all the software that I use. You’ll get the same candidates, but you don’t need to do all the work. And right now it’s free! If this strategy is so good why don’t you charge for it? Yes, I know there are people out there selling trading systems for hundreds (even thousands) of dollars. But that’s just not my style. There are also a lot of people selling “black box subscription services”, where you never know how they come up with their trades. Again, I’m not one of them. If after reading this information, you like what you hear, but don’t have the time to generate your own trading ideas, I can help. But before we get to the end, let’s start at the beginning.



Stages In The Stock Market Every market and each stock goes through four stages. It’s important to have an appreciation of these stages, in order to trade successfully. Stocks don’t go straight up forever and they don’t go straight down either (well in most cases). These stages occur in all times frames, from intraday to daily to weekly to monthly. The First Stage This stage occurs after a prolonged down trend. The stock bottoms out and is starting to trade sideways, forming a base. Prior to this point it was the sellers who were in control, driving down the price. Now the buyers are slowly starting to gain more of an upper hand. The stock drifts sideways without a clear trend as buyers and sellers battle it out. This stock is no one’s favorite. The Second Stage This stage occurs after the stock has broken out of its trading range. Usually no one believes in the rally, as the stock remains out of favor. Everyone and their brother can find a reason to avoid the stock. Whether it’s bad fundamentals or poor outlook, everyone has a reason why the stock is doomed to fail. Everyone except the professional trader. They are the ones quietly accumulating the shares and getting ready to dump them off to those getting in late. The Third Stage This is the “blow off” where “Joe six pack”, the novice trader gets in. Your average Joe is getting all excited over the stock and is buying into what the professional traders are selling. The stock may go up a little more from this point, but very quickly settles into a state of equilibrium. It’s stuck in a trading range again, getting set up for the last and final stage. The Fourth Stage This is the “kiss of death” for poor old Joe. The fundamentals of the company look good. He and all the talking heads have high hopes for the stock. Everyone thinks the downtrend is merely a correction in what is sure to be a resuming uptrend. The more adventurous traders may even “average down”. The rest just hold and hope that it will go back up, and soon! They probably bought at the end of the second stage or during the third stage. Eventually they’ll “cry uncle” and sell out at the end of the stage one, after they’ve gotten tired of watching the stock deteriorate. It is a sorry sight indeed!



The following example should help to illustrate:

Generally in the first and third stage, where there is no discernible trend, you want to have a neutral position. In the second stage you want to be “long” while in the fourth stage you want to be “short”.



Stock Trends A stock doesn’t need to move in any direction in order to make money, if you’re trading options. BUT, that doesn’t mean you should ignore the trend. Stock trends can be a very powerful force. It’s always better to be on the right side of a trend, than on the wrong one. We talked briefly about trends in the second and fourth stages our previous post. In stage two, there’s an uptrend that is characterized by higher highs and higher lows. Here’s an example:

In stage four, there’s a downtrend that is formed by lower highs and lower lows. It looks like this:

Lastly there’s the trading range, where stocks seem to spend most of there time. Here there does not appear to be any higher highs or higher lows, or lower highs or lower lows. The stock just seems to be thrashing around.



This is generally what it looks like:

You’ll notice that when a stock is in a strong trend (whether up or down), there are always short lived pullbacks, before the stock resumes its trend. These pullbacks serve as excellent entry points to establish a position . As an option trader we can structure our position to increase the odds of a profitable trade. Now all of this may seem obvious in hindsight. But how do we tell what is happening now… in the present? For that we’ll turn to a simple technical tool called the moving average. We’ll explore that in the next post.



How To Use Moving Averages Hindsight is a wonderful thing isn’t it? Every chart we’ve seen so far as done a wonderful job illustrating what has happened. But as you know, we don’t live in the past, we live in the present. So, how do we know what’s going on right now? That’s where moving averages come in. They help us first to determine the trend and second to realize when it has changed. A moving average is simply the average price of a stock over time. It’s amazing the lengths some traders will go, trying to make a rather simple indicator very complicated. Some will keep adjusting the period of the line based on price movement, or they’ll tweek it in some other manner based on hindsight. In the end they’re just trying to get the indicator to be an accurate predictor. Personally, I prefer to keep it simple. I don’t use the moving average indicator as a way to predict the future. I use it as an aid to understanding what trend may be evolving. In my trading I use two moving averages: the 10 day simple moving average (SMA) and the 30 day exponential moving average (EMA). The EMA is slightly different from the (SMA) in that the more recent prices have a greater impact on the shape of the line. There’s nothing magical about the two values of 10 and 30. It’s just that they are appropriate based on the length of time I usually hold my trades (10 to 20 trading days). And everybody likes round numbers. I use two moving averages (also known as a dual moving average system) because when the fast one (10 day SMA) moves over the slower one (30 day EMA) it often signals a change in trend. Lets take a look:

Here it’s obvious where the trend begins. When the 10 day SMA is above the 30 day EMA the trend is up. When the 10 day SMA is below the 30 day EMA the trend is down. Focus on long positions when the 10 day SMA is above the 30 day EMA. The reverse applies when the 10 day SMA is below the 30 day EMA. Make sure both averages are sloping upward and that there is plenty of space between both moving average lines.



Keep in mind, life is not perfect. There’s no guarantee that a trend will develop when the faster moving average crosses above the slower moving one. Take a look at this:

In this case the 10 and 30 day moving average crossover hasn’t helped in determining a trend. In this chart I’ve added a third moving average (a 200 day EMA) shown by the green line. I’ve included this to illustrate an important point. The 200 day EMA represents the longer term trend of this stock. Notice how flat it is? When the 200 day EMA is flatlining, there’s no point in getting excited on a 10 day/30 day crossover. The odds just aren’t in your favor of a trend developing. One other interesting thing about moving averages is that prices tend to reverse around this point. This is particularly true around the area of the 50 and 200 day moving averages. Most likely it’s due to the fact that these two averages are the most widely followed. The area around these moving averages forms a zone of support and/or resistance. These two concepts are something we’ll get into in the next post.



How To Find Support And Resistance On A Chart We all know that a stock can’t go up forever. It also can’t go down forever either (in most cases). This is where support and resistance come in. Support and resistance refer to areas of demand and supply on a chart. When there is a large demand for a stock, the buyers outnumber the sellers, causing the stock to go up. We see these places on a stock chart as areas of support. On the other hand, a large supply of stock will overwhelm the buyers, causing the price to go down. We see these places on a stock chart as areas of resistance. There are many theories of why these areas of support and resistance occur. We’re not here to ponder why it happens. Just realize that they do occur… and in a minute we will look at some examples. There are traders who take advantage of the tendency for prices to reverse in these areas of support and resistance. There are others who count on these areas of support and resistance to fail, they trade the breakouts. Personally I’m in the first camp, the one that buys at support and sells at resistance. It’s also important to realize that the more times an area of support (or resistance) is hit, the more signifcant it becomes. Naturally, these support and resistance areas are eventually taken out. Otherwise the stock would never go anywhere at all. Let’s take a look at something more concrete:

During these months in 2008 UPS stock found support around the $66 mark. Everytime it came



down around that area, it got stopped in its tracks and reversed backup. UPS stock also ran into resistance around the $70 mark during this same time period. Every time it ran up to this area, it turned around and ran back down. Take a look at the 200 day EMA (the green line) and notice how it’s going nowhere. Note that when we talk about support and resistance we use words like “around” and “area”. That’s because there is never a precise value for these places of support and resistance. Also recognize that these areas don’t hold forever. Look what happened in mid-June. When UPS entered the area of support, it broke through it and never looked back! That’s where proper risk management comes in, it will save your skin in times like these. Here’s an example from last year of the stock AAPL (otherwise known as APPLE). I’ve highlighted some areas of support.

Notice the 200 day EMA (green line) is on a smooth ascending path. This stock is trending up, and it has to take a breath every once in a while. There’s no point in selling when it pauses for a bit and runs into some support. In fact it’s just the opposite… it’s a great time to be a buyer! Keep in mind that it’s not unusual for a stock to go through periods of extreme price movement, followed by a reversal. In fact, that’s what we’ll discuss next.



Trading Extremes And Reversals Stocks don’t move in a linear fashion. It’s just another way of saying that they don’t go straight up or down. Rather they undergo extremes and reversals; there’s always a lot of back filling going on. Some traders like to trade stocks on breakouts while others, like myself, focus on trading the pullbacks. Buying on weakness and selling on strength is what trading pullbacks is all about. Stocks that are in uptrends will eventually pull back, and this offers an excellent entry point to establish a position. As a swing trader that uses options, you need to wait for these opportunities to occur. Why? Because we want to put the odds in our favour. It’s better to go long a stock after a wave of selling has occurred and the stock has stabilized. Your less likely to get caught in another panic wave of selling. Similarly, it’s better to short a stock after a buying wave has occurred and the stock has settled down. Why? Because you’re less likely to get caught in a “melt-up”. Everybody (in the short term) that wants the stock has already bought in. There’s no one left to get excited about it. So, we want to buy pullbacks and short rallies. But how do we define these so that we have something more concrete? Generalities are fine when we’re talking about concepts, but we need something more specific to use in our everyday trading. For that we’ll use our dual moving averages; the 10 day SMA and 30 day EMA. The space in between the 10 day and 30 day averages forms an area that, for our purposes, is a great place to be looking at entering a position. In an uptrend you buy as the stock pulls back into this zone, while in a downtrend you short the stock as it moves up into this area. Let’s look at an example of MMM (3M).

The slope of the 200 day EMA indicates that this stock is in a nice uptrend. I’ve marked the spots where MMM has pulled back into the area between the 10 day and 30 day moving averages. A The Meatball Effect – A Complete Swing Trading Options Strategy, by Stephen Jeske  2010 Stephen Jeske


nice entry point if there ever was one! Now let’s look at an example on the short side. This is a chart of DD (Dupont) from late 2008 to early 2009 where the stock lost over half its value.

Again we can see the many opportunities available to short the stock. It repeatedly rallied back into the area between the 10 day and 30 day moving averages, only to reverse course and continue its downward descent.



Options Are The Secret Sauce It’s tough just trading stocks. You’re either long or short the stock, that’s it. In order to make money, the stock has to move in the right direction. And to make good money it’s got move there fast. Sure, catching hold of a stock that makes an explosive move (in the right direction) is fantastic. It makes for great newsletter advertising and wonderful conversation at parties. But what’s the reality of doing that on a consistent basis? Therein lies the problem. Stocks don’t make those kind of extreme moves on a regular basis. Just think of where the market would be if stocks made 10% gains, even just once a month! Not a very realistic view. The truth is that most of the time stocks just drift along, accompanied by the occasional spike. Usually these spikes occur during earnings periods. You could try to capture these moves by trading only during these times. But the problem is that these spikes occur just as often in the wrong direction. Absolutely frustrating, no doubt! You never know how the market will react to an earnings release. A company can have a great release and the stock still tanks, because investors were expecting better. On the flip side you can have a terrible earnings release and the stock does great, because investors were expecting worse. Yes, it sure is tough trading only stocks… and that’s where options come in to play. Using options we can construct rather simple positions that can profit, whether the stock moves in our direction, sideways, or even against us! We don’t need to find stocks that make explosive moves. In fact we’re not looking for the big movers. We’re looking for stocks that have the potential for simply drifting along in the direction they’ve already been going. That’s all we need to make good money swing trading options. The stock doesn’t need to make huge moves. As long as it stays around the area it’s currently at, we’ll be fine. The following example should help clarify things. It’s a comparison of an option position vs. straight stock ownership for XOM (a component of the Dow Jones). We’re looking strictly at % return over the next 30 days, so we can compare both positions equally.



Take a look at the blue line, it’s the profit and loss line if you owned shares of XOM, and you’re buying them at the current price of $68. What price does XOM have to reach in order for you to make 10% in one month? It needs to hit $74.80. I’ll leave it up to you to decide how often stocks make 10% moves in one month… By the way, how much will you lose if XOM drops to $65? You’ll lose almost 4.5%… ouch! Now look at the pink line. That’s the profit and loss line of our option position. Where does XOM have to be in 30 days in order to make 10%? As long as the stock is at $65 or more, we’ll make our 10%. With the stock trading at $68 we actually have about a 4.5% cushion, before we get hurt. The stock can drop from $68 to $65 and we’ll still make our 10%. Now that’s nice! XOM needs to reach $74.80 with the next month in order to make 10% with our stock only position. But with our options position, XOM just needs to be above $65 in order to make that same 10%. Intuitively, we know that the odds are much better that a month from now XOM will be above $65 versus being at $74.80. After all, it’s already at $68. There is actually a way of determining the probability of these two events happening. But we’ll leave that for another day. The important point to take away is that options can increase the likelihood of a successful trade. That’s why we use them.



What We’ve Learned So Far So let’s summarize everything we’ve talked about so far. • • • • • • •

Over all time frames, the market appears to move through stages of advancement and consolidation. We identify the current trend by using moving averages; the 10 day, 30 day and 200 day. We trade with (not against) the broader market trend. We hold positions generally for around 10 to 20 trading days. We look to establish positions after a stock has pulled back to an area of support. We use options to increase the probability of a successful trade. We don’t need stocks that are poised to make big moves in our direction. We just need ones that can continue drifting along on the same path they’ve been going.

That’s it for the conceptual stuff. Next up, we’ll get into the meaty stuff… the practical part about putting this all together into one complete swing trading option strategy.



Trading Strategy – Timing The Market OK! Let’s get to work. Time to start putting together the pieces into a process we can use in our everyday trading. The first step is to get a feeling for where the market currently is at. Realize that we can’t predict what will happen in the future. We don’t want to fight the market… we want to trade with the market. Remember that a rising tide lifts all boats.

Using Moving Averages To Time The Market For our purposes the market is well represented by looking at the S&P500. So we go over to stockcharts.com and look up this chart:

Here’s a simple guideline when looking at the S&P500 chart. • •

When the 10 day SMA is above the 30 day EMA, focus on finding long positions. When the 10 day SMA is below the 30 day EMA, focus on finding short positions.

That should help keep you on the right side of them market, as it currently exists. In this particular case you would have been focused exclusively on long trades for the last six months. Will this work all the time? No, nothing ever does. But it will help answer what type of trade you should be looking for. Now we just need to figure out when to buy or sell. That’s where Williams %R can help. The Williams %R helps identify when the market has reached a short term extreme and is likely to reverse. The formula for this indicator calculates the close in relation to a range over a defined period of time. We’ll use a 3 day period instead of the default setting of 14 because it’s more appropriate. Remember we’re out to hold these trades for only about 10 to 20 calendar days. To incorporate this indicator you’ll want to use the following guidelines: The Meatball Effect – A Complete Swing Trading Options Strategy, by Stephen Jeske  2010 Stephen Jeske


• •

When the 10 day SMA is above the 30 day EMA look to go long when the Williams %R is less than -80 (oversold) When the 10 day SMA is above the 30 day EMA look to go short when the Williams %R is greater than -20 (overbought)

Now let’s revisit our previous chart… this time we’ll include the Williams %R indicator to help identify short term market extremes.

What we see is that during the entire time frame of this chart, we would have been focused solely on finding long trades(the 10 day SMA is above the 30 day). The blue arrows show times when Williams%R indicated that the market was temporarily oversold. It’s on these days that you would be looking to go long, any trade(s) you had identified. Notice that we wouldn’t be looking for any short trades, since we only want to trade with the overall trend of the market. Also, we would have ignored any time Williams%R gave us an overbought signal. Again, we’re only interested in trading with the trend of the market, and initiating the trade at the most favorable time. It’s only when the 10 day SMA is below the 30 day EMA that we would look for Williams%R overbought signals as entry points for our short positions. Last point… the dual moving averages and the Williams%R are only used as an aid in determining what type of trade to look for, and when to put it on. They’re not used in anyway to manage existing trades.



Trading Strategy – Scanning For Stocks In our previous post we learned to use the S&P500 chart to determine whether to use long or short trades (using dual moving averages) and when to put on these trades (using Williams%R). Now we have to find which stocks we’re going to use for our actual trades. This is where stock scanning software comes in to play. Instead of manually going through a stack of charts trying to uncover a trade, we can let the software do the work for us. By specifying a set of criteria, the software can generate a much, much smaller list of stocks that we can then manually go through. Instead of sifting through few hundred stocks, we can just focus on a couple of dozen. There are many different sources for screening stocks, with monthly costs ranging from a few dollars to a few hundred dollars per month. Personally, I prefer to use stockfetcher since it’s reasonably priced and quite robust. It’s actually quite easy to specify your criteria using natural language. I’ll be using this software for examples in all my posts. The very first thing we need to look for in our stock scans is stocks that are optionable. No matter how good a chart may look, there’s no point if the stock doesn’t have tradeable options! This one criteria alone eliminates over 70% of the candidates. Our second criteria is the stock price. We’re only interested in stocks that are priced over $40. What’s so special about $40 you ask? Two things… one’s important and the other is a pleasant side-effect. Now, $40 is not a magical number. We just need some cut-off point so that we look at only higher priced stocks. We’re looking specifically for these ones because they usually have more available option strikes. Having more strikes is important because it allows greater flexibility when constructing our option position. The side-effect of our focus on higher priced stocks is that we end up with stocks that are less volatile. Generally, the higher the stock price, the less volatile it is… which is great. We don’t want stocks thrashing around all over the place… specially if they thrash in the wrong direction! We want stocks that will drift lazily in our chosen direction. Remember, our option positions are constructed so that we can usually benefit, even if the stock goes nowhere. In fact a quiet stock that goes nowhere is really fine by us! Here’s how the filter looks in StockFetcher:

Those of you with little programming experience take note of the natural language style used in defining criteria. Very nice!



Trading Strategy – The Action Zone So far our stock scan is searching for optionable stocks that are prices over $40. The next part of the scan deals with our 10 day and 30 day dual moving averages. Previously we discussed how that area between the 10 day and 30 day moving averages forms an important area (at least from our perspective). This action zone is an area where we can look for potential reversals. When we’re searching for bullish (or long) trades, we want stocks where the 10 day SMA is above the 30 day EMA. That’s our action zone, and we define it in StockFetcher like this:

The last line and ma(10) is above ema(30) shows only stocks where the 10 day simple moving average is above the 30 day exponential moving average. Remember we’re looking for bullish stocks and our action zone is the area in between the two averages, where the 10 day ema is above the 30 day ema. If we were looking for bearish trades so we could go short a stock, we would reverse the previous line. Instead it would read and ma(10) is below ema(30). In our next post we’ll find out how to make the filter look for stocks that have pulled back into this action zone.



Trading Strategy – Pullbacks Next up in the construction of our stock scanning criteria is specifying the pullback. Remember, we’re looking for stocks that have pulled back into “the zone”. We define this zone as the area between the 10 and 30 day moving averages. This is how it looks in StockFetcher.

The last two lines in our filter specifies that we only want stock prices that are below the 10 day simple moving average and above the 30 day exponential moving average. Here’s one stock out of a few dozen that were found when the filter was run.

Notice that the blue line (10 day moving average) is above the red line (30 day moving average). You can also see that the stock price closed within the space of our action zone (the area in between the moving averages. So far, so good. It’s not unusual for this filter to return a few dozen trading candidates. I prefer to have a reasonable number of stock charts for me to manually review, as opposed to just one or two. I don’t look at this as a completely mechanical procedure (though some might). I still like to use at least some discretion in my trades. The system, and this filter just help form a framework for making those decisions. That’s why I often refer to things as “guidelines” as opposed to “rules”. But we're not finished yet. We still have one more criteria that we can add to our filter.



Trading Strategy – ADX Indicator The last element we need to add to our stock filter has to do with trends. Though our option positions can benefit even if the stock goes sideways, getting on the right side of a trend just adds to our odds of success. The indicator we’ll use to determine if a stock is trending, is called the Average Directional Index (ADX) by J. Welles Wilder. The ADX is used to evaluate the strength of a trend, NOT it’s direction. That’s fine, because we’ve already taken care of that in our previous lines of StockFetcher code. Most charting software plot the Average Directional Index (ADX) along with two other lines; the Positive Directional Indicator (+DI), Negative Directional Indicator (-DI). Take a look at this example:

The ADX indicator is plotted along the bottom of the chart along with +DI (green line) and -DI (red line). For our purposes, we’re only interested in one line… the ADX (black line). We’re happy if the value of this line is anything greater than 20. Values greater than this indicate that a trend is either underway or developing. That’s all we use the ADX for… to get an idea of where the stock is in the trend. Low ADX values indicate a trading range or possibly the start of a trend. Extremely high readings should be treated with caution as it’s quite likely the trend will soon come to an end.



Here’s the last line of code we need to add to our filter. Note that while most charting software uses a default value of 14 for the period, we prefer to use 10.

That’s it. Our filter is complete. In the next post we’ll review each line of code to make sure we know what’s happening. Then we’ll switch it around to find bearish positions, for the times when we want to short stock.



Trading Strategy – Stock Scanning Code With our StockFetcher code complete, let’s first take a minute to review. Then we can turn it into a filter for bearish positions. Show stocks where price is above 40 and optionable and ma(10) is above ema(30) and price is below ma(10) and price is above ema(30) and ADX(10) is above 20 The 1st line Show stocks where price is above 40 and optionable remains the same whether we’re looking for long or short positions. Obviously we want stocks that are “optionable”… because we trade options. The 2nd line and ma(10) is above ema(30) looks for stocks on an uptrend. The 10 day moving average is normally above the 30 day moving average when a stock is trending up. We’ll need to reverse this when we construct our “bearish” filter. The 3rd line and price is below ma(10) and price is above ema(30) looks for stocks that have pulled back into the zone between the two moving averages. We’ll need to reverse this one as well when we construct our “bearish” filter. The 4th line is and ADX(10) is above 20 specifies stocks that have strong trends. Remember that this indicator doesn’t specify which way the trend is occurring. That means we can keep it the same way in our “bearish” filter. That’s it for our bullish filter. Let’s take a look at the bearish one. Show stocks where price is above 40 and optionable and ma(10) is above ema(30) and ma(10) is below ema(30) and price is below ma(10) and price is above ema(30) and price is above ma(10) and price is below ema(30) and ADX(10) is above 20 I’ve crossed out the lines that need to be changed and replaced them with the correct ones. That’s all you need to create either the bullish or bearish filter that we use in stockfetcher. There’s a couple of other things that I like to add to my charts, which you can do too, by inserting the following code: and and and and and

add column separator add column sector add column industry add column separator draw ema(200) on plot close

The first four lines put some additional info at the top of each chart returned… namely the stock’s sector and industry. In another post we’ll talk about how we use that information. The last line The Meatball Effect – A Complete Swing Trading Options Strategy, by Stephen Jeske  2010 Stephen Jeske


plots the 200 day exponential moving average. I like to be able to see that when I look at the charts to get an idea of the longer term trend. This filter (whether bullish or bearish) effectively eliminates over 99% of the stocks in the stockfetcher universe. It’s allows us to focus on the most promising trades, while allowing some room for discretion. Next up will be a look at the other factors we consider when reviewing the stocks that have passed through our filter.



Trading Strategy – Support and Resistance Our filter helps identify stocks that have pulled back with the zone (that area between the 10 day and 30 day moving averages). The next step is to identify the ones that have encountered some support (in the case of bullish stocks) or resistance (in the case of bearish stocks). Why is this important? Because putting on a position where the stock has hit some support/resistance increases the chance that the stock will move in our favor. It’s the old story about catching a falling knife… sure you might succeed once in a while, but you’ll end up losing a finger more often than not! So we only consider taking a position in a stock that has pulled back, AFTER it has stabilized, NOT before. We may not know the future, but usually stocks have to stabilize before they can reverse direction. Stocks don’t usually follow a “V” shape path. They don’t go down, and then immediately turn around just because you bought it. Take a look at the following graph of MCD (McDonalds):

In early January 2010 MCD pulled back into the zone, and kept pulling back until it reached support around $61. But we only know that $61 is the support area after the fact… because it bounced off of that price. We can’t tell ahead of time what the support area will be. We may have an idea based on previous support levels, but it’s only a guess. So we seek to improve our odds by waiting for the support to be confirmed. If the stock doesn’t this test, then we take a look at another candidate. Otherwise it’s on to the next step.



Trading Strategy – Relative Strength And Weakness Relative strength or weakness is the next hurdle that a stock has to pass in order to be considered a trading candidate. There are many different ways of assessing this characteristic of a stock. What I prefer to do is check what sector/industry it’s in (that’s easy because we put some code in our filter to display this). I take a look at the heatmap that’s available in StockFetcher. It looks like this:

You can even drill down to look at the various industries within each sector… quite nice! What I’m looking for in the sector heatmap is a verification of how the stock’s sector is doing. Why is that important? It’s quite simple. I want to make sure that we have the wind behind our back. Remember the saying that a rising tide lifts all boats. If the sector is doing well, chances are that the stock I’m looking at will do well too. I don’t want a stock that’s a shining star in an sector that’s a dud. It’s tough for a stock in that situation to keep up its performance. I’m not even looking for the hottest sectors either, I’m always concerned those are ripe to flame out. Rather I’m looking for something that’s been performing steadily. I just want it to keep drifting along in the right direction. Remember that the opposite applies when you’re looking for bearish positions. You want weak stocks in weak sectors. So how weak is weak and how strong is strong? There is no absolute value as it’s relative to all the other sectors performances. Don’t get hung up on this. Just remember the principle behind why you are doing it. That’s all. Next, we’ll take look at our last criteria… earnings.



Trading Strategy – Earnings If there’s one event that can move a stock… it’s earnings. The problem is you never know how the public will react when the earnings are released. It doesn’t matter how much research you do. It doesn’t matter how accurate your earnings estimate may be. The only thing that matters is the market’s reaction to those earnings. And that is virtually impossible to do.

Don’t trade during earnings. It’s that simple. A company can miss their earnings, yet the stock rallies because investors expected worse. A company can meet or exceed earnings estimates, yet the stock ends up tanking because investors expected better. The results can be quite dramatic. That’s fine if you’re on the right side. But if you’re on the wrong side… watch out!Besides, we don’t need any stock to make an explosive move. So why risk it? If earnings are going to be released before options expiration, then I pass and go on to the next stock. I use earnings.com to check when the release date is for each stock. If they don’t have the upcoming date available yet, then I’ll look at the prior year and use that date. And that’s it… Any stock that makes it past this last hurdle is a trade! Next we’ll investigate how to structure a trade for any stock that meets our criteria.



Swing Trading Options Quick Reference The following quick reference guide for finding swing trading option candidates. It’s a summary of all the steps you need to take to find the right trading candidates:

1. Look at an S&P500 chart to determine the type of trade to look for. BULLISH when the 10 day simple moving average is above the 30 day exponential moving average AND Williams%R (3 period setting) is below -20 (oversold). BEARISH when the 10 day simple moving average is below the 30 day exponential moving average AND Williams%R (3 period setting) is above -80 (overbought).

2. Run the stocks through your filter. In Step 1 you’ll have determined which filter to use; either bullish or bearish. So use that one to generate your list.

3. Examine the filtered results for stocks that have reached support/resistance. If you’re looking for bullish positions, you want stocks that reached some support. Bearish positions require stocks that have reached some resistance.

4. Confirm the stock is in an appropriate sector. Check out the heatmap on StockFetcher. If you’re bullish, make sure the stock is in a sector that’s been performing relatively well over the last few weeks. If you’re bearish, make sure it’s been performing poorly.

5. Check for earnings. Make sure that earnings aren’t going to be released before your option position expires. Not, that we’ll necessarily be holding it that long. It’s just that a stock can get extremely volatile after earnings get released… we don’t want anything that’s going to cause us problems. If there’s a pending earnings release, avoid the stock! So that’s it. Any stock that makes it this far is worth putting on as a trade. Next up, how to structure your option position for the best possible outcome.



Constructing An Option Position Avoid using options with lots of time premium when swing trading. Options provide you with many choices… but not all choices are the best one. Option prices are made up of two components; intrinsic value and extrinsic (time) value. The time value component of an option price is the one that decays with time. If you’re not careful you could end up buying an option whose price moves very little, even if the stock moves a lot. The following option matrix for AAPL shows clearly the dramatic impact as Time Premium decays. Keep in mind that upon expiration all the time premium has gone out of the pricing. If the option expires out of the money (even one penny), then it will expire worthless!

Matrix courtesy of OptionVue

Traders that purchase out of the money options are counting on a big move in order to make a profit. Even if the stock does make a strong move, it’s usually not enough to counter the effects of time decay. Unfortunately, these large moves happen less often than we would like to believe. If a big move happens at all, it’s usually due to an earnings announcement. And then you’re counting on the move to happen in the right direction. Besides, we don’t trade during these times. And even if we did, the options on stocks with an upcoming earnings release are extremely expensive, making it even more difficult to profit. There’s no such thing as a free lunch! The market makers know that the potential is great for extreme price movement during these times. They want to be justly compensated for the risk they take in selling these options. But there are two strategies you can employ to avoid the negative aspects of time premium decay. Let’s take a look at them.

Buy only deep-in-the-money options. Deep-in-the-money options have little time premium and are not greatly affected by the passage of time. Also the delta of these options is much greater than out-of-the-money options. That means that the option price will change at closer to a one-to-one ratio with the stock price.



Take a look at this example:

Matrix courtesy of OptionVue

Though these types of trades are easier to execute and appear easy to manage, you must be careful. Appearances can be deceiving. In traditional swing trading (using only stocks, no options), traders often set a trailing stop (usually about 2%) as a way to limit losses. Using this type technique could result in far greater losses than anticipated, specially if you’re stopped out closer to expiration. We’ll cover this in more detail in another post, just be aware that options require different risk management than stocks.

Use option spreads. This is personally my favorite method for using options in swing trading. An option spread is constructed by buying one option an selling another. This is very useful in negating the effects of time decay. In fact, you can reverse the effect to the point that you actually benefit from the passage time. Here’s an example of a put spread on AAPL:

Option chart courtesy of OptionVue



This position costs around $2,500 to put on. AAPL stock is currently priced at almost 210 and this position will make money as long as in stays above 205.64 at expiration. That means AAPL could even go down $5 and we’d still make money. This spread position yields a maximum of 77% if AAPL stays above 210 at expiration in 37 days. Contrast that with a straight long option position:


This position has a breakeven of 212.47 at expiration in 37 days. In fact AAPL really has to move a long way (up to about 230) for this long call position to make as much as the put spread. Sure it can happen. But more often than not, stocks don’t make really strong moves. In fact, they seem to make those explosive moves at precisely the time when you don’t own them. On the following page is a chart showing both positions, overlaid. The purple one is the long call and the blue one is the put spread. Take note of the pink bar along the bottom that runs from 188 to 234. That represents one standard deviation of stock movement. That’s the range where AAPL is more than likely to be thirty-seven days from now. Over this range (the most likely price movement for AAPL) the blue line (put spread) is more often above the purple one (the long call). It will be more profitable most of the time. There are occasions where I will use just a single option, but in most cases I prefer the use of option spreads.






You Can’t Win If You Don’t Play Risk management is the most important skill any trader can acquire. In the world of trading you can’t play if you blow out your account. So… don’t blow out your account. Or you definitely won’t win!

Don’t risk a lot of capital on any one trade. It seems obvious. But in the heat of the moment, when you’re absolutely positively sure that you’ve found the perfect trade… You know, the one that’s destined to make an explosive move… It’s really tempting to take a chance on such a sure thing. And it’s easy to go overboard, putting a lot more money into the trade than you should. But remember, we’re running a business… NOT gambling. So don’t do it! How much capital should you risk? Generally, from what I’ve read, a lot of traders recommend anywhere from 0.5% to 1% of your capital. Risk 2% and most traders will consider you a gunslinger. Look at it his way, the less you risk on any one trade, the lower the risk of ruin. If you risk 1% of your capital per trade, it will take 100 trades to blow out your account. Risk just 0.5% and it will take you 200 trades. Rule 1. Don’t blow out your account. Rule 2. Always remember the first rule. Note that we’re not talking how much capital is required to put on the trade. We’re talking about how much you should be willing to lose. In the end, the percentage you choose is up to you. What I’ve given are merely guidelines.

Be consistent in how much you risk If you’re going to risk $500 per trade, make sure it always $500 (or close too it). Don’t risk $500 one trade, then $1500 the next. Sure you may get lucky and win on the bigger trades, but on the other hand you might be unlucky. I know that being consistent is easier said than done. But it’s something you need to work at, in order to be successful… consistently. Consistent is the keyword here, have I mentioned that?

Don’t risk more than you can win. We’re always looking at trades over a finite period, because all options expire at some point. Even if your position is simply a long option, there is a limit to how far a stock can move within a month (even if it is theoretically unlimited). With option spreads there is a very real limit (theoretically and actually the same) on what you can make. So we don’t want to risk more than we can earn on the trade. Let’s look at an example where we risk $500 per trade. We’re willing to lose $500 to make $500. Win 60 trades = $30,000. Lose 40 trades = -$20,000. Net result is $10,000 Profit.



Now we’re going to change things a little. This time we’re willing to lose $750 before we close the trade. If we’re ahead by $500 we’ll still close like we did in the previous example. Here’s what it looks like: Win 60 trades = $30,000. Lose 40 trades = -$30,000. Net result is $0 Profit. That’s right. All that hard work and 100 trades later, you’ve made nothing…zilch…nada! You’re win ratio may have gone up a bit (which we didn’t account for) and improved your results. But the point is that the results can be quite dramatic (in a negative sort of way) if you start risking much more on a trade than you can win.



Swing Trading Option Resources We've come to the end of our mini course on swing trading options. I thought I would take a moment just to list all the resources I use in one place. As you can see the list is not long. But it doesn't have to be.

Charting Software: I use Stockcharts.com to look at my timing chart with the 10 day/30 day moving averages and Williams%R. It helps me determine what type of trades to look for (bullish or bearish), and whether it's a good time to establish a position.

Stock Filtering / Scanning. StockFetcher is what I use to scan through hundreds of stocks and come up with a shortlist of only the most promising prospects. I also use it to check if a stock is in a relatively strong/weak sector.

Earnings Check. Since I don't want to be in a trade if there's a pending earnings announcement, I refer to earnings.com to make sure all is good.

Structuring and Managing An Option Position. For this I use OptionVue. I use it to determine my initial position and I refer to it daily when I'm managing my trade.

Trading Platform. Over the years I've used a number of brokerages, but Interactive Brokers ranks as my favorite. If you can use a spreadsheet, you can use their trading platform. Great execution, great prices and great support... that's been my experience anyway.

Last But Not Least. Take a look at themeatballeffect.com where you'll get trade ideas and much more, always fresh! Thanks for taking the time to read this ebook.



Swing Trading Options

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