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# WEEK 10A - FINAL by Awumsuri

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```									Money Management
• Kelly System • Back in the early 50’s Bell Labs needed a formula to determine the optimum usage of lines in a telephone cable • J.L. Kelly published his findings in a technical journal in 1956 on information theory • Somehow his findings ended up in the gambling community, since most Big Casinos do employ mathematicians to calculate odds

Money Management
• When Kelly’s analysis were applied to gambling, this money management system became known as the Kelly System. • It has since been adapted to the stock market as a money management system as well • The system assumes you are going to bet a fixed percentage of your bankroll on each item and; • If you are making money, your bets will grow in size as your bankroll does. • If you hit a bad streak and are losing the Kelly System automatically reduces your actual bet size as your bankroll decreases.

Here is the original Kelly Formula in its simplest form
• Amount of bet = (W + L) x p – L • Where W= amount you could win • L = amount you could lose. • p = probability of winning • Example: You risk (1) unit and pay a 10% “commission”. • The amount would would win (W) would be 1.0 and the amount you could lose (L) would be 1.1 • The \$0.10 is the 10 percent commission

The Formula would look like this
• Amount of bet = (W + L) x p – L • Amount of bet = (1.0 + 1.1) x p – 1.1 • Amount of bet = 2.1p – 1.1
• So in order to complete the equation you just need to plug in your probability of picking winners • So if you could pick 60% winners. • You would plug in 0.60 for the variable p

Original Kelly System
• • • • • • Amount of bet = (W + L) x p – L Amount of bet = (1.0 + 1.1) x p – 1.1 Amount of bet = 2.1p – 1.1 Amount of bet = 2.1(.60) – 1.1 Amount of bet = 1.26 – 1.10 Amount of bet = .16 = 16%

The Kelly System also tells you that if you pick only 52% that you may need to find a new strategy or a change professions

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Amount of bet = (W + L) x p – L Amount of bet = (1.0 + 1.1) x p – 1.1 Amount of bet = 2.1p – 1.1 Amount of bet = 2.1(.52) – 1.1 Amount of bet = 1.09 – 1.10 Amount of bet = - (.01) = -1%

• The Kelly System formula can’t be directly applied to the stock market because results are more complicated. • Unlike Gambling, which produces a win/loss or either or scenario. The stock market is not a complete loss or 100% profit as in a Casino. • Therefore the Kelly System had to be adapted somewhat to use for the Stock Market. • We not only have to gauge the probability of having a winning trade but, • We also have to take into consideration how big the wins or losses are. • In other words, we have to factor the average return into the Kelly formula.

Kelly Formula becomes
• Amount to risk = ((r + 1) x p – 1 • r
• Where p = Probability of winning and • Where r = average win/average loss • Under this strategy ( where the average win and loss are computed, assuming an equal investment in each trade. • ( assuming an equal investment in each trade.) • R is also the average rate of return on a trade for whatever system you are using

• Suppose you have historical results of a trading system and know that is has produced 35 winners and 4 losers ( 44% winners ) • In addition we know that the average winning trade produced a profit of \$1,000 • And a losing trade lost \$500. • This is all the information we need in order to use the Adjusted Kelly Formula

• p = 44 % • r = 2 = (\$1000/\$500) =2

• Amount to risk = ((r + 1) x p – 1 • r • Amount to risk = ((2 +1) x 0.44 – 1) • 2 • =0.16 or 16% of your total funds should be invested when using this strategy

Kelly Formula
• With that information it allows us to increase the size or your trades when the account is increasing and, • Forces us to cut back on the size of our trades when we are losing. • However the system still has some problems in regards to stock/option trading

Kelly Formula
• Assumption you are trading the system one trade at a time. • However most traders are trading several things or making several trades at a time. • You might have 2 or more credit spreads or long put or call purchases. • And what happens if you have 6 or more positions to put on at one time and the system is telling you to invest 20% per trade

Solution
• • • • 1.You could margin? 2. Better solution = use risk adjusted Kelly Method EXAMPLE: Suppose that we computed the Kelly criteria, and they say to invest 20 percent of our capital in each trade. • Then incorporating the risk adjusted method trading the following amount of capital would be invested in each trade ( see next slide)

Thus if Kelly criteria say to invest 20 percent, then the first trade would consume 20 percent of our whole equity. That would leave 80% of our equity to be invested. The next trade then would be 20 percent of the available equity – or 20% or 80 percent ( 16%) of the entire account and as follows:

Kelly Formula
• The problem that exist is that the first trade is bigger than the rest. • However, it is the only way to guarantee that you don’t over invest and still adhere to the Kelly criteria • In addition, this scales back the chances of overtrading any system • This risk adjusted system will even allow you to combine different strategies ( which would have different Kelly percentages

Kelly Formula
• In summary: • The Kelly criteria can be coupled with the risk-adjusted method to produce a useful and impartial way to help you manage your money as you establish each new position.

Major Market Theories
• Two traditional approaches to market prediction: • 1. Fundamental Analysis • 2. Technical Analysis
• And an additional approach which needs to be considered, no matter which of the above approaches one’s prefers

• 3. Market Sentiment ( Sentiment Analysis)

Fundamental Analysis
• Benjamin Graham and David Dodd, co-authored the book, “Security Analysis” in 1934. • Fundamental Analysis uses such factors as: 1. financial ratios • 2. Earnings • 3. Dividends • 4. Projections of the economic environment to forecast stock prices.

Fundamental Analysis
• However, due to longer holding periods of fundamentalists, option players cannot rely solely on this type of financial data. • However some of the fundamental indicators we believe are useful for option players to determine the direction of short-term to intermediate trends are as follows:

Fundamental Analysis
• 1. Earnings momentum and negative earnings surprises. • 2. Corporate restructuring • 3. New product and product recalls • 4. New CEOs • 5. Stock buybacks

1. EARNINGS MONMENTUM
• Research has shown earnings growth is the single most important indicator of a stock’s potential to make a big move in price. • Most institutions buy stocks that exceed earnings and short stocks the fall short. • The magnitude of a stock’s quarterly earnings surprise can be a short term catalyst for the equity’s performance. • The bigger the positive surprise relative to analyst’s consensus earnings estimate, the more likely an up trend will ensue. • Positive market reactions to other fundamental developments can also boost the shares in the short run • They reactions are important as it serves as a “driving force”for future performance, as a story that gets investors excited about the stock’s future.

Example of positive earnings momentum teen-retailer URBAN OUTFITTERS. SYM (URBN) The Company has over a 400% run from July 2003 – November This is the kind of trend the options players are looking for when they are looking for a bullishly trending equity • WHY? A primary reason is that the company had consistently beaten Wall street earnings estimates. • In fact, the five quarters prior to November 2004, URBN exceeded Wall street estimates by an average of 15%. • In addition, company earnings grew by 82%

Example: Slowing or negative growths can benefit option players. SYM (QLGC) Steep sell off from November 2003 –August of 2004
• Why? Earnings growth was not as strong as in the past. First dose of poor earnings news came on January 15, 2004 when QLGC reported slowing 3rd quarter earnings. On March 30 the electronic storage vendor lowered 4th quarter earnings an revenue guidance numbers to the low end. An option buyer who purchased puts after either of these events would have been well rewarded as the shares gapped lower following each announcement and fell from around 50 to the mid 20’s

2. Corporate Restructuring
• Option players can benefit from corporate restructuring. Let’s look at a restructuring

Summer of 2004, Robert Mondavi

SYM: (MOND)
realized it needed to make changes in its wine operations as earnings were slowing and shares were lackluster.
• • • On August 23, they did just that. 1. Announced they were eliminating their class B shares and splitting the company’s business lines into two parts. 2. The company’s wine list would have two units – one focused on bottles selling for less than \$15 and the second, for selling expensive bottles. 3. Eliminating the Class B shares excited the street since it reduced the family controlled companies voting stock from 85% to 40%. 4. Analyst saw the splitting of the companies wine list into two lines as an Attractive “Take over “candidate 5. Two months later the company stock jumped 30% in 1 day after Constellation Brands announced it was going to buy MOND for \$1.3 billion. 6. If you check the chart you will see option players had plenty of time to get on board for this play

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3. New CEOs
• Changes in direction an structuring are usually driven by the CEO • A new CEO can bring about changes that make a huge impact on a stock’s price action. • In December 2002, McDonald’s (MCD) announced that James R. Cantalupo had replaced Jack M. Greenberg as CEO. • Cantalupo ha been with the company 20 years, working his way up to International Division Chief before taking over as CEO. • CEO position usually is NOT a significant event, but in this case it was

McDonalds: SYM:MCD
• • MCD shares ha performed poorly while Greenberg was running the show. Cantalupo began fixing problems with McDonald’s restaurants first, instead of worrying about companies that MCD had acquired over time ( including Donatos Pizza, Boston Market, and Chipotle Mexican Grill.) He also worked to improve MCD’s tarnished imagine by offering healthier foods. Once again, astute option players ha an opportunity fo benefit from the CEO change It took about three months for the stock to build a base, but then it took off Those looking for a turnaround play based on a new CEO could have used longer term options of LEAPS to reap the benefits of the stock’s rally

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3. New CEOs
• 2nd Example: BEBE

4. NEW PRODUCTS and PRODUCT RECALLS
• • • I need say no more then IPOD and you have one of the best examples of how a new product line can rive share price. In early January 2004, AAPL released this newer, extremely popular version of the already hot-selling IPOD brand. As the year progressed , sales soared for both AAPL and iTunes ( which allowed music to be downloaded from the internet for as little as \$0.99 a tune. AAPL sold more than 2,000,000 IPODS in the fiscal fourth quarter that ended September 25, 2004. In addition Itunes accounted fo 27% of AAPL’s \$2.35 billion in sales in that quarter compared with just 8% in 2003. Add the IPOD’s mini introduction in January of 2004 thru November 2004 and AAPL’s shares more than tripled in price to a four year high.

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4. NEW PRODUCTS and PRODUCT RECALLS
• The introduction of the IPOD mini was one of the most successful product launches in recent history, an AAPL shareholers an call buyers were the primary beneficiaries of the rally

4. NEW PRODUCTS and PRODUCT RECALLS
• However, unexpected recalls of popular products can have the same effect to the downside. • Merck’s unexpected recall of its poplular arthritis drug Vioxx in 2005 due to the increased risk of heart attacks and strokes, shows how the impact from a product recall can affect the share price

Merck: SYM: MRK
• Vioxx was one of MRK’s top selling drugs, with sales of more then \$2.5 billion in 2003 Accounting for more than 10% of total revenue. Because of the recall, MRK lowered its 2004 earnings by 50-60 cents per share, from previous estimates of \$3.11 per share. On September 30, 2004, the shares plunged nearly 27% to a new eightyear low after news of the recall was released. Even after analyst tried to defend the stock after the drop, the stock continued to fall another 20 % over the next six weeks

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• According to Graham and Dood, “Security analysis”. • “ A company which buys an sells its stock advantageously, thereby increasing both the book value and per share of the remaining shareholders and, in particular, the earnings per share, has an attraction that goes beyond the basic earning power” • In otherwords, a company that is willing to repurchase its outstanding shares through a stock buyback plan can change investor perceptions about the company. • The size of the buyback usually determines how far perceptions among analysts an the investing world will change ( 6% buyback, investors take notice)( 10% buyback or more is often a strong “Buy” signal

• However, there is more than one way to view a buyback. • Some view it “negatively” • Skeptics believe the company has no better strategy so use excess cash. • Why not put the money to better use like “capital expenditures, or research and development” • The Key CAVEAT is to take note of the percentage of outstanding shares being purchased rather than the absolute dollar amount

Raven Industries
SYM: (RAVN) A buyback program that had a positive effect on the stock price. The diversified operations bought back 11.8 million shares of its stock over seven years prior to November 2004, this was signicant buy back • Figure shows how investors could have benefited from the slow steady advance in the shares over the years, thanks to the continued share buyback

TECHNICAL ANALYSIS
• The founding fathers of technical analysis are Robert D. Edwards and John Magee, who first published Technical Analysis of Stock Trends in 1948. • Technical analysis focuses on historical price patterns and volume characteristics to predict future price movement. • This form usually takes the form of various charts that track a stock’s movements to discern a pattern or trend that allows a technical analyst to determine how the stock will likely behave in the future.

TECHNICAL ANALYSIS
• Strong (weak) fundamental and technicals are usually a necessary condition for a stock to move higher (lower). • However, we believe looking at the fundamentals and technicals alone are not sufficient to effectively determine the direction, speed, and magnitude of stock’s move. • We will look at some of the technical tools we find that are most useful in analysis of stocks used for option trading. • In no way are these all the available technical tools available, but they are the most commonly used

TECHNICAL ANALYSIS
• • • • • • • 1. Moving Averages 2. Oscillators 3. Relative Strength 4. Support and Resistance 5. Fibonacci Numbers and Price Retracements 6. Half-Highs and Double Lows 7. Volatility Bands

1. Moving Averages
• Moving averages are among the most popular technical indicators technicians follow. • Not only do they graphically demonstrate the directional trend of the stock and • They also tend to indicate support and resistance levels • You examine moving averages using monthly, weekly, daily and intra-day charts, depending on the time frame we are trading. • CAVEAT: It is important to match the appropriate moving average with the expected holding period for an option trade.

1. Moving Averages
• Example: • A one month time frame will rely on the daily and weekly moving averages • While LEAP trades generally emerge from the weekly and monthly charts • The tendency of the technicians are to focus on the 10-unit and 20-unit simple moving averages on each chart. • When looking at charts you look at the longer-term trend and work your way back to shorter-term moving averages. • This gives a more complete picture of a stock’s movement

1. Moving Averages
• A simple moving average is a series of points calculated by averaging a specific number of a stock’s most recent closes on a bar chart. • For example, a stock that closes at 20, 21 and 22 over three days has a three day moving average of 21. • These points are updated for each bar, creating a smooth representation of a stock’s performance. • Weekly and monthly moving averages are based on a stock’s weekly and monthly closing prices. • As mentioned technicians tend to 10 and 20 unit moving averages however • There are indices and stocks that respect even longer-term trendlines that can extend to 40,80 and even 160 units

1. Moving Averages
• The figure in 6.10 is an example of a
10 month moving average, which represents the average monthly closes over the most recent 10 months. With approximately 20 trading days in each month, this is approximately the same as a 200 ay or 40 week moving average ( although they are not identical ) Note that in late 2002 through 2004 eBay (EBAY) was in a uptrend that received very strong support from its 10-month moving average. Consolidation (November 2003) or pullbacks (July 2004) to this trendline would have represented excellent entry points for bullish option trades.

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2. Oscillators
• Technical indicators that give readings within a pre-defined range are called oscillators. • They tend to work well in trading-range periods. • Traders should be aware that trading-range periods can quickly become trending periods and vice versa • This makes what appeared to be useful tools at one point in time, useless at a future point in time.

2. Oscillators
• An example of an oscillator is Welles Wilder’s Relative Strength Index (RSI) • It is a formula comparing upward and downward moves and gives readings between 1 and 100. • A high reading is defined as “Overbought” • A low reading is defined as “Oversold” • The reason oscillators such as RSI work well in trading range environments is that: • 1. Overbought situations are more likely to reverse lower and oversold conditions are more apt to reverse higher

2. Oscillators
• CAVEAT: If there is an underlying
trend, oscillators that fight that trend will often be overpowered, making their signals useful only if they so with the trend. Look at the Wal-Mart Stores – WMT that showed good predictability utilizing RSI. 1. Arrow 1 shows the perfect time to buy WMT moving from 51.25 – 59.88 where it become “overbought” (arrow 2) This presented an opportunity to short WMT shares. CAVEAT: Remember all signals will not hold true on every occasion. In addition arrow 3 & 4 also presented favorable opportunities to buy the stock

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3. Relative Strength
• The traditional focus of the relative strength indicator ( not to be confused with RSI ) is the comparison of a stock to an underlying index such as the S&P 500 Index (SPX) creating a single line showing relative performance • The comparison usually involves a key stock vs. the entire market, a sector or another stock. • We think of relative strength like a funnel of money flows. • As the the is outperforming the the SPX, for exmaple money is flowing more heavily toward the equity than toward the broader market

3. Relative Strength
• The contrary side, a stock under performing in a down market is experiencing money outflows at a faster rate than the broader market. • Examine RIMM vs. the SPXX. • The better a stock is performing vs. the index, the stronger the relative strength

• (* see chart)

4. Support and Resistance
• One of the most basic concepts in technical analysis is that of support and resistance. • Key points below the current price can act as support • While key points above the current price may offer resistance.

4. Support and Resistance
• For example if a stock falls to a level where enough buyers find it worth wile to enter ( and a few potential seller care to exit), the stock will reverse higher, marking a point of support. Trend lines extending out from important peaks and valleys can also act as support and resistance Example: an up trend with an ascending trend line, buying opportunities arise when an up trending equity pulls back to its ascending trend line. On the other hand, look to short a downtrending stock (better yet, buy a put) when it rallies to meet a descinding trendline

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4. Support and Resistance
• Option activity can also play a role in support and resistance levels at round number strike prices, especially with strike prices that have large put and call open interest.

5. Fibonacci Numbers and Price Retracements
• Leonaro Fibonacci, a mathematician born around 1170, discovered a relationship between a sequence of numbers that now bears his name. • The Fibonacci number sequence is a series of numbers beginning with 1 in which each successive number is the sum of the two previous numbers: • EXAMPLE:

• 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, etc.

5. Fibonacci Numbers and Price Retracements
• What is unique about the sequence is that any given number ( after the first very few numbers ) is approximately equal to 1.618 times the preceding number and approximately 0.618 times the following number. Within technical analysis, the Fibonacci number sequence is used to gauge price and time movements, although it is usually applied to price movement. The most commonly used numbers in this form of retracement are 38.2 %, 50 % and 61.8%. After a significant move up or own, prices will often retrace a portion of this original move.

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6. Half-Highs and Double-Lows
• Other price retracement levels that may serve as important areas of technical support and resistance are the equities half high and double low price level. • Example: • Half of the SPX’s all time high of 1,553 is 776. ( as seen in figure The July and October 2002 lows of 775 an 768, respectively were at or near this half-high level

7. Volatility Bands
• Volatility Bands (VB) to identify an equity’s momentum. • The bands are based on a short term moving average, and the stock’s intra-day highs and lows are used to create upper and lower bands

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