YGGDRASIL

Trading the NDX - How the Little Guys become Big Guys

10/14/00

Lets first review the vehicles available to you as a beginning trader, and then we will review the methodology that allows you to trade profitably with a minimum of time required during the day, and a minimum of interference with your work.

Trading Vehicles

Less than $500 - A QQQ call or put contract (NDX/40)

Let us suppose that you have very limited resources and you open a $500 account with Ameritrade, E-trade or one of the other discounters. Make sure you get approval for option purchases, as there is little else you can buy for $500. You will also need internet access during the day, although you will not necessarily need internet access to your account for trading. A phone call is just as fast. Check to see that the same low commission is charged.

Before you trade, you will need to access Yahoo Finance. Type in QQQ to the left of the "get quotes" button and then select "options" in the pull down menu to the right of that button. Scroll down to the long list of QQQ options with ticker symbols, bid and asked quotes and, most important, open interest. You always want to trade a contract with high open interest, since that will be the most liquid with the smallest spread between the bid and the ask. If a contract has high open interest, your limit order is likely to be filled in between the posted bid and asked prices. Buy one with low open interest and you will have to use a market order to buy or sell it, and you will always be faced with a huge and unfavorable dealer spread in fast markets. Generally, you will get the largest percentage return by buying a strike price slightly above the current price, in the case of a call, and slightly below the current price, in the case of a put.

Less than $1200 - CBOE mini NDX contract (NDX/10)

This contract is four times as large as the QQQ contract and roughly four times the price. Exercise of "in the money" contracts is in cash rather than in QQQ stock, and is automatic at most brokerages. This means that you must sell QQQ options before expiration unless you have enough money in your account to have the contract or contracts exercised on margin. With the CBOE mini, there is no practical requirement to trade it before expiration. Otherwise, the instructions are the same as for QQQ, except that the ticker symbol for yahoo is ^MNX.

More than $5000 - QQQ stock (NDX/40)

Buying and selling the QQQ, an NDX tracking stock, on margin is the most conservative way in which to trade. Make sure your account at the discount broker is approved for margin purchases. While a typical 2 day swing of 3 points on the QQQ will usually produce a 50% profit on one of the above options, the market is going to be around a long time, and you should not be in any great rush. The commission charge of your discount broker is critical here as Schwab will charge $60 dollars round trip, while most other discounters will charge in the neighborhood of $30 for limit orders. Market orders with a $7 commission are almost always going to be a bad deal on the bid-ask spread. One QQQ point is $100 on a round lot of 100 shares now selling at about $8000. You need a 3 point swing for the trade to make sense. The economics are much improved if you have $10,000 of capital and trade 200 shares at a time.

More than $25000 - CME NDX mini contract (NDX/5)

To trade this futures contract you will need a commodities account with a discount commodities broker. With $25,000 you have enough margin to trade the big NDX contract, an instrument that gives you about $330,000 of exposure. However, I strongly recommend against it as all big contract orders must go to the floor, where the floor trader has 2 minutes before he has to attend to your order and you will not get a fill report for about 10 minutes. A limit order is likely to be off the mark 2 minutes after it is placed, and a market order on a futures contract can be a real wild card in a fast moving market. In contrast, the mini NDX contract (about $65,000 of exposure) trades electronically without going to the floor, and you can get instant fills from your broker. In addition, the CME provides live, real time quotes for this contract over the web at CME Real Time Quotes under the symbol NQZ00 towards the bottom of the list. The page refreshes every few seconds automatically, so you and your broker will be viewing the same information as you call in your order. Commissions are much lower than for QQQ tracking stock trades, as a round turn will cost only $29 at most discounters, and there are no spreads as in options.

How to trade

All of the above instruments trade according to the same rhythm. The first thing you will need is access to and familiarity with an hourly chart of the NDX or QQQ. The chart below is from Bigcharts.com. You will need to go over to the side frame, select a moving average and type in 20, then select bollinger bands, then for the first lower indicator select Williams %R and then for the second lower indicator select the MACD. Play around with it until you can duplicate the chart you see below. This chart can just sit in an extra Netscape window dormant for most of the day while you do other things. You should check it and refresh the screen every couple of hours.

You will notice that the 20 period Bollinger bands and the 20 period moving average give you excellent entry and exit points when the NDX is trending. Basically, you sell whenever the QQQ hits the moving average (or perhaps one point above) and you buy back whenever the QQQ hits its lower bollinger (or perhaps 50 cents below). Remember, the object of trading is not to capture every last nickel, but to increase the cash in your account. You haven't lost a thing if the NDX moves beyond your exit point.

Over the past 10 days the NDX has been a sale every time the Williams %R hits the 20 line, and a buy every time it hits the 80 line. You will also notice that the 10 period Williams %R tends to be a couple hours early. This is a good thing, because the Bigcharts data feed is about 30 minutes delayed, and the last hourly bar you will see on that hard right edge of your screen is from one hour ago. So you need an indicator that alerts you to begin to pay attention before the probable turn arrives in real time. The Williams %R is your basic indicator.

Over the past 10 days, the most accurate hourly timing indicator in retrospect is the 12/26 MACD. But by the time you see a lower MACD divergence bar on the histogram, or a tick in the opposite direction from the %D line on the hard right edge of your screen, two hours of new trend has already passed you by. The MACD is too late to be a useful signal, but it is important because you want to enter a position while the hourly %D line is still trending against you, and you want to exit your position while the hourly %D line is trending in your favor. In other words, the time zone of action is generally in between the Williams %R signal and the MACD signal.

Once the Williams %R signal flashes, you should switch to a five minute realtime chart available free at Ask Research. Select QQQ or NDX as appropriate and leave the time at the default 5 minutes, uncheck the volume box and check the Williams %R and MACD boxes under "Indicator Chart Settings", hit "go" and then observe the chart similar to the one below. This chart will automatically refresh every three minutes. You can make it refresh much more frequently if desired by selecting the automatic refresh rate at the bottom.

You will notice that the Williams %R on this 5 minute chart nailed every QQQ trading top and bottom on 10/12/00 when it hit the 0% and 100% lines, respectively. On the short covering panic of 10/13/00, it nailed every trading entry to the long side at the 30 line.

The psychological difficulty that every trader faces is the fact that as this %R indicator is rising (or falling) on the hard right edge of your screen, you have no way of knowing that it won't keep on rising (or falling). Remember though that the entire methodology described in this post is designed to be certain of the trend by looking at the weekly trend, and then drilling down to the daily, the hourly and the 5 minute trends to be certain that we are maximizing the probability of a good entry at a short term counter-trend extreme. If the 3 dma on the daily chart is rising consistent with a positive weekly trend, you aggressively enter long (buy calls) at counter trend lows and exit less aggressively/ quickly at trend highs. If the 3 dma on the daily is falling consistent with a negative weekly trend, you aggressively enter short at counter trend highs and exit less aggressively/ quickly at the lows. If the daily 3 dma is moving counter to the weekly trend (as it is on the day this is written) then you must enter and exit aggressively with careful stop protection. Since option traders cannot use stops effectively, they should stand aside until the weekly and daily are running in the same direction.

Risk Management.

The most important element of risk management is having and following a system that keeps you trading with the trend in all relevant time frames.

For option traders using the system, the only effective means of risk control is to sell the contract as soon as you have decent economic profits. Remember that when you buy an option you are paying for time. The less time you keep it the less you pay. You must sell the option while the market is running in your direction while the premium is high and the contract is actively bid by other traders. In other words, if you own a call you must sell it while QQQ is rising, and if a put, while it is falling. Wait until the market turns, and the premium collapses and your profits melt away very quickly. Because of this fluctuation in premium or time and volatility value, stop loss orders for options are a very bad idea. The most important risk control is built into the trading system and the leverage of the contract and the limitation of your risk to the price you paid. Therefore, if the market starts running against you (indicating a probable daily trend change) then you must sell the contract on the first hourly %R move in your direction. Most trend changes will involve a "retest" of the breakout point (the price at which you bought the option) and you must sell the option at the first retest before the market reverses and heads back in the direction of the new trend.

The advantage of trading the QQQ or the mini NDX contract is that you can use stop loss orders to limit your losses. A second advantage is that you can and should wait until the Williams %R turns one tick in the direction of your trade before trading either vehicle. Unlike an option, a very important element of risk control when trading the QQQ or the NDX contract is entering as soon as the market begins to move in the direction of your trade. Then you place a stop loss order just above the high (or below the low) set immediately before your entry. The quicker the entry, the tighter the stop. In other words, if the NDX reverses on you and goes through the high (or low) that you just sold (or bought) then you don't want to own that position yet. You then reenter at the next higher high (or lower low) in the same fashion until the price action indicates a potential daily trend change, or you get it right! In general, stop orders make no sense at all except in reference to relevant chart tops or bottoms. Part of your risk control is having an exit strategy that forces you to let your profits run. This means you exit using the same method, drilling down from weekly, daily, hourly, and finally 5 minute trends and exiting immediately after the market reverses against your position.

Some traders will modify the above risk management rule by insisting that the high to be traded be accompanied by a lower high on the 5 minute RSI indicator or a lower high on the 2 minute MACD histogram (or that a low to be traded be accompanied by a higher low on these indicators). This refinement ensures that the short term up move (or downmove) to be traded is accompanied by falling momentum, thus increasing the odds of an immediate direction change in your favor. In general, this modification should not result in the loss of very many profitable entry and exit points. This same modification can be applied to option trades.

Some traders will go further and insist on waiting for a second lower high or higher low before entering or exiting a trade. In general, this modification is desirable only for exit trades at extremes in the direction of the trend, as extra insurance that profits have been allowed to run to the maximum reasonable extent. Any asymmetry in your trading strategy should be biased in the direction of the trend.

Watch this web site and "paper trade" the system before you commit real money. Remember that the market will be around for a long time, and there is no rush. You will trade better if you feel that you understand what you are doing.

And good luck!

Yggdrasil-


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