Meta-Trader - Wagging the Dog

Welcome back Meta-Traders.

It was another good week in equities, not quite as good as last week, but pretty respectable. While I swore off blow-by-blow recaps of my equity trading, I have a story to tell which led me to some important conclusions regarding trading so read on for more.

Apple Computer continued to fascinate this past week. Recall last week that Apple computer threatened the $500 mark, but closed last week short of the mark at $493. Recall also that I was watching the $497.62 level to re-enter on the long side.

This past week was option expiration and price behavior around option expiration is always interesting. Prices move quickly between strikes, but typically settle around a strike price. My challenge with AAPL was to observe the price action and position accordingly.

Monday morning came along and after a big run-up in the pre-market session, the stock opened the day at $499.53 taking out the old high by over 2 points. The stock ran up to about $502 and started to falter. Gaps are often filled, so I took a bearish position by going long the $520 puts looking for a move back to the low $490s. This position seemed to work out and within a few hours the stock was down to $497 and I was in the money 2+ points on the puts. I entered a stop loss for about 1.5 points below where I bought it to limit losses, but did not take profits. I figured unless I was able to take 3X times the profit as I was willing to lose, I was not trading properly.

That trade did not work out and I got stopped out a few hours later as AAPL once again crossed $500 mark and slowly worked its way higher. Having defended the $500 mark, I figured the next test was to the upside, so I went long the Feb 480 calls for about $22 with the stock at about $501.50. This contract was expiring this Friday Feb 17th, which explains the very low premium. I took a similar position in my 401K Rollover account at a slightly higher price and went about my business. The stock closed Monday at about $502 in quiet action.

On Tuesday, the stock opened at nearly $505, a 3 point gap to the upside. During the day Tuesday, the stock traded as high as $509.50 and closed just below that, not far from the $510 strike. After hours, CEO Tim Cook made some comments and there was some other news, and AAPL was up to about $513 before the after-hours session ended at about 6PM EST. I don’t ever recall seeing so much action in the pre-market and post-market sessions which are usually quiet.

Wednesday rolled around and the stock went as high as $518 in the pre-market, but opened the day at $514. After that, AAPL moved quickly to the $520 area – another important strike and started to settle down. Apple had come much farther than I expected, and much faster. Between 10 and 11 AM, prices pushed higher and soon cleared $520 and within minutes were at $523, $524 then $525! Straight to the moon!

Right around this time, I checked the Option chains for the Options expiring Friday and saw something crazy, see above screen shot. The daily volume in the Options was incredible. It was before noon, and already 37,700 of the 520 calls had transacted, and the open interest in that contract was only about 10,700 contracts! At 100 shares a contract, that represents over 1 million shares of stock at this strike price alone, and this is a stock that only trades about 5 million shares a day on average!

After the fact, I added up all the daily volume for the 14 strikes that would fit on the quote board and came to an incredible 197,000 contracts volume for one day. This represents almost 20 million shares stock for that day alone!

Why is this important? As “Dr J” Jon Najarian described to me one time (I was in the audience at a trader’s expo) when the public buys a call, the market makers turn around and hedge that with long stock within seconds. So with the public buying calls like crazy, the market makers had no choice but to buy stock to hedge their positions to flatten their exposure.

At this point, it became clear to me at this run up was feeding frenzy in APPL stock caused in part by the public and momentum players like myself buying the options, and the market makers buying the stock to hedge their exposure. It was a case where the Options were driving the Underlying and a classic case of the “Tail wagging the dog.”

Since it was about noon on Wednesday, it became clear that we had passed the week’s mid-point, and all of these call contracts would expire by Friday. And I figured that very few of these option holders would take delivery of the stock at $50,000 per contract. That means most of these contracts would have to be sold to close, and that would also cause the market makers to close their hedges. In other words, the frenzy on the upside would soon turn into frenzy on the downside. So I slipped out of my $480 calls at about 43 and took about a 20 point profit within about 2 days!

Shortly after, APPL topped $526 and for a short time, $530 was the next strike target. I almost went log the March calls at this but did not. Within another hour or 2, APPL was back down to $523 and I was feeling okay about being out. At that point, I stepped away and for some lunch and talked with my son who was home from school for the day sick.

I looked a short time later, and the stock was down to about $518, wow, what a sell-off! Within another 20 minutes or so, the stock was about $510, Amazing. It was the classic blow-off top, and I managed to skip out unscathed. I was king for a day, even if it was just a one-lot! After that, I took the rest of the week off, because I figured after that trade, it could only go downhill.

The next day, the stock gapped down to open in the low $490’s then find a bottom at $484 before finding a bottom. So what’s the point of my story?

The point is that trading is complicated. It’s a function of Price, and a function of Time, and the Hour of the Day, and the Day of the week, whether it Options Expiration week and about 1000 other things that cannot be fully quantified. I have been programming computers for 30 years - since punch cards were in use – and I don’t think all this information can be programmed. It is also a matter of instinct and experience, and conventional computer algorithms can’t handle that much information, not in my humble opinion anyway.

Here are my conclusions:

1) Automated Trading has limitations

Sure Hedge Funds can use them for high-frequency trading or arbitrage or one of dozens of other uses. But position trading is just too much information for computers to be relied upon to make market-beating trading decisions.

2) Selectivity is key

Trading is about knowing what to do and when. Computer algorithms can’t distinguish between dead times with no news pending the day before a major news event. Sure, it can be programmed, but is this possible or practical?

3) Know the Material

This is perhaps the most important point. Why am I trading AAPL and not the 7000+ other instruments available?

You may have noticed that currency trading results have been terrible lately. Daniel put out a video last week on the issue of trade chain dependency, but I think the answer is much simpler than that. The reason is that the Euro zone is a complete mess and that EUR/USD has performed poorly as a result. EUR/USD historically has a positive correlation with the S&P 500, but that association has failed recently with EUR/USD underperforming due to its poor performance.

Back in the 1990’s I bought some trading software and did a bunch of research around trading methods, buying new all-time highs, range breakouts etc. What I found is that breakout systems worked well if the stock had a good performance. If the stock had a poor performance, sideways down, etc, I had lousy results. This means that what you choose to trade is as least as (but probably more important than) the system you use to trade the underlying!

Take some time to consider my conclusions and let me know your input.

Enjoy your weekend.