Wednesday, April 11, 2012

Swope and Howell, Trading by Numbers

The title of this book by Rick Swope and W. Shawn Howell is somewhat misleading. It’s not intuitively obvious, or at least it wasn’t to me, that Trading by Numbers: Scoring Strategies for Every Market (Wiley, 2012) is primarily about options.

But let’s start, as the authors do, with their trend and volatility scoring methods. The trend score has four components: market sentiment (the relationship between a long-term moving average and a short-term moving average and the position of price in relation to each moving average), stock sentiment (the same parameters as market sentiment), single candle structure (body length relative to closing price), and volume (OBV trend). The range is -10 to +10. Volatility scoring has three legs: historical market volatility, historical stock volatility, and expected market volatility. The range is 0 to +10.

Before moving on to the standard option strategies, the authors address risk management, which they wisely describe as nonnegotiable. Risk management again has three legs: risk/reward, concentration check, and position sizing.

And, with chapter five (of sixteen), we’ve reached covered calls. The reader who has no experience with options will be lost. Even though the authors push all the right buttons (ITM, ATM, OTM strategies; the Greeks; position adjustments), they push the buttons almost as if they were playing a video game. Very fast.

Assuming that the reader is not new to the option market, what can he/she learn from this book? Let’s look very briefly at three strategies and see how they reflect three different market or individual stock conditions: a long call, a straddle/strangle, and an iron condor. Traditionally described, in the simplest of terms, the first is looking for a significant bullish directional move, the second anticipates a surge in volatility, and the third expects a rangebound market.

The authors try to quantify these traditional descriptions. According to their methodology, to initiate a long call the trend score should be positive, the higher the better. Volatility doesn’t matter much, although higher volatility will translate into higher premiums. A straddle/strangle position doesn’t fit in well with the authors’ template. The trend score is essentially irrelevant, and the volatility score is in the eye of the beholder—low potentially exploding into high. The authors don’t even bother to include a market score trade figure for the straddle/strangle; instead, they rely on Bollinger Bands. For the iron condor the trend score should be close to zero. More conservative traders look for low volatility scores, more aggressive and experienced traders for scores of 5 or higher.

I’m hard pressed to say that the authors have improved significantly on my “simplest of terms” traditional description. They might argue that they have made the trade selection process more objective. I would have to tell a story; a trader following their scoring method could presumably rely on two numbers. But are these numbers always a good guide? For instance, a trader might profit mightily by buying a call when a stock is in the doldrums but he has reason to expect a major breakout to the upside.

The authors supplement their scoring method with technical analysis. In deciding to buy a call, for example, the trader might consider a Fibonacci retracement setup or a breakout over the top of a bull flag.

As option trading has become increasingly popular, the literature has likewise expanded. Although Trading by Numbers occasionally makes excellent points and although it covers a wide range of strategies, I can’t put it at the top of my must-read list. It doesn’t get a 10.

1 comment:

  1. More detailed review than we usually get -- thank you to Ms. Jubin. Do you mean to say that the book basically presents no tradeable method?