We have been asked on many occasions what is the best way to screen for trades and find a handful of opportunities from the large number of stocks and ETF's that are out there. Over the years, we have managed to develop a system with pre-set criteria that finds trades for us here at Nextoptions.com and we have spent a great deal of time and money to automate the process. However, this is not possible for many people so we are going to take this opportunity to present a method that you can use to manually find trade candidates. The best thing about this method is that it is very easy to use and most often than not, you will find a good stock ( or option) within 20 minutes.
Now, many of you may already be familiar with the method and the principles behind it but we will still try to stick to the basics and keep it as simple as possible so as not to make it unnecessarily complex. We have even gone as far as to combine what were steps 3 and 4 into one single step. Our aim here is to make it so straight forward that an absolute novice can learn and implement it after reading this post. You should also note that this is JUST ONE of many many methods and we are not posting it here because we think it is the Holy Grail. We are just posting it because we think it is a simple and effective method that can be used by persons who want to find good trades but do not have an enormous amount of time to spend doing it. This method just narrows the universe of stocks/ETFs that you have to look at and presents you with a few high probability candidates.
The Basic Principle
The principle behind the method is that Supply and Demand moves markets. What triggers the sentiment that drives Supply and Demand is a whole other matter that may have to be dealt with in another post on Market Psychology, but for now just focus on the fact that a stock only moves because of the supply and demand dynamic. There is no other way for price to change.
So essentially, what this method does is find where the supply and demand are and tries to get ahead of it. Listed below are the steps that you can use to find these situations and set up a high probability trade to take advantage of it.
STEP 1: Look For Volume Advances/Spikes
Volume activity is like the voice of the market. You will find that very often the volume will tell you what most indicators won't and it can often be a leading indicator ( as opposed to a lagging one like most others) and tell you what is about to happen if you read it correctly.
Normally, when you see a significant increase in volume it means that the institutional money is active and that they are either actively accumulating or distributing a stock. So the first step is to pull up the data after the close (end of day data) and look for stocks which had a >20% increase in volume for the day. That kind of volume, in most cases, is driven by institutional money. Most stock screeners will allow you to search with the volume advance setting but there is also a list that is produced for free daily at Barchart.com
STEP 2: Determine If the Volume Is Bullish/Bearish
After you identify the volume advances/spikes you will now need to determine if the activity is Bullish or Bearish. Now, under normal circumstances, a Bullish move can be identified by increasing volume on an up move or by decreasing volume on a down move. Similarly, a Bearish move can be identified by increasing volume on a down move or by decreasing volume on an up move. Read this again until you get it.
The up moves are strongest ( and indicate more upside ahead) when they close the day at the high and are followed by a low volume down day. Similarly, the down moves are strongest ( and indicate further downside) when they end on the lows and are followed by a low volume up day.
This means that you may have to follow these stocks with a Bullish/Bearish volume advance for more than one trading day to really get a lock on it.
STEP 3: Use Volatility For Confirmation
Here you want to compare the Historical Volatility of the stock in question to the Implied Volatility in order to gauge the expectations or broad sentiment. The volatility is basically a measure of how the price has moved over time and the Implied Volatility is a measure of traders' expectations based on the price of the Option Contracts on the underlying stock.
If the Implied Volatility (IV) is rising relative to the Historical Volatility (HV) at the same time that the volume on the stock has spiked, it basically confirms that a move is either imminent or underway and that you should position yourself for it. How you position yourself is obviously based on whether the Volume is Bullish or Bearish and that was addressed in Step 2 above.
Most trading platforms will give you volatility charts for stocks and Implied Volatility charts for the related Options contracts. However, if you do not have this functionality on your platform and want a single place where you can overlay the IV on top of the HV for easy comparison you can use Optionistics. It is free but the data is delayed 20 minutes which really shouldn't matter since we are using end of day data.
STEP 4: Set Up The Trade
Since we are dealing with Options trading we have to take into account things like the volume and Open Interest on the Options contracts. These are critical because you always want to trade liquid issues so that you can get in and out with ease. So you basically have to to check the Options chain for every stock that the screen turns up to see which one is most liquid and fairly priced.
There will be a future article on Option Pricing, but for now, you just have to be mindful of the fact that if the Implied Volatility (IV) on an option contract is too high relative to the Historical Volatility (HV), there is a strong chance that the move ( indicated by the volume spike etc) is already priced in and that you could find yourself in a situation where the Option premium collapses instead of rises even though the underlying tock price is going up. In this case you would be better off selling the Calls rather than buying them.
So you want to look for a liquid contract ( >250 contracts traded with a high Open Interest) with the IV slightly above, or inline with, the HV and clearly trending up. This will, in most cases, present a situation where there is more upside to be had.
1. Run a search at the end of the session for stocks that had a >20% increase in volume on the day
2. Check to see if the volume activity was Bullish or Bearish in nature ( this may require an additional day of monitoring)
3. Use the IV/HV comparison to confirm the move
4. Choose the right Option Contract and set up the trade
Conclusion & Notes
As we mentioned earlier, we reduced the number of steps in order to make it simpler to follow. We also deliberately avoided the use of diagrams or images simply because we find that when images are posted, people tend to just start looking at charts for similar set ups instead of trying to grasp the concept. When the concept is grasped and understood then it will reveal itself in the charts.
You may want to spend some time just trying out the steps and paper trading the opportunities you come across before actually committing real money to it. Just like everything else, you have to test it first before you jump in.
This is not meant to be an exhaustive or authoritative post on finding a trade. It is just supposed to be an answer to the many questions I received last week. Hopefully, you will find it useful and make it another tool in your arsenal.