by Chris Verhaegh

The entire PULSE System is based on math.  The math centers around but is not limited to option pricing and the “Greeks”.  We add historical precedence to map out a game plan.  We try to make low risk – high reward trades in an effort to get results in the range of “well above average” to “incredible”.

The function of the PULSE System is one of elimination.  We strictly eliminate anything that doesn’t match our criteria until only the few and the profitable remain.  The key to this function is rejection.  There’s a huge universe of stocks out there.  We don’t want to have to wade through every one looking for a good trade.  We want to whittle this massive menagerie of stocks down to an acceptable short list. 

Our core trading concept is to focus on stocks whose price moves in such a fashion as to give its options a high likelihood of doubling in a short period of time.  I do a lot of match trying to pare the large universe of possibilities down to a manageable amount.

As I said, the PULSE System is all about a process of elimination.  We move further and further down the funnel, eliminating more stocks as we go.  Basically, we’re looking for stocks with options which have: liquidity, strike price availability and movement.  Let’s put this elimination process in the form of a questionnaire.  As we answer each question, we will eliminate more candidates, until we are left with a profitable few.

Question #1: Does this stock have options?  This may seem like kind of a no-brainer.  Since the PULSE System is an option-trading system, it stands to reason that any stock without options should be tossed out.  There are nearly 8,800 stocks and a little over 3,000 of them have options, so we’ve done a significant amount of culling with round one!

One caveat: I don’t want you to get discouraged at the elimination process.  This is designed to identify good potential candidates for the PULSE trading system.  It’s not a carved-in-stone “off limits” list of prohibited stocks that you can never follow again.

I believe trading should be fun!  There are stocks that I follow just because the companies are located in my hometown.  I keep tabs on how they are doing.  I talk with the company executives are our kids’ ball games.  I may even own a few shares of the companies’ stock.  I just don’t apply the PULSE System to them.

Question #2: What expirations are available?  I must confess, I’m really excited about the Weekly expiration program.  I have been ever since the CBOE started it in 2010.  That said, I don’t trade Weekly exclusively, because the volume just isn’t there for all stocks.  My preference is to trade Weeklys because the opportunities are greater than on other expirations.  If a stock offers Weekly options, it stays on our list.  But every now and then I will include a stock that only has Monthly expirations if I see a good setup.  In that case, we take what we can get… or more accurately, what the Market Makers will give us.  Basically, we trade Monthlys for the twelve weeks out of the year that they expire, and the other forty weeks we trade Weeklys.

Question #3: What strike prices are available?  This is really simple math if you think about it.  Each strike price offers a new option opportunity.  Every time a stock’s price crosses over a strike price, either up or down, an option goes In-the-Money.  If the strike prices are five dollars apart, then the stock has to move five dollars to go from one strike to the next.  During that move, one option goes In-the-Money.  If the strike prices are one dollar apart and the stock makes that same five dollar move, then five different strike prices have gone In-the-Money!  Five times the opportunity for profiting!

The important thing to keep in mind when looking at strike prices is not just the price itself, but the relationship of strike range to stock price.  This has very important bearing on the potential profitability of trading options.

Let me give you an example: There are a few stocks that trade around $1,000.  The options for these stocks have five dollar wide strikes.  The stock only needs to make a half percent move to cross a strike.  On the other hand, there are many stocks that trade in the single digits.  If a stock is trading at, let’s say four bucks and the options have fifty cent wide strikes, this stock would need to move twelve and a half percent before it crosses a strike!

Price of the stock notwithstanding, which is more likely under normal circumstances: a half percent move, or a twelve and a half percent move?  Even though the strike prices are ten times as wide, based on this section of our questionnaire, the more expensive stocks have the greater potential for profit.

Question #4: Are the options priced in penny increments?  As explained above, this can really make or break a decision on whether we want to trade options on a particular stock.  With smaller increments in the option pricing, our cost of doing business decreases.  It doesn’t take much movement of the stock to make an option move a penny.  If the pricing increments are in nickels or dimes, the stock needs to have a much bigger move for the option to change price.

The fact that so many options are now priced in pennies reflects how the market just keeps getting better and better for traders.  Understand though, the real value in penny priced options is in how it affects the Bid/Ask spread.

Question #5: How wide are the Bid/Ask spreads?  The Bid/Ask spread basically shows us lazy liquidity.  Let me explain: The Black-Scholes formula gives a theoretical value to an option.  Market Makers try to buy options for less than the theoretical value and sell them for more than the theoretical value.  They set the Bid/Ask spreads to show us the limits that an option will trade for.  Bid is the low end and Ask is the high end.

We consider the Bid/Ask spread our cost of doing business.  If the Bid/Ask spread is wide, there is no liquidity in the trade, our ability to profit is limited and the Market Maker gets rich.  If the Bid/Ask spread is tight, it means there is a lot of liquidity in the trade, so we have an easier opportunity to get rich!

A good rule to follow when deciding whether or not to enter a trade is to imagine that you’re going to buy at Ask and sell at Bid.  This will be the worst case scenarios and will help you avoid unpleasant surprises.

Bonus Question: How high is the Open Interest?  Every time a trade takes place, a certain number of shares are bought by Buyers, as the same number of shares are sold by Sellers.  When everyone agrees on price, Buyers and Sellers meet at that price at that point in time.  If the Sellers want to Sell, they will lower their selling price to meet the Buyer’s expectations.  If the Buyers want to Buy, they will raise their purchasing price to meet the Seller’s demands.  This Buyer and Seller dance is what moves the market.

By definition, in order to trade, I need somebody to trade with.  Meeting all the other criteria won’t matter much if nobody wants to trade with me.  Open Interest shows how many option contracts have not been settled from the previous day.  In other words, how many open positions in that strike price of that stock are still being held by traders.  When we see the Open Interest, what we see is a running total of open contracts on that strike price option, going into the next trading day.  When a stock has a high Open Interest, we can expect the Bid/Ask spreads are going to be tight.

Open Interest is closely tied to Volume.  The difference is Volume is the summation of contracts traded that day.  Open Interest shows how many contracts were not closed by the end of the day.  Every morning, volume is reset to zero and climbs throughout the day as trades take place.  At the end of the day, any contracts – Long or Short – that were not closed are added to Open Interest.  Any contracts that were previously opened, which were closed that day – Long or Short – are subtracted from the previous Open Interest.

We like to see Open Interest across the board.  That means there are a lot of traders in positions, keeping the Market Makers honest.  A high Open Interest means there will be a lot of activity around this option.  Volume will be up.

While Open Interest is an important factor to watch, it’s not absolutely critical.  I call this a “Bonus Question” because, while it is an important factor for you to take into consideration, you should only trade real money on a stock you’ve traded before.  No, I’m not creating a logical conundrum – I’m talking about paper trading.  The fact is, if you are checking Volume and Open Interest, you’re probably not familiar enough with the stock to trade real money.  Paper trading costs nothing except time.  I can’t emphasize enough – paper trade, paper trade, paper trade!  Paper trade until you are comfortable with what you are doing!

I am generally conscious of other fundamentals, but the above list is what I go by to find my Watch List.