Trading Options Using Point and Figure

The key to understanding how option strategies are applied to stock portfolios is in gaining a basic grasp of the normal distribution concept we discussed in Chapter 7. This normal distribution shows up everywhere in nature. Sixty-eight percent of the time anything you evaluate—stock trades, men's heights, peoples' blood pressures worldwide, and so on—will fall one standard deviation above or below trend in a bell curve. What does this mean? Think of it this way. Each bell curve is constructed of six standard deviations or zones, three above center and three below center. Center is considered perfectly normal. In the stock market, stocks that decline in price fall down to the lower zones. Stocks that do well will rise to the upper zones. Sixtyeight percent of your trades will hang around the middle. In other words, most of your trades will be what I call “middling” or hanging around center. They go up a little, then fall back a little, then rise a little, and so on, but never become a clear winner you can sell for a profit, nor do they decline enough for you to consider the trade a bad bet and sell it. So the normal distribution of your trades might look like this (See Figure 12.1). This is the most simplistic way of explaining it because all you need is a visual concept of what I'm talking about.

You can see in Figure 12.1 that 68.2 percent of your trades are likely to fall in the dark blue portion of the curve. Truly winning trades ...

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