Sentiment 2010 Summer

8/9/2019 Sentiment 2010 Summer

1/36

MART OPTIONS

OR TODAYS INVESTOR

UMMER 2010

12/MODERN CONTRARIANISMTRADING WHAT OTHERS DONT SE

16/STRATEGIES FOR TRADING BULLISH FEA

23/VOLATILITY PRIMER

WHAT IS IT AND WHY YOUSHOULD CAR

>>

ERNIE SCHAEFFERS


2/36

1. CNBC streaming news and the CNBC logo are provided for informational purposes only under a license agreement with CNBC, Inc. Neither E*TRADE FINANCIAL nor any of its affiliates are responsiblefor its content and no information presented constitutes a recommendation by E*TRADE FINANCIAL or its affiliates to buy, sell or hold any security, financial product or instrument discussed therein orto engage in any specific investment activity.2. For information and details about the Commission-Free Trade offer, please visit www.etrade.com/tradefree. Commission-free trade offer applies to a new E*TRADE CompleteTM InvestmentAccount opened with $2,000 minimum deposit. The new account holder will receive a maximum of 500 free trade commissions for each stock or options trade executed within 60 days of the depositedfunds clearing in the new account. You will pay $9.99 for your first 149 stock or options trades (plus an additional 75 per options contract). You will pay $7.99 for stock or options trades between 150and 500 trades (plus an additional 75 per options contract). Your account will be credited $9.99 for the first 149 stock or options trades and $7.99 for stock and options trades between 150 and 500within eight weeks of trade execution (excluding options contract fees). Accounts must be opened by December 31, 2010, the offer expiration date. Limit one per customer.Securities products and services are offered by E*TRADE Securities LLC, Member FINRA/SIPC.System response and account access times may vary due to a variety of factors, including trading volumes, market conditions, system performance and other factors.2010 E*TRADE FINANCIAL Corp. All rights reserved.

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12

The Eternal ContrarianThe rules havent changed much in the decades sinceHumphrey Neills iconic The Art of Contrary Thinking

was published, but the investment landscape sure has.

Not only is it important for todays contrarian to real-

ize that the crowd is usually wrong on both ends of a

trend, but also to understand why.

/

VOLATILITY SPECIAL

16

How To TradeCautious OptimismWhen volatility creeps in before your bullish convic-

tions end, its time to listen to that little voice in yourhead that tells you to change your strategy. The ques-

tion is, which strategy? How about one that looks like a

long call, but acts like a hedge when youre wrong?

/

23

Volatility Primer:THE KEY TO OPTIONS ENLIGHTENMENT

Theres more to options trading than simply

buying calls and puts. Without an understand-

ing of volatility, you can be right on direction

and still watch your trades turn to dust. If

volatility has you confused about options, it's

time to get back to basics.

6

The Sentiment ReportThe elephant in the

room is that blue-chip

investing in the past

decade has been a bust.

But perhaps what you

should be looking at is

much smaller.

/

8Making News, Etc.

A serving of highs, lows,

and relevant news for

option traders.

/

11Ask Bernie

Though they may not be

talked about much,

when it comes to meas-

uring market volatility,

theres more than just

the VIX.

/

29Confessions of a

Trader

When faced with a loss

on your long option

position, theres a

chance you could fix it

with a few tricks of the

trade.

/

30Idea Lab

How to determine when

the VIX is a bargain.

+ TOOL REVIEW:

Schaeffers VolatilityIndex distilled.

/Photographedby Fredrik Brodn

/

4At the Open

When the de facto trade

in 2010 is to sell pre-

mium, theres a reason

to question the crowd.

/

32.COM

Where to go and what

to see right now atSchaeffers Research

online.

/

0 (34)Page Zero

PRO PEARLS

iVolatility.coms Jack

Walker dishes up his

top 5 option trading

rules to live by.

/

SM ART OPTIONS

FOR TODAY S INVESTOR

SUMMER 2010

12/MODERN CONTRARIANISM:TRADING WHAT OTHERS DONT SEE

16/STRATEGIES FOR TRADING BULLISH FEAR

23/ VOLATILITY PRIMER:

WHAT IS IT AND WHYYOUSHOULD CARE

>>

BERNIE SCHAEFFERS

FEATURES COLUMNS

COVER

REGULARS

PUBLISHERT3 Publishing LLC

EMAIL: [email protected]

www.t3publishing.com

ADVERTISING CONTACTSadia Ashraf

513.589.3800 X1200

[email protected]

Schaeffers InvestmentResearchMAIN OFFICE: 513.589.3800MAIN FAX: 513.589.3810CUSTOMER SERVICE:

800.327.8833 prompt #2E-MAIL: [email protected]: 800.448.2080 prompt #4

5151 Pfeiffer Road, Suite 250Cincinnati, OH 45242www.SchaeffersResearch.com

SENTIMENT is published quarterly.

If you prefer not to receive thispublication, please call 800.327.8833.

To view SENTIMENT online, go toschaeffersresearch.com/sentiment.

Please send your comments and questionsto the editor at [email protected].

BERNIE SCHAEFFERS

SENTIMENT

EDITORIAL DIRECTORKevin Lund

CONTRIBUTING WRITERSTodd Salamone, Bob Kraft,

Rocky White, Elizabeth Harrow,

Andrea Kramer

ART DIRECTORTom Brown, TBA+D

ASSISTANT EDITORJennifer Agee

DESIGNERJennifer Roberts

CHIEF PHOTOGRAPHERFredrik Brodn

CONTRIBUTING ILLUSTRATORJoe Morse

www.schaeffersresearch.com S U MM E R 2 0 10 Contents 3


4/36

Letter from

Bernie

A CASE AGAINSTTHE CROWD

4 S E N T I M E N TSUMMER 2010

I HAD THE PLEASURE OF ATTENDING

the 28th annual Options Industry Conference(OIC) in Phoenix this spring, an event Ivealways considered a must for industry profes-

sionals. This years offering proved to be noexception, and the near-record attendancewas a testimony to the health of the optionsindustry despite a spotty economy and somelingering regulatory indigestion in the wake ofthe 200809 financial crisis.

As with any good conference, one oftenlearns as much from conversations in the hall-ways as from the formal program. So it was atthe OIC. In particular, I had the opportunityto catch up with my good friend Alex Jacob-son, education officer at the InternationalSecurities Exchange (ISE), at one of the

luncheons. He had some very interestinginsights about what was resonating mostamong the many individual investors hedirectly and indirectly encounters. From hisperspective, premium harvestingsellingcalls against stock, selling naked puts, as wellas selling condors and butterflieswas thepredominant strategy favored by individualinvestors. Alexs assessment was echoed inpanel discussions.

ELIZABETH HARROW

Senior Equities Analyst andcontributor to MarketRecap. She writes OptionActivity Alert, hosts theSchaeffers Daily Q&A videoseries, and is a regular con-

tributor to Blogging-Stocks.com.

ANDREA KRAMER

Senior Equities Analyst andcontributor to Market Recap.She writes Options Update,hosts the Options Stewvideo series, and is a regularcontributor to Stock-house.com.

Schaeffers

Contributors

to This Issue

ROCKY WHITE

Senior Quantitative Analystand contributor to MondayMorning Outlook. He holdsa masters degree in finan-cial engineering, and hisresearch is quoted onBloomberg TV, CNBC, andFox Business News.

In the immortal words of the Seinfeld televi-sion series: Not that theres anything wrongwith that. Certainly, these are legitimatestrategiessome might even call them con-servativeand they are considered by manyto be vastly superior to (and more sophisti-cated than) the option buyers approach ofpurchasing a wasting asset. But as is alwaysthe case in options trading, timing is every-thing, and there were a number of reasons (inretrospect) to question premium harvesting asthe go-to strategy earlier this year. First and

foremost, the CBOE Volatility Index (VIX)had reached its lowest level in three years, andgiven that the VIX is a proxy for premium lev-els throughout the equity option spectrum, itis fair to say that premium sellers were notbeing paid a kings ransom for the risk theywere incurring. And when premiums are thin,profit probabilities decline for the premiumseller, and all the metrics for such trades dete-riorate. Plus, outlier moves that can blow up a

TODD SALAMONE

Senior VP of Research andauthor of the MondayMorning Outlook. His mar-ket insight is featuredregularly on CNBC,Bloomberg, The Wall Stree

Journal, and Fox BusinessNews.

Bernie Schaeffer has been bringing you trading tipsand market timing insight with the Option Advisornewsletter for 28 years. For a free copy, go to:

www.sentiment.com/OpAd6

trade become increasingly likelyfirst,

because of the low premium and its negativeimpact on P&L parameters, and second,because low premiums often signal the calmbefore a storm.

But theres yet another reason to havebeen wary of premium harvesting, and thiswas the very fact that these strategies hadbecome so popular. As I discuss in The Eter-nal Contrarian feature article (page 12), thepopularity of a trend can often be a strongindicator that it is late in the game and that

you should seriously consider breaking withthe crowd. Options traders need to be as vigi-

lant about avoiding the crowded optionstrade as stock traders must be about avoidingthe crowded stock trade. No further proof isneeded than the fact that the flash crash during which volatility soared and manyoption premium buyers profited hand-somelyoccurred just four trading days afterthe final day of this conference.

So its particularly timely that our specialfocus for this, our sixth issue ofSENTIMENTis on volatility. Be sure to check out ourVolatility Primer (page 23) and our specialfocus on strategies for volatility trading (page

16), as well as the other insights on volatilityappearing throughout the magazine. Enjoy!

Bernie SchaefferFounder and CEO,Schaeffers Investment Research

/ / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / /

>> Please let us know your thoughts. Send your feed-back to [email protected]./ / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / /

At the Open


5/36

ISE FX Options, the ISE globe logo, International Securities Exchange and ISE are trademarks of the International Securities Exchange, LLC. Options involve risk and are not suitable for all investors. Prior to buyingor selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies of the document may be obtained from your broker or from the International Securities Exchange by

calling (212) 943-2400 or by writing the Exchange at 60 Broad Street, New York,NY 10004. 2010, International Securities Exchange, LLC. All rights reserved.

www. .comGet exposure to rate movements in some of the

most widely traded global currencies. Apply the

same trading and hedging strategies you use for

equity and index options, including spreads with

up to four legs. ISE FX Options are cash-settled in

US dollars, European-style exercise exercised and

can be traded from your existing brokerage account.

per US $

USD/AUD

USD/BRL

USD/GBP

USD/CAD

USD/EUR

USD/JPY

USD/MXN

USD/NZD

USD/SEK

USD/CHF

SYMBOL

AUX

BRB

BPX

CDD

EUI

YUK

PZO

NZD

SKA

SFC

in US $

AUD/USD

BRL/USD

GBP/USD

CAD/USD

EUR/USD

JPY/USD

MXN/USD

NZD/USD

SEK/USD

CHF/USD

SYMBOL

AUM

-

GBP

-

EUU

-

-

NDO

-

-

CURRENCY

Australian dollar

Brazilian real

British pound

Canadian dollar

Euro

Japanese yen

Mexican peso

New Zealand dollar

Swedish krona

Swiss franc

calling (212) 943-2400 or by writing t

eor selling an option, a person must rISE FX Options, the ISE globe logo,

NY 100,orkeet, New Yad Stre Exchange at 60 Br

ceive a copy of Characteristics and Risks of Standenational Securities Exchange and ISE arInter

LCnational Securities Exchange,Inter 2010,4.

dized Options. Copies of the document may bearnational Securities Exchangtrademarks of the Inter

eserved.. All rights r

nationalomthe Interokeror from your brbtained frnot suitable fe, LLC. Options involve risk and ar

Securities Exchange byr all investors. Prior to buying


6/36

The Sentiment Report6 S E N T I M E N TSUMMER 2010

THE AUGHTS HAVE GAINED NOTORIETY

as a terrible decade for investors. FromDecember 31, 1999, through December 31,2009, the S&P 500 Index (SPX) lost roughly

24% of its value, while the Dow Jones Indus-trial Average (DJIA) shed more than 9% of itsworth. In fact, that dismal 10-year period isnow informally known as The Lost Decadeamong many investors.

These losses are even more disturbingwhen you consider that investors have histori-cally regarded large-cap, blue-chip stocks tobe a relatively safe haven during times of eco-nomic turmoil. When volatility reigns, saysthe conventional wisdom, play it safe byinvesting in big-name Dow stocks, wherelong-term returns are virtually guaranteed.

The bleak performance of large-cap stocksover the past 10 years has left many investorswith serious reservations about this tradi-tional safe haven strategy. In fact, as a resultof the market's stomach-churning turbulence,the entire concept of buy-and-hold investinghas come under fire.

For example, an October 2009 TIMEcover explained Why It's Time to Retire the401(K), with the accompanying articledescribing the retirement funds as a lousyidea, a financial flop, a rotten repository forour retirement reservesthanks, in no smallpart, to the drastic market downturn in 2008

that pummeled the large-cap stocks many ofus hold in our 401(K)s.

Plus, in a recent roundtable, Forbes chiefinvestment strategist Vahan Janjigianobserved that buy-and-hold investing cer-tainly did work for people like Warren Buffett,but weve seen over the past few years thatthis strategy can really backfire.

Not to be outdone, CNBC personality JimCramer weighed in. The Mad Money hostrecently warned viewers, Never plan onowning a stock forever. In an episode recap,

TheStreet.com reporter Scott Rutt summa-rized the main takeaway: If the financialpanic has taught us anything its that thebuy and hold philosophy is dead.

Contrarian View

Amid this buy-and-hold backlash, punditshave overlooked the outperformance of theRussell 2000 Index (RUT), which tracks abasket of smaller-cap stocks. Just like bluechips haveor hada reputation for beingsafe, smaller caps have a reputation forbeing risky. However, during the so-calledLost Decade, the RUT rallied nearly 24%.

This remarkable price action suggests that itstime to update the conventional wisdom.

In the current economic climate, smallercaps boast another advantage. Compared totheir larger corporate cousins with sizableglobal footprints, smaller-cap stocks are morelikely to be sheltered from overseas turbulence.

Many fund managers have caught on tothe trend, and appear to be shifting their

focus to smaller-capstocks. In fact, ouranalysis of optionactivity indicatesthat big money play-ers have been accu-

mulating the stocksin the RUT.The RUT contin-

ues to have the windat its back from atechnical perspec-tive. The index istrading above its 80-week moving aver-age, which hasserved a key role inthe past as a demar-cation line between

periods of bullishand bearish price action (Figure 1).For those looking to take advantage of

continued outperformance in the RUT,active traders may want to consider invest-ing in smaller-cap stocks that are character-ized by low expectations on Wall Street. Ofcourse, hedging your bets is always a goodidea in this market. By purchasing puts onthe iShares Russell 2000 Index Fund (IWM)in combination with your smaller-cap stockportfolio, you can protect your investmentfrom serious suffering during major market

declines.Meanwhile, more passive investors orthose with very long investment horizonsmay want to consider investing directly inthe sector through IWM itself, perhaps usinglong-term calls to closely mirror the rewardscollected by investors.

Smaller Caps: The Market's

New Safe Haven?

FOR EVERY BEAR MARKET, THERES A BULLMARKET. YOU JUST NEED TO THINK SMALLER.

>> By Todd Salamone and Elizabeth Harrow

TFIGURE 1:Weekly chart of the Russell 2000 Index (RUT). During the LostDecade between December 31, 1999, and December 31, 2009, the RUTgained 24%, while the S&P 500 lost 24%.

For free weekly market insight, new trading ideas,and education from Schaeffers top analysts, signup for the Monday Morning Outlook at:

www.sentiment.com/mmo6

1 0/ 13/ 03 12 /31 /04 0 3/ 24/ 06 06 /15 /07 0 9/ 05/ 08 11 /27 /09

850

800

750

700

650

600

550

500

450

400

350

80-weekMoving

Average

RU T


7/36

Visit www.cboe.com/sentiment and start your options education today!

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Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies are available from your broker, by calling 1-888-OPTIONS, or at www.theocc.com.

CBOE , Chicago Board Options Exchange , OEX and VIX are registered trademarks and SPX and The Options Institute are service marks of Chicago Board Options Exchange, Incorporated (CBOE). Copyright 2010 CBOE. All Rights Reserved. SM SM

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Copies are avust receive a copy of Characteristics and Risks of Standardized Options.SM

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.theocc.com.oratwwwby calling 1-888-OPTIONS,ailable from your broker,

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ment


8/36

MakingNews, Etc.8 S E N T I M E N TSUMMER 2010

Time to Take A Bite? Apple Inc. (AAPL) is shining in 2010.Shares are probing record highs, the company has officiallyoutsized nemesis Microsoft in sheer market cap, and since itsrelease in April through the end of June, more than 3 millioniPads flew off the shelves. Meanwhile, iPhone 4 made itsdebut on June 24 and was greeted by long lines of eager

buyers outside stores throughout the U.S., Europe, and Asia,selling a whopping 1.7 million phones in its first threedaysa company record. So, with vir tually every analystwooing Apple and its future, perhaps its appropriate to ask:At what point does the innovator of all things i take an iFallBest to keep an eye on sentiment with this one.

Rock BottomJust when the housing sector seemed to startturning a corner earlier in the year, recent new home sales sta-tistics have been downright bleakhitting record lows not seein decades. The ongoing woes in the housing world have moti-vated a lot of new option action in the SPDR HomebuildersTrust (XHB). Despite interest rates hovering at levels not seen

in decades, after losing nearly 25% of its value from Aprilthrough June, some investors are flocking to XHB put optionsfor fear of additional losses in the foreseeable future. Now,before you go hopping on this bearish bandwagon, rememberthat old adage: Everything seems darkest just before the dawn.

OPTIONMARKETDATES

YOUSHOULDKNOW

1NEW HIGHS AND LOWS>Schaeffer's Investment

Research has launched aseries of online educa-tional webinars to helpoptions rookies and vet-erans alike with tradingideas and advice. Ourpresenters have includedsome of our most expe-rienced and knowledge-able traders and analysts,including Todd Salamone,

senior vice president ofresearch, senior technicalstrategist Ryan Detrick,and senior equities ana-lyst Elizabeth Harrow.Topics have includedHow to Trade Optionsin Three Easy Steps,Four Sectors to MakeYou Money in 2010, andThree Options Strate-gies for Today's MarketEnvironment.

Upcoming webinarswill include some basicintroductory options pre-sentations, along with dis-cussion of more advancedstrategies. Please visitSchaeffersResearch.comto learn more.

3Bernie Schaefferappeared on PBSsNightly Business Report

on June 4, while seniortechnical strategist

Ryan Detrick made

two media appear-

ances in June, appear-

ing on Fox Business

with Chris Cotter and

Tracy Byrnes on June

1, and on CNBCs The

Early Tick on June 11.

Volatilitynatu-

rallywas the subject

during Bernie's

Nightly BusinessReport appearance.

In fact, the CBOE

Market Volatility

Index (VIX) soared

20% that day to 35.48.

Bernie pointed out

that, even at that ele-

vated level, the VIX

was off its peak of less

than a month before

by about 10 points,

and he cited some

technical indicatorsthat pointed to a con-

tinued volatility

decline.

OCTOBER

20Volatility Inde

Options Expir

(VIX, VXN, RX

SEPTEMBER

17Equity&OEX

IndexOptions

StopTrading

SEPTEMBER

24Schaeffers

Option Advisor

Released

OCTOBER

14SPX, RUT, DJX

Index Options

Stop Trading

SEPTEMBER

16SPX,RUT,DJXIndexOptionsStopTrading

OCTOBER

15Equity&OEXIndexOptionsStopTrading

2

SEPTEMBER

15Volatilit

yIndex

OptionsExpire

(VIX,VXN,RXV

)

NEW PRODUCTS

SIR IN

THE MEDIA

When asked, So,

are you on the longside? Are you bullish

at these prices? he

responded, On the

long side, but you

have to watch those

technical indicators

you want to be

long, but you want to

look for hedges as

well. He also dis-

cussed several sectors

that he likes.

Ryan voiced similararguments on Fox.

Speaking to hosts

Chris Cotter and

Tracy Byrnes, Ryan

said, I think we're

getting pretty close to

a meaningful bottom

in the market. He

cited a number of fac-

tors to back up his

view, including the

relative strength of

small caps, and, froma contrarian stand-

point, continuing high

levels of fear among

retail investors.

We think U.S.

markets will continue

to outperform other

world indexes, Ryan

concluded.

Ryan made the

same points later in

the month on

CNBC. You can viewany of our prior media

appearances at

sentiment.com/

medap.

AUGUST

27Schaeffers

Option Advisor

Released


9/36

www.schaeffersresearch.com SUMMER 2010 Making News, Etc. 9

CBOE Debut You want to buy a piece of the options market? Now you

can. After a long-standing dispute over payment for ownership with the

CME was settled, the doors swung open for the Chicago Board Options

Exchange to hold its long-awaited IPO. On July 15, the CBOE started

trading on the Nasdaq Stock Market under the symbol CBOE for $29 pershare. So far, however, the best trade to date on the CBOE has nothing to

do with its newly traded shares. Each member/seat-owner received 80,000

shares for his or her seat in the exchange. According to BloombergBusi-

nessweek, a seat was purchased for a low of $131,500 in August 2002, near

the bottom of the tech crash at the time. At the peak price of $34.18 on

the day of the IPO, each seat was worth $2.83 million (including a

$100,000-per-seat payout to each member).

Reforming Derivatives. Congress is currently working on a financial

reform bill that will certainly have major implications for some areas of the

derivatives market. Lawmakers ironed out the final details of the legisla-

tion in late June. After it clears both chambers, President Obama could

sign the bill into law in early July. Among the proposals is a plan to move asubstantial number of derivatives from the over-the-counter market and

onto the exchanges. The idea is to have greater information and trans-

parency in the derivatives market, as some blame these complex instru-

ments for triggering the global financial crisis. Now, these products will

4News @Schaeffers

San Francisco

Money Show

>Bernie Schaeffer,

founder, chairman,and CEO of Schaef-

fers Investment

Research, will address

the opening cere-

monies at the San

Francisco Money

Show on Thursday,

August 19, 2010. The

show, at the San Fran-

cisco Marriott Marquis

Hotel, will run from

August 1921. Also

speaking at the showwill be Todd Salam-

one, senior vice presi-

dent of research.

To learn more or to

register for this event,

please visit sentiment

.com/news06. If you

attend this show,

please visit us at Booth

501. If you cant

attend, visit Schaeffers

Research.com during

the show dates, wheresenior equities analyst

Andrea Kramer will be

live-blogging from the

event.

Option Bits

begin trading on organized exchanges and will

settle through a clearing organization. How will

this affect equity options traders? Not at all.Although options are derivatives, the puts and

calls we trade are already listed on exchanges

and cleared through the Options Clearing Cor-

poration (OCC).

Put Some Weeklys on Your Calendar. The

number of Weeklys is expanding. A Weekly

options contract is one that begins trading on

Thursday and expires the following Friday. Prior

to June 2010, Weeklys were only available on a

handful of indexes, such as the S&P 500 Index

(.SPX). That has changed. On June 4, the

Chicago Board Options Exchange said it wouldbegin trading Weekly contracts on four

exchange-traded funds: the S&P Depositary

Receipts (SPY), the Powershares QQQ

(QQQQ), the iShares Small Cap Fund (IWM),

and the Dow Jones DIAMONDS (DIA). Later

in the month, contracts were listed on four

stocks: Citigroup (C), Bank of America (BAC),

Apple (AAPL), and BP plc. (BP)

Weekly contracts have advantages and dis-

advantages. On the one hand, these short-term

contracts have very little time value and offer

a lot of leverage. That is, the contracts exist only

for a few days and are therefore relatively cheap.On the other hand, Weeklys also experience a

fast rate of time decay. All short-term options

do. So, rather than simply buying Weekly puts

and calls as a way to speculate on potential

moves in the underlying (index, stock, or ETF),

some traders prefer to sell them as part of other

strategies, such as calendar or diagonal spreads.

DECEMBER

16SPX, RUT, DJX

Index Options

Stop Trading

DECEMBER

17Equity&

OEX

IndexOptions

StopTrading

How are we doing?

SENTIMENTis always evolving, and

we want to make sure were pushing all theright buttons. Please help us improve yourexperience by providing your feedback atwww.sentiment.com/survey

DECEMBER

22Volatility Index

Options Expire

(VIX, VXN, RXV)

NOVEMBER

19Equity & OEX

Index Options

Stop Trading

NOVEMBER

18SPX,RU

T,DJX

IndexOptions

StopTrading

NOVEMBER

17VolatilityIndexOptionsExpire(VIX,VXN,RXV)

DECEM

24TradingHoli(ChristmasObserved)

OCTOBER

22Schaeffe

rs

OptionAdvisor

Released

NOVEMBER

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(Thanksgiving)NOV

EMBER

19Schaeffers

OptionAdvisor

Released

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I sold covered calls on one of my stocks.The calls were 10% out of the money. Tomy surprise, the stock rallied 15% in oneday! I dont want to sell the stock now, butthe calls are in the money! Is there any-

thing I can do? DannyBERNIE:Thats a good problem to have! Witha covered call, the investor sells one calloption for every 100 shares. For example, if Ibuy 100 shares of my favorite stock at $50 pershare and I sell one June $55 call for $1, I cre-ate a covered call by writing a call option thatis 10% out of the money. My cost to own thestock falls to $49 per share ($50 for the stockminus $1 for writing the call). If the stock fallsbelow $49, I show a loss on the position.

On the other hand, if it moves higher, Ibegin to see profits. If the option expires in

June and the stock is trading for $54, I canclose the position for $5 per share, or 10.2%,profit ($4 from stock appreciation and $1from the call that I sold). Of course, I donthave to sell the stock. I might sell anotherout-of-the-money calllike a September 60.

If the stock rallies 15%, the call is in themoney. A 15% move would push the stock to

$57.50. Now, the calls will be assigned at expi-ration if they are in the money at that point.The strategist will be asked to sell the stock at$55. In fact, in some cases, the calls can beassigned before expiration.

What can you do to avoid assignment onin-the-money calls if you want to hold yourwinning stock? You can close out the callsthrough an offsetting transaction. That is, youbuy back the June $50 call. The result willprobably be a loss on the call, but youll have again on the stock and can also sell another

callsuch as the July 60. Importantly, by

making this adjustment (which is called aroll), you are changing the risk profile of thetrade. The breakeven and the risk of the tradewill be greater, but the upside profit potentialwill be higher as well.

Q:How do I place a spread order? Do Ienter each contract separately, or can Ienter the spread as one order? RussBERNIE:Whether trading online or with alive broker, spread trades are often entered asone order. For example, say I want to initiatean Apple (AAPL) January call spread. Look-

ing at current prices, I decide buying the Janu-ary 200 at $20 and selling the January 250 at$7.50 is a good trade. Im willing to pay $12.50($20 $7.50) per spread, and I instruct thebroker to buy to open x number of January200/250 call spreads at a $12.50 debit. On theother hand, if I want to sell the spread, I enterthe order to sell to open the spread for a$12.50 credit. Most online brokers offer thetools necessary to enter simple spread orderssuch as these electronically.

While spread trades are most often enteredand executed as one trade, legging in refers

to initiating one side first (usually the longleg) and then open the other side (the shortleg) at a later timeeither one right after theother, or perhaps days apart. For example, if Iwant to buy Apple January 200/250 callspreads and I think Apple will have a strongrun-up during the week, I might buy the Janu-ary 200 calls on Monday and sell the January250 calls on Friday.

The risk to legging in is that if the stockmoves the wrong way before you get thatshort leg on, the spread will widen (250 callswill get cheaper) and no longer look like a

good trade. If that happens, Im left holding ariskier position in January 200 calls.

When Taking ProfitsIs Not an Option

WHEN A STOCK RUNS UP TOOQUICKLY, COVERED CALLS CANPOSE AN INTERESTING DILEMMA.>> By Bernie Schaeffer

Bernie Schaeffer isfounder and CEO ofSchaeffers InvestmentResearch, Inc., a leadingprovider of research andanalysis on the stock andoptions market. Hereceived the Best of the

Best Award from theMarket Technicians Asso-ciation for his ground-breaking work onsentiment analysis, andhis award-winningSchaeffersResearch.comsite is consistently ranked

#1 in the options cate-gory by Alexa.com. Heappears frequently onCNBC and The NightlyBusiness Report and is reg-ularly quoted in theWallStreet Journal,Business-Week, and USA Today.

Only have a limitedtime to learn how totrade options? Go tosentiment.com

/HSP6

Q:

The Man withthe Answers:

BernieSchaeffer

www.schaeffersresearch.com SUMMER 2010 Ask Bernie 11

/ / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / /

>> Got a question for Bernie? Send it [email protected].

/ / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / /


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www.schaeffersresearch.com SUMMER 2010 13Contrarian Investing

T H E F I R S T E D I T I O N O Fwhat Ive long considered to be thebible for the contrarian approachto investingThe Art of ContraryThinkingby Humphrey Neillwas

published more than five decadesago in 1954. Neills contrarian prin-ciples have proven their timeless value timeand again over the years, in large partbecause they are based on the ever-presentand often-predictable impact of humanemotions on the market.

Googling Contrarian Investing

The best way to illustrate the timelessnessof Neills contrarian approach is with a tourof the sentiment backdrop for the most her-alded initial public offering (IPO) of the

past decade. On August 19, 2004, the IPOof shares in Google, Inc. was completed at ashare price of $85. This offering raised$1.67 billion, and as a result the companywas valued at $23.1 billion. By November2007, Google shares had traded as high as$747, and the market capitalization of thecompany reached $237 billionmore than

By Bernie SchaefferILLUSTRATION BY JOE MORSE

THINGS ARENT ALWAYS WHAT THEYSEEM. THATS THE AXIOM THAT LIES AT

THE HEART OF CONTRARIANINVESTING PHILOSOPHY. TODAYS

CONTRARIAN HAS AS MUCH,IF NOT MORE, TO GAIN FROM THE

INFORMATION AVAILABLE INTHE STOCK AND OPTIONS

MARKETS BY RE-EXAMININGSOME CORE PRINCIPLES

INTRODUCEDDECADES AGO.

THE

ETERNAL

CONTRARIANT


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the analysts rated Google a buy, with 60%carrying hold ratings and 10% rating the

company a sell. And it wasnt until Novem-ber 30, 2004, after the shares had catapultedabove $180more than double the $85 IPOpricethat more analysts rated the companybuy than hold.

What we had here was a classic case ofinvestor disbelief, despite the acknowledgedstrengths of the company and despite verystrong post-IPO price action that quickly leftthe original offering price of $85 in the dust.Of course, as the shares continued their amaz-ing ascent and the company continued to out-grow expectations, we moved fairly quickly

into the acceptance stage and ultimately toeuphoria. By May 26, 2005, with Google trad-ing at $260, 80% of analysts were rating it abuy. And by March 8, 2007, just 8 monthsbefore the ultimate price peak at $747, analystsentiment had become unanimous100%had buy ratings on Google.

No Country for Blind Contrarians

In one of the most apt quotes from The Art ofContrary Thinking, Humphrey Neill tells us:The crowd is right during the trends, butwrong at both ends. We can easily see thisphenomenon at work in our Google example.

By June 23, 2006, more than 90% of the ana-lysts who followed Google rated the stock a

buy. By any reasonable standard, Google waan overloved stock, yet it would have beenvery foolish, indeed, to short it based on a contrarian take of this bullish sentiment. Howfoolish? Google shares were trading at thattime at $405, on their way to a peak of $747less than 18 months later in November2007a gain of 84%. And this rally occurredafter the shares had already more thanquadrupled from their IPO price.

Humphrey Neill obviously understood thayou should never adopt a blindly contrarianstance on a strong stock that is very highly

regarded on Wall Street. But how do you avoidthis pitfall in the real world? The key is to focuon situations in which the sentiment is clearlycounter to a stocks fundamental and techni-cal picture. The sweet spot for a contrarianbullish position in Google shares was theperiod from the IPO in August 2004 throughNovember 2004, when less than half the ana-lysts had buy ratings on the company. Anargument could also be made for holding atleast part of your position beyond November2004 in recognition that Wall Street opinionwas still playing catch-up with the companyspowerful price and earnings momentum. In

Contrarian Investing14 S E N T I M E NSUMMER 2010

10 times the valuation at the IPO price in just

a shade over three years.Since Google had already become a house-hold word by 2004, you might think thatinvestor sentiment, as reflected by the opin-ions expressed in the financial media and bythe ratings of the various analysts assigned tocover the company, would have been quitebullish at the time of the IPO. Think again.

On the fifth anniversary of the Google IPOin 2009, we find this reminiscence from The

New York Times :

Googles success can make it hard to

remember that in 2004, many in SiliconValley were bearish about its market debut.There was skepticism about how the offer-ing was being handled and whether theWeb search company was overhyped andovervalued.

Im not buying, Stephen Wozniak, anApple co-founder, declared to The NewYork Times in the weeks before Googlewent public. Past experience leaves thetaste that a few peoplenever ourselveswill make out the first day, but that its notlikely to appreciate a lot in the near future

or maybe even the long future, he said.The day after Google started trading,an editorial in The New York Timespraised the offerings structure butsounded dubious about what it describedas Googles bubbly post-IPO valuationof $27 billion. Only time will tell if thecompany can fend off efforts by Yahooand Microsoft to build superior searchengines, the editorial said.

Just prior to the Google IPO, on August 9,2004, TIME magazine featured the following

headline: Googles IPO: Buyer, Beware. Andfrom an opinion piece in the August 24, 2004issue ofNewsweek: This price is insane. Andanyone buying Google as a long-term invest-ment at $109.40 will lose money.

This skepticism about the prospects fornewly minted Google shares also extendedinto Wall Streets analyst community (see Fig-ure 1). As of October 13, 2004, with theshares already trading above $140, just 30% of

FIGURE 1: GOOG sentiment from analysts upon its IPO in 2004 was quite negative. Three years later, at 10times its IPO price, there wasnt a negative analyst to be found.

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www.schaeffersresearch.com SUMMER 2010 Contrarian Investing 15

BY ANY REASONABLE STANDARD,

GOOGLE WAS AN OVERLOVED

STOCK, YET IT WOULD HAVE BEEN

VERY FOOLISH, INDEED, TO SHORT IT

BASED ON A CONTRARIAN TAKE

OF THIS BULLISH SENTIMENT.

HOW FOOLISH? GOOGLE SHARES

WERE TRADING AT THAT TIME AT

$405, ON THEIR WAY TO A PEAK LESS

THAN 18 MONTHS LATER OF $747.

liable or out of date; a technical indicatormight no longer apply in the new era ofexchange-traded funds (ETFs); and a senti-ment indicator might not be measuring theactivity of the crowd the contrarian islooking to trade against.

Humphrey Neill was very concerned withthe accuracy of the sentiment indicatorscontrarians use to reach their conclusions.As he states in The Art of Contrary Thinking:No problem connected with The Theory ofContrary Opinion is more difficult to solvethan (a) how to know what prevailing gen-eral opinions are; and (b) how to measuretheir prevalence and intensity.

Ive always been a proponent of options-based indicators as contrarian tools. Theactivity of options speculators, many ofwhom are poorly capitalized and inade-

quately informed, can be an excellent meas-

ure of the extremes in crowd sentiment that

can provide strong contrarian trading sig-nals. The challenge over the years has beento separate the activity of these option buy-ers from those who are selling options as partof a conservative trading strategy and thosewhose activity is generally irrelevant to con-trarians. But the biggest challenge these daysis the fact that a large constituency of optionbuyersparticularly in the ETF worldarehedging against concurrent positions in theunderlying securities.

For example, a hedge fund bullish onsmall-cap stocks might take a position in the

iShares Russell 2000 Index Fund (IWM) andat the same time protect this position againstunanticipated market weakness by buyingIWM put options. Should this IWM hedgedtrade become popular, IWM put volume willsurge, and the would-be contrarian mightconclude that bearish speculators are bettingagainst the market by accumulating theseputswhen in fact this activity was gener-ated by bullish hedged buyers of the underly-ing security. The contrarians assumptionthat the speculative crowd is bearish mightwell result in him taking a bullish position in

IWM. But the correct assumption is that bigmoney is accumulating small-cap stocks.Thats fine while it lasts, but could be verybearish in its implications when the buyingpower dissipates.

Conclusion

Neills statement is as true today as it was in1954: The crowd is most enthusiastic andoptimistic when it should be cautious andprudent; and is most fearful when it shouldbe bold. And it is equally true that yoursentiment indicators and your interpretation

of them are as critical to your success as thecontrarian approach itself.

other words, this was a period in which the

crowd was migrating from disbelief to accept-ance of the companys prospects. But byMarch 2006, with the shares at $455 and with100% analyst buys, it was certainly time forbullish contrarians to exit their positions.

The final rally by Google into its top at$747 in November 2007 was a period thatshould have been avoided by both bulls andbears. Bulls needed to be concerned that sen-timent had entered the euphoria phase andthat a severe dissipation of buying power couldresult in a top at any time. Bears needed to beconcerned that while sentiment was poten-

tially euphoric, price and earnings momentumwere so powerful that the shares could bedriven much higher before they would ulti-matelypeak. (For a detailed explanation of thestages of a stocks sentiment cycle, see "TheExtra Edge," SENTIMENT, Spring 2009.)

Contrarian Indicators, 2010-Style

No market indicator, no matter how well-conceived, is perfect, whether based on fun-damentals, technicals, or sentiment. Butmany investors make the fatal mistake of uti-lizing indicators that are flawed in their very

construction. Economic data might be unre-

FIGURE 2: Even at its IPO, shares of Google (GOOG) were mired in investor disbelief (red shade), only onestep up from the despair that prevails at bottoms.When GOOG proved everyone wrong, investor accep-tance (yellow shade) eventually led to euphoria (blue shade), at which point 100% of the analysts coveringthe stock had buy ratings.

For an extended discussion on contrarian invest-ing techniques with Bernie and his use ofoptionsbased indicators as contrarian tools, go towww.sentiment.com/ContVideo.

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www.schaeffersresearch.com SUMMER 2010 17Strategy ShowcaseSUMMER 2010

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By Frederic Ruffy andAndrea KramerPHOTOGRAPHS BY FREDRIK BRODN

OPTIMISM

CAUTI

US


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term directional play for fear the underlyingsecurity will succumb to unfavorable priceswings before the call or put expires. However,one way for more conservative traders to rollthe dice on a long-term betand, on occa-

sion, even profit from a price swing in theopposite directionwithout suffering a trade-related heart attack in the near term is via thecalendar strangle.

To initiate the calendar strangle, you wouldpurchase a longer-term, in-the-money optionthat reflects your bias toward the security. Inother words, if youre bullish, you would pur-chase a longer-term call on the underlyingstock, whereas if youre bearish, you would buya longer-term put. Then, to guard your posi-tion against adverse price action in the nearterm,you would simultaneously buy a shorter-

term, at-the-money option with the oppositedirectional bias (a put for bulls; a call for bears)as insurance.

Ideally, the longer-term option will haveabout three to six months to expiration, andwill harbor a high delta (the amount theoption changes relative to the stock chang-ing). With the high delta, the options valuewill move in near parity with the stock price.On the flip side, the shorter-term option willhave only one to two months before expira-tion, and will boast a relatively lower deltamaking it much cheaper to purchase than itslonger-term counterpart.

Given recent events, it isnt surprisingthat some investors are willing to pay morefor portfolio protection. During the so-calledflash crash of May 6, 2010, the Dow JonesIndustrial Average plummeted nearly 1000

points in less than half an hour. It was a seri-ous meltdown. While regulators have workedon plans like circuit breakers to prevent arepeat of the 2010 Flash Crash, they admit-tedly dont really know exactly what triggeredthe volatility. So there is no assurance thatsomething similar wont happen again.

How should investors operate in thisenvironmentwhen the risks of speculatingwith long options are high and the cost ofportfolio protection has become high, too? Isit smart to buy and hold stocks with nohedge at all? Or, is it worth paying a higher

premium to hedge market risks? What canyou as an option trader do when premiumsseem too expensive to buy, but not richenough to sell?

Fortunately, there are ways to navigatethese uncertain markets using options. Letslook at two very attractive strategies: the ratiobackspread and the calendar strangle.

Strategies for an Uncertain Market

CALENDAR STRANGLES

Amid turbulent market conditions, manyoption traders hesitate to gamble on a long-

Anatomy of a Trade

To fully appreciate this adaptation of the longstrangle strategy over multiple time frameslets dissect an example.

To start, lets say you have high expecta-tions for stock XYZ in the long term, but arenervous about jumping into a bullish tradewithout any protection. With XYZ flirtingwith the $50 level, you opt to construct a cal-endar strangle on the stock by purchasing thedeep-in-the-money December 40 call for $12,and simultaneously buying the at-the-moneyAugust 50 put for $3resulting in an initialcash outlay of $15.

Considering the December 40 call is 10points in the money with plenty of time toexpiration, the option has a delta of 0.8meaning the call should increase $0.80 invalue for every point XYZ advances on thecharts. Furthermore, should the call remaindeep in the money over the long term, theoptions delta should inch closer to 1.0 as expi-ration draws near. Against this backdrop, youcould argue that the addition of the August 50put to this December in-the-money call posi-tion is similar to buying a married put, whichlimits the risk of a long stock position.

In fact, much like the concept of the mar-ried put, the primary goal for the calendarstrangle is for the shares of XYZ to rally overthe long termmeaning you dont mind if thenear-term put expires worthless, as this wouldmean your bullish forecast is coming to fruitionand your profit from the call you purchased wil

18 S E N T I M E N TStrategy Showcase SUMMER 2010

FIGURE 1: XYZ. Risk profile of the calendar stran-gle. All the leverage of a long call with low time decayand the protection of a cheap put hedge.

heres little doubt that the volatility landscape haschanged dramatically in recent years. On a daily basis, in the four years ended

December 2007, the CBOE Volatility Index (VIX) averaged lessthan 15. However, from early 2008 through mid-June 2010, the volatility index

produced an average reading of around 30, or more than double the levels seen the

four years before. VIX tracks volatility on the S&P 500 index, and its rise since2007 reflects the bigger daily price swings seen in the equity marketwhich hasalso resulted in richer premiums across the options market. Essentially, as

market volatility has gone up, so has the demand for options. The cost of portfolioprotection has risen, as well as speculative strategies using long calls and puts.

T

39 50

Stock Price

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( + )

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is to consider using the ratio backspread; apopular strategy among experienced optionstraders. They can be initiated with either callor put options and differ from a traditionalspread, in that you sell one option and buy a

larger number of another with the same expi-ration. (Whereas, in a traditional spread, youbuy and sell an equal number of options.)

Popular ratios for backspreads are 1x2 (i.e.1 short option to 2 long options), 2x3, andsometimes 3x5. The goal in setting up theratio backspread is to enter the trade for acredit. Well explain how to do this next, butthe important thing to understand is that theratio backspread profits when the stock movesin either directionyour additional longoptions profit from a move in the desireddirection, or you simply keep the credit from amove in the opposite direction.

more than offset the loss on the put. In other

words, you view the short-term put in the samelight as your homeowners insurance policyanecessary evil bought to protect your belovedinvestment from the elements, not necessarilyto profit from a devastating storm. But there isan advantage the calendar strangle holder hasover the married put buyer in that you canactually profit from a huge move against yourdirectional view, while a married put neverproduces a profit from a stock plungeit onlymitigates the cost of the decline.

More specifically, the objective of the cal-endar strangle is for the shares of XYZ to finish

north of your breakeven at the $55 level (callstrike + net debit) by December options expi-ration, with the August-dated put chalked upas a $3 sacrifice. However, should that storm,in fact, touch ground before your bullish hopesare realized, the short-term insurance policyprovided by the 50-strike put could come inhandy, to say the least.

Example in Action

Lets assume the shares of XYZ unexpectedlypull back to the $45 level before August-datedoptions expire. In this instance, your longer-

term 40-strike call will be worth less than whatwas paid at initiation, but your 50-strike putwill be five points in the money, lessening theloss suffered by the December-dated call.

In fact, lets assume the shares of XYZ sud-denly plummet all the way to the $30 levelbefore August options expire. In this case, theAugust 50 put will have an intrinsic value of$20or $5 more than it cost to establish yourcalendar strangle. In other words, should youchoose to close out the entire position early,XYZs unexpected move lower would stillresult in a net profit of 25% on the trade.

Finally, while there are a few points of cau-tion to consider before constructing a calendarstrangleincluding a slightly slimmer reward,a higher cash outlay at initiation and, as aresult, wider breakeven levelsthe definedrisk of this non-traditional strategy and thepossibility of profiting from a big move in theopposite direction of your forecast offers con-servative traders something invaluable involatile markets: peace of mind.

RATIO BACKSPREADAnother way to speculate on direction, whilemitigating the risk of unfavorable price swings

www.schaeffersresearch.com SUMMER 2010 19Strategy Showcase

FIGURE 2: Daily chart of GS.High-priced stocks in volatile sectors make great candidates for ratiobackspreads, such as the down-trending stock of Goldman Sachs, shown here near $140.

FIGURE 3: Goldman Sachs (GS) put ratio backspread:The profit and loss profile of this tradeshows nearly unlimited profit potential to the downside (1), a small profit to the upside (2), or atworst, the options gradually decay between now and expiration (3).

For Example

Lets consider a real-world example usingGoldman Sachs (GS) as a bearish case. Atthe time of this writing, shares are tradingaround $140. GS is widely traded, has very

liquid options, there are many strike pricesto choose from, and the spreads betweenbids and offers are normally quite narrow. Ifpanic and fear reign, you want to be in avery liquid and actively traded instrument.With volatility picking up and the stock tak-ing a hit earlier in the year (see Figure 2), aput ratio backspread might be an excellenttrade.

A 2x3 GS put ratio backspread can beconstructed by selling 2 October 135 puts at$10 and buying 3 October 125 puts at $6.The net result is a credit of $2.00 per spread([$10 x 2] [$6 x 3]).

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How would the trade unfold? Accordingto Figure 3, we can see three profit/loss sce-narios unfolding:

1. If shares come under pressure and GStanks, your position acts like a long put fornearly unlimited profit potential. Remem-ber, since youre selling two puts and buyingthree, the extra long put per spread is whatgives you the extra juice from a downward

move.

2. On the other hand, should the shares ofGS stay in a range above $135 or trendhigher through the October expiration, youdo nothing and all the puts expire worthless.You keep the $2 credit received at the onsetof the trade and call it a day.

3. Should the stock drift below $135 andremain there until expiration, time decay willeat away at your premium; which is relativelypredictable on a day-by-day basis (using theta

and vega data available in the option chainsat www.schaeffersresearch.com). Your great-est risk is if the stock settles at $125 at expira-tion, which is the price at which your short135 puts realize their greatest loss and the125 puts are at-the-money.

In Figure 3, you can see the first (curved)line shows the profit potential at the time thetrade is initiated, while the second shows therisk-reward at expiration. Notice the $200profit per spread if shares hold above $135,which is the initial credit received at the onsetof the trade. Also notice the maximum risk at

expiration, which is considerable if shares set-tle at exactly $125. The reason being is that atthat point, the 135 puts, which were sold, are$10 in the money, but the 125 puts, whichwere bought, expire worthlessa low proba-

bility, worst-case scenario. Ultimately, in theideal scenario, the stock sees a volatile movelower in the weeks or months prior to theexpiration. And the sooner it happens, thebetter, but relative to other directional strate-gies, you wont get hurt too badly if it doesnt.

AS WE SAW IN THE WEEKS LEADING INTO

the correction that began at the end of Aprilof this year, and the subsequent days justprior to the flash crash in May, fear premiumwas already building up in the market. Why?While complacency seemed to be the pre-vailing psychology, smart money investors

began reaching into the options markets tobuild hedges on their positions. This causedoption premiums on the whole to rise, andbecame a difficult trading environment foroption buyers and sellers: Call buyers cant

buy because premiums are too expensiveand put sellers dont want to sell becausethey cant get the protection they need tojustify outright short positions. In suchcases, the calendar strangle and ratio back-spreads are extremely attractive strategies.

HOW SHOULD INVESTORS

OPERATE IN AN ENVIRONMENT

WHEN THE RISKS OF SPECULATING

WITH LONG OPTIONS ARE HIGH

AND THE COST OF PORTFOLIO

PROTECTION HAS BECOME

HIGH, TOO? FORTUNATELY,

THERE ARE WAYS TO NAVIGATE

THESE UNCERTAIN MARKETS

USING OPTIONS.

20 S E N T I M E N TStrategy Showcase SUMMER 2010

When it comes to momentum, using optionsinstead of stocks is a smar t way to trade. To receivereal-time momentum trading ideas, sign up for ourPowerTrends Series options alert service atwww.sentiment.com/PTS


21/36

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www.schaeffersresearch.com SUMMER 2010 Special Focus 23

IF YOURE TRADINGOPTIONS, WHATYOU DONT KNOWABOUT VOLATILITYCAN CERTAINLYHURT YOU. BUTDESPITE ALL THEBOOKS WRITTENABOUT THE SUBJECT,ALL THATS REALLYNEEDED IS AGOOD HANDLEON THE BASICS.

VOLATILITY

PRIMER

The Key toOptionsEnlightenment

ByOphir GottliebandKevin Lund

PHOTOGRAPHBY FREDRIK BRODN


24/36

When option traders use the terms

expensive or cheap, theyre generallyreferring to the amount of IV built into theprice of an option. Whats important tounderstand is that IV has a direct impact onan options premium. As IV rises, option pre-miums rise, and vice versa. The following is asimple example showing the impact of anincrease in IV on option premiums:

Assume an at-the-money call option witha $20 strike on a $20 stock, with 30 days toexpiration, interest rates at 1% annually, andno dividends (these are the variables typi-cally needed to plug into an options pricing

model). The following table demonstrateshow the option premium changes with thelast variable, implied volatility:

Looking at the table, you can see thattheres a direct correlation between anoptions IV and its price, though the formulaisnt always 1:1 (as is shown here for an at-the-money option). Out-of-the money options, forexample, will increase as IV rises at a much

faster rate than those that are at the money.

Assessing Market Volatility:

High or Low?

Have you ever purchased an option, beencorrect on the direction that the stock was

volatility was not a consideration, optionstrading would be all about buying calls when

you expect stocks to move up and buyingputs when you expect stocks to move down.Unfortunately, its not that simple. But itdoesnt have to be complicated, either. Just alittle bit of knowledge about volatility couldmake the difference between choosing a longcall loser or a short put winner.

So, lets get back to basics and examinejust what volatility means to you, the optionstrader, before moving on to more advanced

concepts.

What Exactly is Volatility?

There are three main issues that must be con-sidered in your stock analysis prior to initiatingan options position:

1 /Direction. Is it going up, down, orsideways?2 /Duration. The amount of time youexpect the direction to last.3 /Magnitude. What is the volatility ofthe underlying asset? This includes how big

a securitys move will be and to whatdegree that expected move is already fac-tored into the options price.

Its important to realize that volatilitymoves in cycles, going from one extreme toanother over the course of time. Typically, itbounces back and forth around an averagelevel, which is why volatility is considered tobe mean reverting. A good analogy is thatvolatility is similar to a spring. When thespring is coiled tightly, it will explode out-ward; once it has stretched out to anextreme, it will snap back to its mean.

This is exactly how volatility works.

When it's too low, it will explode upward;too high, and it will revert back down to nor-mal levels. In the real world, this keeps hap-pening until the fundamentals of theunderlying asset change (i.e. oil spill, newproduct announcements, FDA approvals,etc.). When that happens, the new normal(mean) moves up or down. Its important torealize that its rarely possible to time thesemoves perfectly; volatility can stay inextreme ranges for periods much longer than

you might anticipate.

The Volatility We Care AboutAs an options trader, there are two types ofvolatility you should be concerned with: onethat looks at the past, and one that attemptsto forecast the future.

1 /Historical volatility (HV) measuresthe underlyings past realized movementover a period of time. Since its in thepast, it is entirely known (observed) andis expressed as an annualized numberbased on the period of time used to meas-ure it (i.e., 20-day HV is 35%) .

2 /Implied volatility (IV) is the optionmarkets forecast of the future volatilityof the underlying, and is directly reflectedin an options premium. IV, which is for-ward-looking and can change, is alsoexpressed as an annualized number.

Special Focus: Volatility Primer24 S E N T I M E N TSUMMER 2010

If10% 20% 50% 70% 100%

$0.23 $0.46 $1.14 $1.60 $2.28

IV

Option price

FIGURE 1: Weekly chart of VIX.As a measure of the S&P 500 Indexs implied volatility, the VIX is a good proxyfor overall broad market volatility. This chart can help you get a sense of whether equity options in general arecheap or expensive relative to the VIXs current trading range.

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Certain known future events areexpected to have a substantial impact on thestock price before they occur. In such situa-tions, its expected that the IV will be greaterthan the HV. The most common of these isan earnings release.

Scheduled Volatility Events

IV rises into earnings because on release daythe underlying can experience greater move-ment (stocks can make huge short-term

moves after earnings announcements). Asearnings approach, the IV for the month rises.Think of volatility rising into earnings the

way you think about airfare at Christmas-time. Prices go up, and everyone knows it.Take the implied volatility data for Apple(AAPL) just before and after earnings on

January 25th of this year. Three days beforeearnings, at-the-money IV was at 37%. Theday before earnings, it spiked to 49%. And

then the options are said to be cheap rela-

tive to those with higher IVdue to thelower perceived risk of movement implied bythe market.

Comparing IV to past IV puts the oddssubstantially in your favor on any position.And a quick way to do this for any option-able equity is with the Schaeffers VolatilityIndex (SVI) (Figure 2), which averages theimplied volatilities of both the at-the-moneyputs and calls. For this reason, its a bit likean equity VIX for individual stocks, andcan be a quite useful tool. (For more detailon how to use the SVI, see Idea Lab, page

31, or Tools of the Trade, page 27.)

COMPARING IV TO HV

With the two types of volatilities (IV andHV), you can see that every options trade isa bet on how future volatility will play outcompared to the implied volatility pricedinto the option. In a theoretical, predictabletrading environment, where a stocks IValways eventually converges to its HV, a sim-ple trading rule emerges: Buy options whenthe implied volatility is lower (cheaper) thanthe historical, and sell options when the

implied volatility is higher (more expensive)than historical. The rule proves profitablewhen the IV converges with same level asthe HV.

Oddly enough, the same trading rulederived from a predictable trading worldisnt too far from the real-world trading rule.That is, the rule stands unless there is a rea-son to think otherwisebuy low IV and sellhigh IV when compared to HV.

www.schaeffersresearch.com SUMMER 2010 Special Focus: Volatility Primer 25

heading, and yet the option still went down

in value? If so, then youve probably experi-enced the direct effects of a change in IV.Though the option you purchased may havebeen cheaply priced, dollar-wise, it may havebeen relatively expensive IV-wise. This is avery common mistake among newcomers tothe options market, and is one reason why itsimportant to have an understanding of theunderlying securitys IV. There are a coupleof ways to approach this:

COMPARING IV TO PAST IV

The quickest way to get a sense of overall

market volatility is to compare the currentIV to its past. Perhaps the best place to startis by viewing a chart of the CBOE VolatilityIndex (VIX). (See Figure 1.)

The VIX represents the weighted averageof the implied volatilities of near- and at-the-money S&P 500 Index puts and calls. Oftendubbed by the media as the markets feargauge, the VIX can be viewed as a measureof implied volatility on the market itself, andit helps to give traders a feel for how expen-sive or cheap options are in general based onthe activity of the options in the S&P 500

Index. As you can see in Figure 1, at its cur-rent price of around 24, it is at the lower endof its recent range. That indicates options ingeneral are cheaper than when the VIXwas trading at 40.

Once you have a grasp on the level ofimplied volatility for the broader market, acritical step to deciding what type of optionstrategy to trade is to assess the impliedvolatility of the security youre interested in.For example, when looking to buy options onequities, its a good idea to look for those onthe lower end of their IV range and sell

options that are in the higher end of thatrange. Why? Just as the old adage says, Buylow, sell high. And if IV is close to its lows,

FIGURE 2: Schaeffer's Volatility Index (SVI) on IBM.

At the lower end of its recent range, if you werebullish on IBM, youd look to buy calls while thevolatility priced into the option is minimal.Source: SchaeffersResearch.com

SchaeffersTake:Debunkingthe GoogleMyth

contract, you can buy 10contracts of XYZ with

your $2,000. Its thesame investment. Now ifboth stocks rise 5%(translating to a $25move in GOOG or a$2.50 move in XYZ),your GOOG call shootsup $17 to $37, for a totalof $1,700 in profit. Onthe other hand, the XYZcall rises $1.70 to $3.70,for a profit of $170 percall. Because you own 10contracts, your totalposition profits $1,700as well. In the end, its the

volatility.Suppose youve allo-

cated $2,000 to invest inan option trade, andyouve got your eye onGOOG at $500 as wellas XYZ at $50. An at-the-money GOOG callthat expires in 30 dayscosts $20, while the $50stocks at-the-money, 30-day option costs $2.Both options have 35%implied volatility. Thefirst thing you shouldsee, aside from price, isthat while youre onlyable to buy 1 GOOG

an inaccurate tenet oflogic: Big moves in high-

priced stocks equate tobig moves in theiroptions. While its truethat the options on a$500 stock typicallymake greater nominalmoves than those of a$50 stock, the reality is, ifyouve invested identicalamounts in each trade,the same percentagemove in the former canresult in a far lowerreturn on investmentthan the latter, depend-ing on the implied

Q: Do the options inhigh-priced stocks

offer greater leveragethan those of lower-priced stocks?

A: Many new traders arelured into the world ofoption speculation hop-ing to cash in on the nextGoogle story for theleast amount of capitaloutlay. Perhaps inno-cently, they wronglyassume that monsterstocks like Google havethe greatest leverage foroption buyers based on


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An options trader reads this as, Downsidevolatility is higher than upside volatility.

ConclusionBy now, you should see that options trading isactually volatility trading. When you buy (orsell) an option, youre essentially takingavolatility position. Before entering any optionsposition, its a good idea to examine impliedvolatility relationships such as IV to past IV orHV, in case theyve diverged, and ask yourselfif they make sense in the context of yourexpectations.

If youre making a bet on the direction ofthe stock, search the skew for spread opportu-nities. If youre making a bet on future volatil-

ity, research the historical volatility and set aspecific volatility expectation. With a strongunderstanding of the basic and advanced con-cepts of volatility, youll find yourself armedwith a bigger edge in a world of unique, newopportunities.

/ / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / /

>> Contributing authorOphir Gottlieb is head ofclient support and algorithmic trading at LiveVol.com, asite dedicated to options and volatility analytics. He canbe reached at [email protected]./ / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / /

finally, just one day after earnings wereannounced, IV reverted back to 38%.

Court decisions and FDA announcementsfollow the same methodological approach torising IV. That is, there is one single day with amuch higher implied volatility (forecastedstock movement) than the rest. As that dayapproaches, the implied volatility of theoptions increases. Large lawsuits and drug rul-ings can have implied volatility days several

times that of a normal trading day for a stock.In these cases, we would expect a divergencebetween historical and implied volatilities, sothe simple trading rule of selling optionswhose IV greatly exceeds HV doesnt fit andcan be very dangerous if the event proves verysignificant.

Advanced Volatility 201: The Skew

So far, weve discussed volatility as a singlenumber. In the real world, the volatility ofeach strike price is different. Were you to

plot each volatility level of each strike on a

graph (Figure 3), you can see that the curve(function) that the volatility forms. This iscalled the skew. The shape is often referredto as the volatility smile or smirk. Ratherthan simplistic comparisons between IV andHV, it is the discrepancies in the volatilitysmile that often present the greatest tradingopportunities.

The volatility smile exists for two reasons.First, because of a basic real-life principleabout the investing world: the investingworld is long stock. Thus, the vast majority ofthe equity positions are long stock. This is

driven by rules that govern pension funds,mutual funds, 401(K)s, and the retail public,as well as a general phenomenon that humanbeings prefer to own securities in the expecta-tion that they will rise in price rather than sellthem in the expectation that they willdecline. These realities have a direct impacton options prices (and therefore volatilities).

A long investor makes two general optionstrades to hedge his or her long stock. The firstis to purchase downside puts as insuranceagainst a portfolio drop. This increases thedemand for downside puts. The second trade

is to sell calls against long stock (coveredcalls). This acts both as an income-generatingstrategy and as a small hedge for downsidemoves. Call sellers imply a decrease indemand for upside calls. Options are likeevery other asset: Increased demand frombuyers raises put prices; increased supply fromsellers depresses call prices.

The second reason a volatility skew existsis because, typically, the market moves downfaster than it moves up. Historically, bear mar-kets are much more abrupt than bull markets.

FIGURE 3: Volatility smile of AAPL options.

Depending on the demand for a particular strike,option volatility (vertical axis) typically increasesto the downside and drops to the upside.

Source: LiveVol.com

HAVE YOU EVER PURCHASED ANOPTION, BEEN CORRECT ON

THE DIRECTION THAT THE STOCKWAS HEADING, AND YET THE OPTIONSTILL WENT DOWN IN VALUE?IF SO, THEN YOUVE PROBABLYEXPERIENCED THE DIRECT EFFECTSOF A CHANGE IN IMPLIED VOLATILITY.

same profit/loss sce-nariodollar in equalsdollar out.

Now, without makingthings complicated,implied volatility isessentially the price ofrisk. As mentioned inthis issue already, thehigher the impliedvolatility, the more themarket anticipates largefuture swings in thestock price. And whilethe higher risk translatesinto higher options pre-

miums (aka risk pre-mium), it actuallyreduces the leverage ofan option for buyers. Infact, in our example, ifthe implied volatility ofthe GOOG option washigher at the onset ofthe trade , say 60%rather than 35%, theprice to buy thatGOOG call would beabout $29, and the same5% move would net youa $15 gainnot $17. Sohigh fliers like GOOG

arent necessarily thebest deal in town. Youcan see this for yourselfby plugging some num-bers into an option cal-culator such as the oneat SchaeffersRe-search.com before plac-ing your next trade. Justgo to www.sentiment.com/calc06.

Taking it a step fur-ther, often youre betteroff with lower-priced,lower-capitalizationstocks that can make

moves (in particular tothe upside) that far out-run anything a volatility-based option pricing cananticipate. In otherwords, the lognormalreturns assumption asstocks increase in valueworks better on high-priced, mega-cap stocks,but not so well onsmaller-cap stocks, whichcan potentially double ortriple before your eyesbased on a new productor takeover.

Each week at Schaeffers Research we take a closelook at volatility readings and new trading ideas inourMonday Morning Outlook.For a free sub-scription, go towww.sentiment.com/VolMMO


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this data point against the other charts anddata on this page, you can begin to determinewhats driving the SVI.

Step 2: Pinpointing Volatility Trends

Next, click on the SVI thumbnail chart. Thiswill bring up a more detailed view of the SVI,with the indicator laid over a graph of thestocks price action. (For greater detail on howthis tool works, go to page 31 of this issue.)More often than not, youll find that surges inthe SVI coincide with periods of bearish price

actionfor example, Figure 1 displays thehuge climb in implied volatility that coincided

with BP plcs (BP) oil-spill-related sell-off.Of course, a stocks SVI wont always movedirectly inverse to the stocks price. Thatswhy you can zoom in for a closer look at thepast three months worth of data, or broaden

your scope to examine trends during the pastyear or more.

Plus, the table youll find to the right dis-plays the specific SVI readings for each of thepast 10 days, allowing you to drill down on thecurrent exact reading, as well as recentchanges. This table also confirms that impliedvolatility trends are rarely a straight line in

either direction.

Step 3: Letting History Be Your Guide

From Step Two, scroll your way down to thebottom of this page, where youll see a handylist of related links and tools. Clicking throughto Implied Volatilities, will help you find keyhistorical context for your volatility research.

As noted on page 24 of this issue, impliedvolatility is a key component in determiningoption prices. However, its not always easy togauge whether options are cheap or expensivesimply by looking at the history of implied

volatility as shown on our SVI charts. It is alsohelpful to compare current implied volatilitylevels against the stocks realized historicalvolatility for a comparable time frame.

Using SR.coms Implied Volatilities tool(www.sentiment.com/IV), you can pull up amontage of the current implied volatility read-ings for a number of near-term options on yourselected stock (Figure 2). Even better, youllbe able to view the underlying stocks histori-cal volatility for the past one-, two-, andthree-month periods. By comparing theimplied volatility of the equitys near-the-

money options versus the stocks realized his-torical volatility, you can begin to gaugewhether option prices are fairly inexpensive,or relatively pricey.

And you dont have to be an options expertto read the volatility tea leaves, either. Whenimplieds are running higher than historicalvolatility, its a warning sign that options couldbe expensive meaning, it might not be thebest time to buy premium. Conversely,implied volatility readings that are lower thanthe equitys historical volatility point to com-paratively inexpensive option prices, whichcan be a boon for option buyers.

Get Your Volatility Fix

BEFORE YOU TRADE, RESEARCH YOUR

VOLATILITY IN THREE EASY STEPS

Tools of the Trade

FIGURE 1: By taking a more detailed look at SVI, youcan get a sense of how price action of the underlyinghas corresponded with spikes in implied volatility.(www.sentiment.com/SVI)

FIGURE 2:Using the Schaeffers Implied Volatilitiestool can help you determine if the underlyingsoptions are cheap or expensive.(www.sentiment.com/IV)

PAYING TOO MUCH FOR IMPLIED

volatility is a rookie mistake, but veteran

options traders can get burned just as easily.When youre caught up in the excitement ofa new trading idea, its easy to forget to do

your volatility homework. However, a quicktrip to SchaeffersResearch.com before youplace that order with your broker can save

you from discovering after the fact that youpaid too much for your option, resulting inan unattractive reward/risk profile for yourtrade. With just a few clicks, youll be wellon your way to navigating the rocky road ofimplied volatility.

Step 1: Putting Volatility in ContextA logical starting point is the Get Quotebox, located on the upper right-hand side ofSchaeffersResearch.com homepage. Simplydrop in a ticker to pull up six sentiment-spe-cific thumbnails.

Once there, you can eyeball a stocksSchaeffers Volatility Index (SVI) to get ageneral idea as to whether implied volatili-ties are rising or falling. A rising SVI couldpoint to rising fear levels as traders bid upthe price of put protectionbut it could justas easily be the result of a looming earningsreport for a well-loved stock. By comparing

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www.schaeffersresearch.com SUMMER 20 10 Confessions of a Trader 29

SOME PROFESSIONAL SPORTSLIKE

skiing, surfing, and skateboardingrequireathletes to learn how to take a fall withoutserious injury. Professional boxers learn howto take a punch without getting hurt (well,

nottoo

hurt). And professional traders dontjust learn how to make a profit; they alsolearn how to manage losses. Why tell youthis? Because falling is to skiing as losses areto tradinginevitable. And the sooner youaccept that, the sooner you can begin formu-lating your strategy on how to lose less when

you take your own punches.Id love to give you the perfect anecdotal

trade that I screwed up on to discuss for thisarticle, but there are just too many. Ive beenwhipsawed, stopped out, spooked out, and ofcourse, taken the all-too expensive coffee

break, only to find a tidy profit turn into a bumloss in the course of 20 minutes. So instead offocusing on my own loser, lets focus on

yoursyour next one, that isand how youmight be able to fix it.

When Should You Adjust?

The reality is, every trade you take starts outwith a loss. When you buy at the ask, you can

only turn around and sell for a bid thats lessnever morethan what you just paid. Butsomewhere between your entry and your painthreshold (i.e., stop loss), theres probably anopportunity to adjust your trade if your con-viction remains that the underlying will turn

back around.Since every trade is different, under whatcircumstances would you want to adjust atrade (rather than simply close it out and puton a different one)? It depends, but typically,its when you still believe your analysis is cor-rect, but the trade is experiencing a short-termhiccup. Youre down, but not out, so to speak.Provided that hiccup is somewhere between

your entry and your predetermined stop loss(you do have a stop in mind, dont you?), youcan mitigate your risk, take back some of theloss, and buy some time for the trade to turn

around.One little caveat: trade adjustments onoptions tend to work better for swing and posi-tion trades that youre holding for a few days orlonger. Because of the volume of trades andsmall profit targets, intraday traders are likelybetter off sticking to a tight stop-exit strategyrather than to meddle with adjusting.

Adjusting a Long Call

Lets start with a common scenario: Supposestock XYZ is trading at $50 in June. You buya number of August 50 calls for $4 each

(with a stop loss at $2). Over the course ofthe next week, the stock drifts down to $48,and your calls are now worth about $3(halfway between your purchase price and

your stop loss). Whats the fix?Obviously, you could simply get out, but

that would work against your trading planand foster a gambling mentality. On theother hand, there is one simple alternativethat can appease your emotional need to exitand your conviction to stick with your plan:adjust the trade.

When adjusting a losing long call posi-tion, look to sell something to take back

some of the losses incurred. One way is tosimply sell calls against your position at thenext higher strike, converting the long callsinto vertical spreads (see Going Vertical,SENTIMENT, Spring 2009). Assumingthere is premium to sell at that strike, by

doing so, you will (1) help to mitigate, andslow down, further risk, and (2) recoupsome of the losses. The downside? If you sellcalls against all of your longs, then youvecapped your profit potential to the differ-ence between the strikes and the total debit

you paid. One sneaky workaround for this isto simply not sell as many calls as you own(assuming youve bought more than one),which leaves you with unlimited upsidepotential on the unhedged calls.

ITS IMPORTANT TO REM

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