Sentiment 2011 Summer

8/6/2019 Sentiment 2011 Summer

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14

Trading On the LevelSome traders squeeze a charts data until it confesses

what they want it to say. Others rely on tried and

true signposts to tell them where a stock might be

headed. Using price levels as your guide can reveal a

lot about a stocks direction with less torturous

means.

/

20

Seven Habits of VerySuccessful TradersCaught in an options trading funk?

Break the bad habits, forget about what

youve been doing wrong, and focus

on what you should be doing right.

Here are seven habits the best

options traders use to get back on

their feet again.

6

The Sentiment ReportRising prices at the

pump havent stopped

consumers from spend-

ing. After a nearly 300%

return since 2009 lows,

what should a contrar-

ian think about discre-

tionary stocks?

/

10Making News, Etc.

A serving of market

highs and lows, industry

news, and important

dates for option traders.

/

13Ask Bernie

Advice from our

founder on equity

volatility, open interest,

and what it means to

tie a stock.

/

25

Confessions of aTrader

Struggling with what

options strategy to use?

Think inside the box.

/

26Idea Lab

How to gauge whether

options are expensive or

cheap in the blink of an

eye + TOOL REVIEW:

Bernie Schaeffer From

the Top/

Photographed

by Fredrik Brodn

/

4At the Open

With multi-year lows in

volatility, there couldnt

be a better time to buy

options.

/

28.COM

Where to go and what

to see right now at

Schaeffers Research

online.

/

0 (30)Pro Pearls

In an interview about

contrarian techniques,

Paul Montgomery

reveals some tricks of his

trades./

SM ART OPTIONS

FOR TODAY S INVESTOR

SUMMER 2011

BERNIE SCHAEFFERS

14/TECHNICALLEVELS REVISITED

20/SEVEN HABITS OF VERYSUCCESSFUL TRADERS

25/EASING THE PAIN OFMAKING DECISIONS

>>

FEATURES COLUMNS

COVER

REGULARS

PUBLISHERT3 Publishing LLC

EMAIL: [email protected]

www.t3publishing.com

ADVERTISING CONTACTKatie Schaeffer

513.589.3800 X1145

[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 SENTIMENTonline, go toschaeffersresearch.com/sentiment.

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

BERNIE SCHAEFFERS

SENTIMENT

EDITORIAL DIRECTORKevin Lund

CONTRIBUTING WRITERSTodd Salamone, Rocky White,

Elizabeth Harrow, Andrea Kramer

ART DIRECTORTom Brown

ASSISTANT EDITORJennifer Agee

DESIGNERJennifer Roberts

CHIEF PHOTOGRAPHERFredrik Brodn

CONTRIBUTING ILLUSTRATORJoe Morse

www.schaeffersresearch.com SUMMER 2011 Contents 3
http://schaeffersresearch.com/sentimenthttp://schaeffersresearch.com/sentiment


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Letter from

Bernie

4 S E N T I M E N TSUMMER 2011

THERE HAS BEEN LOTS OF TALK THESE

days about low volatility, and rarely do I see

it presented as a happy concept. Some marketanalysts complain about low volatility as anindication of a dangerous complacency byinvestors thats often associated with markettops. The high-frequency trader contingent,which accounts for as much as half the dailytrading volume in equities, grouses that theirtrading opportunities become sparser whenvolatility is more muted. And covered callwriters and naked put sellers are forced tooperate with much thinner rewards for thedownside risks they incur.

The good news is that lower volatility is

unambiguously bullish for the option buyer,for the simple reason that premiums for at-the-money options (on non-dividend payingstocks) are directly proportional to theimplied volatility (IV) of those options. Forexample, the premium for a three-month,100-strike call on a $100 stock with an IV of50% is about $10; at a 25% IV, this premiumgets cut in half to $5. Chop the option pre-mium and you leverage the options lever-

ELIZABETH HARROW

Senior Equities Analystand Editor for SchaeffersResearch.com. She writes

the Trading Floor Blog, editstheMonday MorningOutlook, and contributes

to SFO Magazine.

ANDREA KRAMER

Senior Equities Analyst andan Associate Editor forSchaeffersResearch.com.She writes the Daily OptionBlog, hosts the Options Stewvideo series, and contributes

to Stockhouse.com andStockTwitsU.

Schaeffers

Contributors

to This Issue

ROCKY WHITE

Senior Quantitative Analystand contributor toMonday

Morning Outlook. He holdsa masters degree infinancial engineering, andhis research is quoted onBloomberg TV, CNBC,and Fox Business News.

age for a given move in the stock. And inthis example, a 20% stock rally to $120 byexpiration will result in the 50 IV optiondoubling from $10 to $20, but the 25 IVoption will quadruple from $5 to $20.

So with IV at its lowest level in four years,we know the environment is favorable forbuying option premium and will remain so ifIV remains relatively flat. But what are therisks to this bullish scenario for option buyers?A slow and steady rise in IV would actually be

favorable for premium buying, as you wouldbe buying premium at todays IV level and,presumably, volatility will rise during theholding period for your option. The worst-case scenario would be a sharp spike higher inIV, followed by a period where realized volatil-ity falls short of the aggressive volatilityassumptions built into option pricing. A goodexample of such a period was the second halfof 2009. Another challenge could be pre-

TODD SALAMONE

Senior VP of Research andauthor of theMonday

Morning Outlook. Hismarket insight is featuredregularly on CNBC,Bloomberg,The Wall Street

Journal, and Fox BusinessNews.

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

www.sentiment.com/OpAd9

sented if IV continues to decline, perhaps tothe levels we saw in 2005. While leveragewould remain attractive for option buyers,achieving the price movement to cash in onthis leverage could present a challenge over aperiod of low and declining volatility.

For now, I think it behooves us to look tosharpen our trade timing skills to best takeadvantage of the outsized rewards availablein the options market to those who can suc-cessfully forecast significant directional

movement in focused time periods. MyTrading on the Level feature (page 14)will identify for you some shortcuts to find-ing price levels that can serve as ideal tradeentry (or exit) points, yet can easily fallunder the radar for many traders. And youllalso want to take careful note of our SevenHabits of Very Successful Traders co-fea-ture (page 20), so you dont end up lookingfor leverage in all the wrong places!

Between these SENTIMENT featuresand the insights from our regular depart-ments, I think youll agree you have another

great resource for bolstering your tradingresults in your hands.

Bernie SchaefferFounder and CEO,Schaeffers Investment Research

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

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

At the Open

MULTI-YEAR LOWS IN

VOLATILITY BRING

GARAGE-SALE PRICES

TO OPTIONS TRADERS


5/32

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6/32

The Sentiment Report6 S E N T I M E N TSUMMER 2011

EVER SINCE THE GREAT RECESSION FIRST

took its toll on both Wall Street and MainStreet, pundits have waxed endlessly aboutthe dire prospects for U.S. consumersnot tomention the retailers and restaurants thatdepend almost wholly upon discretionaryspending. Against the backdrop of stubbornlyhigh unemployment and a shaky-at-best eco-nomic recovery, it seemed to be a foregoneconclusion for many talking heads that con-sumers just arent willing to shell out like theyused to.

More recently, surging fuel prices reignitedthese old, familiar worries. A recent spike in

oil and food prices could weigh on employersdesire to hire, interrupting the improvementin the job market, and curb consumer spend-ing, warned the Associated Press on May 19,echoing the resoundingly grim mood inspiredby higher prices at the pump.

However, as regular readers of our MondayMorning Outlook are already aware, stocks inthe consumer discretionary space have beenan underappreciated pocket of strength forquite some time now. With so many naysayersstill refusing to capitulate to the bullish trend,the solid fundamental and technical perform-ance of so-called leisure stockscombinedwith the lingering skepticism and negativesentiment levied against the grouptrans-lates to prime trading opportunities for con-trarian-minded investors.

Starting FactsBased on the following, it seems that con-sumer spending is alive and well, despitereports to the contrary. Retail sales rose 0.5%in April, according to the Commerce Depart-ment, marking the tenth consecutive monthof expansion. Even if the effects of higher gasprices are factored out, retail sales still

increased 0.2% for the month. Along thesame lines, the 25 major retailers tracked byThomson Reuters saw same-store salesincrease by 8.9% in April, topping expecta-tions for a gain of 8.4%, and marking the bestoverall month in a year.

And, for the record, its worth noting thathigher oil prices do not necessarily translate tolower prices for consumer discretionarystocks. The SPDR S&P Retail (XRT)exchange-traded fund (ETF), which tracks abasket of consumer cyclical names, advancedfrom $34 to $50 per share from February 2010through February 2011a time frame duringwhich oil prices jumped from $70 to $100 perbarrel. This simultaneous rise in both oil andXRT seems to shatter the myth that healthyconsumer spending habits and higher oilprices cannot coexist.

Sentiment: The Contrarian TakeAdditionally, stocks in the consumer discre-tionary groupwhich includes gaming,

restaurant, and retailnamesrank highly inour internal scorecardsystem, which weightsthe sentiment backdropon individual equitiesagainst their technical

performance. In otherwords, components ofthese sectors haveshown a strong propen-sity to rally amid evi-dence of skepticism.

Taking a closer lookat the sentiment data,stocks in this sectorcould benefit from bull-ish analyst attention.Zacks reports about48% buy ratings for

equities in the retailand restaurant sectors,suggesting that theresample opportunity for

upgrades as the positive price action contin-ues. Any optimistic notes from brokerage firmcould help to draw new buyers to the table.

Elsewhere, the 50-day buy-to-open put/calvolume ratio for XRT has been trendinghigher lately. The rise in this ratio reveals thattraders have been buying puts over calls at anaccelerated pace as the ETF rallies, which canbe viewed as a bullish indicator. Deep-pock-eted investors often purchase ETF puts tohedge their long stock holdings, so an increasein the sectors put/call ratio is frequentlyindicative of share accumulation. Since thesebig-money players are purchasing optionhedges, theyre less likely to panic-sell on neg-ative news. In short, this data suggests to us

that strong bullish handsare beginning to buy intoXRTs rally. That beingsaid, a rollover in this indicator would signal thepotential for short-termcaution.

Will the Consumer Stop Buying?

DESPITE CONVENTIONAL WISDOM, RISING OIL ANDLEISURE SPENDING CAN COEXIST. BUT FOR HOW LONG?

>> By Todd Salamone and Elizabeth HarrowEFIGURE 1:The relentless consumer.Even oil piercing $4 a gallon at the

pump and gold making all-time highs hasnt stopped consumers fromspending on unessential items, as evidenced by this chart of the SPDRS&P Retail ETF (XRT).

LEARN MORESEE PAGE 8 FORMORE IDEAS ONCONSUMERDISCRETIONARIES.

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

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

01/30/09 08/14/09 02/26/10 09/10/10 03/25/11

55

50

45

40

35

30

25

20

15

0.1

10-week MA 20-week MAXRT


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please read the Characteristics and Risks of Standardized Options available by visiting etrade.com/optionsdisclosure, calling 1-800-ETRADE-1 or writing E*TRADESecurities LLC, P.O. Box 1542, Merrifield, VA 22116-1542.1. This offer applies only to new Power E*TRADE accounts opened with a minimum $2,000 deposit from an external bank or brokerage account. You will receive up to 500 tradecommissions for each stock or options trade executed within 60 days of the deposited funds clearing in the new account. You will pay $9.99 for your first 149 stock or options trades and $7.99thereafter up to 500 stock or options trades (plus 75 per options contract). Account must be funded within 60 days of account open. Credits for cash or securities will be made based on depositsof new funds or securities from external accounts made within 45 days of account open, as follows: $250,000 or more will receive $500; $100,000-$249,999 will receive $250; $50,000-$99,999will receive $100; $25,000-$49,999 will receive $50. Your account will be credited for trades and deposits within eight weeks. You will not receive cash compensation for any unused freetrade commissions. Excludes current E*TRADE Securities customers (except IRA accounts), E*TRADE Financial Corporation associates and non-U.S. residents. This offer is not valid for IRAs,other retirement, business, trust or E*TRADE Bank accounts. New funds or securities must remain in the account (minus any trading losses) for a minimum of 6 months or the credit may besurrendered. One promotion per customer and per linked account. E*TRADE Securities reserves the right to terminate this offer at any time. Accounts must be opened by December 31, 2011, theoffer expiration date.2. All customers will be charged an additional $45 for broker-assisted trades. The options customer service team can be reached at 1-866-222-6124 from 8:30 a.m.to 5:00 p.m. EST.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.2011 E*TRADE Financial Corporation. All rights reserved.

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The Sentiment Report8 S E N T I M E N TSUMMER 2011

THE CONSUMERDISCRETIONARYPLAYERS

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

SPDR S&PRetail (XRT) 19%

13%

Ann Inc.(ANN),

OReilly Automotive(ORLY),

Childrens PlaceRetail Stores

(PLCE),J.C. Penney Co.

(JCP)

RetailHOLDRS Trust

(RTH)

Wal-Mart Stores(WMT),

Home Depot(HD),Amazon.com(AMZN),

Walgreen Co.(WAG),

Target Corp.(TGT)

PowerShares

Dynamic Leisureand Entertainment

Portfolio

(PEJ)

Starbucks(SBUX),

Liberty Media(LINTA),

Priceline.com(PCLN),

Wynn Resorts(WYNN)

PowerShares

Dynamic Food &Beverage Portfolio

(PBJ)

Starbucks(SBUX),

Campbell SoupCompany(CPB),

Coca-Cola Co.(KO),

Yum! Brands(YUM)

ETF TOP HOLDINGS SVI*(AS OF 5/31/11)

SCHAEFFERS

VOLATILITY INDEX (SVI)

The SVI helps you tellwhether option prices

for a stock are relativelycheap or expensivebased on prior impliedvolatility. It measuresimplied volatility relativeto itself and plots it overtime. A run-up in the SVImight pose a risk tooption premium buyers,for example, but could bean opportunity for pre-mium sellers. Current SVIreadings are at schaeffersresearch.com/svi.

THE SETUP

BUY IN-THE-MONEYCALL+BUY OUT-OF-THE-MONEY PUT(same strike as call)

THE RATIONALE

BULLISH STOCK AFTERA LARGE RUN-UP Lingering negative senti-ment, i.e. high short inter-est, low analyst buy ratings,excess speculative putactivity. Low volatility (SVI) rela-

tive to past volatilityargues for the purchase ofcheap out-of the-moneyput protection in casebullish forecast does not

play out.

THE GOOD AND BAD

WHAT YOU SHOULD LIKE

Acts like a call on anupward move in the stock,with limited loss or poten-

tial profit on a downwardmove Maximum risk is defined

WHAT YOU MIGHT NOT LIKE

Requires purchase oftwo legs Time decay will erodemore quickly if no move-

ment in stock occurs

STRATEGYWATCH ////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////THE TRADE

BULLISH STRADDLEON A CONSUMERDISCRETIONARY ETF

Will a trade unfold in the consumer discretionarysector? Follow along in our Monday MorningOutlookeach week for updates. You can sign up at:www.sentiment.com/mmo9

WhatIt Should

LookLike:

BULLISHSTRADDLE

(3-month)

HYPOTHETICAL EXAMPLE:

Stock at

$53Straddle the 50 strike:

50 strike call option = $3.6050 strike put option = $0.80

Straddle price = $4.40

At trade onset:

Trade acts like a long call, but with abetter safety net. Profits almost immedi-

ately if stock moves higher. Limiteddownside at this point.

At trade expiration:

Breakeven prices are$54.40 and $45.60.

In other words,the stock would need to move only

2.64% higheror

13.96% lowerto make a profit.

Maximum loss ifstock finishes at $50.

Stock Price

Start of tradeExpiration

Stock at Startof Trade

100

75

50

25

0%

-25

-50

-75

-10040 42 44 46 48 50 52 54 56 58 60


9/32

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access to this platform, you must execute at least 30 stock or options trades by the end of the following calendar quarter.2. 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 affiliatesare responsible for 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 orinstrument discussed therein to engage in any specific investment activity.3. This offer applies only to new Power E*TRADE accounts opened with a minimum $2,000 deposit from an external bank or brokerage account. You will receive up to 500 tradecommissions for each stock or options trade executed within 60 days of the deposited funds clearing in the new account. You will pay $9.99 for your first 149 stock or options trades and$7.99 thereafter up to 500 stock or options trades (plus 75 per options contract). Account must be funded within 60 days of account open. Credits for cash or securities will be madebased on deposits of new funds or securities from external accounts made within 45 days of account open, as follows: $250,000 or more will receive $500; $100,000-$249,999 willreceive $250; $50,000-$99,999 will receive $100; $25,000-$49,999 will receive $50. Your account will be credited for trades and deposits within eight weeks. You will not receive cashcompensation for any unused free trade commissions. Excludes current E*TRADE Securities customers (except IRA accounts), E*TRADE Financial Corporation associates and non-U.S.residents. This offer is not valid for IRAs, other retirement, business, trust or E*TRADE Bank accounts. New funds or securities must remain in the account (minus any trading losses)for a minimum of 6 months or the credit may be surrendered. One promotion per customer and per linked account. E*TRADE Securities reserves the right to terminate this offer at anytime. Accounts must be opened by December 31, 2011, the offer expiration date.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.2011 E*TRADE Financial Corporation. All rights reserved.

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MakingNews, Etc.10 S E N T I M E N TSUMMER 2011

Feeling Gassy?While the national average of gas prices atthe pump has reached nearly $4 per gallon, savvy traders hav

been enjoying the upside of the U.S. Gas Fund (UGA)anexchange-traded fund (ETF) that tracks gasoline pricesthrough futures contracts traded on the New York MercantilExchange. Touching a 52-week low of $30 in late August 2010it nearly doubled by May 2011 to $56. You might lose yourwallet at the pump, but that doesnt mean you cant hedge thcost of driving your SUV with a few bull call spreads.

A Silver Lining As the U.S. dollar continued its abysmaldescent early this year, the inflation hedge of choice by traderswas silverpushing the metal 81.3% from January to April toan all-time high of $48.60 before it came crashing down to $3a share by mid-May. Part of the volatility has been blamed on

ETFs like the iShares Silver fund (SLV), which represent owner-ship of the metal stored in bank vaults. Have investors overre-acted? Keep an eye on the SLVs sentiment indicators for clues.

OPTIONMARKETDATES

YOUSHOULDKNOW

1NEW

HIGHSAND

LOWS>Schaeffers Leverage isoff to a bang-up start in2011proving thatsometimes it pays to take

the conservative route.This real-time alert ser v-ice provides subscriberswith six to eight in-the-money option recom-mendations each month,

each targeting 100%gains. Since these optionsalready carry a healthydose of intrinsic value,exposure to time decayis minimized. Plus, in-the-money options offer ahigher delta than theirout-of-the-money coun-

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3>Our founder andchairman, BernieSchaeffer, was onceagain tapped to

deliver a keynoteaddress at the Las

Vegas MoneyShow in

May. His speech, Top

or No Top?, offered a

point-by-point argu-

ment as to why the

bull market is still

firmly intact. As regu-

lar followers of

Bernies analysis

might have guessed,

our analyst-in-chief

believes that techni-cals are keybut

investor sentiment

also plays a key role in

determining whether

this bull still has legs

to run higher.

In general, the

degree of disbelief

associated with the

huge rally off the

March 2009 bot-

AUGUST

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toma rally in which

the Russell 2000

Index (RUT) has

more than doubled

has been unprece-

dented in my decades

of tracking investor

sentiment, he

explained. There are

four stages of investor

sentiment as the mar-

ket moves from bot-

toms to tops. Thedominant sentiment

at bear-market bot-

toms is despair; the

initial rally off the

bottom is then met

with disbelief. The

rally finally goes

through the accept-

ance phase, and the

final warning sign

that a top is at hand is

investor euphoria. To

suggest we are at amarket top before this

rally has been fully

accepted by main-

stream investors is to

believe we are going

to skip the euphoria

stage this time

around, and I see this

as highly unlikely.

For further reading,

see The Argument

Against a Market

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11/32


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There is a substantial risk o loss in trading commodity utures, options and o-exchange oreign currency products. Past perormance is not indicative o uture results.

The inormation provided herein is taken rom sources believed to be reliable. However, it is intended or purposes o inormation and education only and is not guaranteed by CME Group, Inc. orany o its subsidiaries as to accuracy, completeness, nor any trading result and does not constitute trading advice or constitute a solicitation o the purchase or sale o any utures or options. TheRulebook o the applicable exchange should be consulted as the authoritative source on all current contract specifcations.CME Group is a trademark o CME Group Inc. The Globe logo, CME, Chicago Mercantile Exchange, E-mini and Globex are trademarks o Chicago Mercantile Exchange Inc. CBOT and ChicagoBoard o Trade are trademarks o the Board o Trade o the City o Chicago. NYMEX, New York Mercantile Exchange and ClearPort are trademarks o New York Mercantile Exchange Inc. COMEX isa trademark o Commodity Exchange Inc. All other trademarks are the property o their respective owners.

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How can I use Schaeffers Volatility Indexto determine the appropriate options strat-egy for the stock Im watching?BERNIE: The SVI will not only provide youwith a historical implied volatility chart foreach equity, but also a table displaying the last

10 days (schaeffersresearch.com/svi).Perhaps the simplest way to use the SVI isto compare the most recent trading days datawith the historical average from the past.Because volatility is mean-reverting, that is, ittends to oscillate around an average level,support and resistance levels are fairly easy tospot. If the current SVI is higher than the his-torical SVI, the option premiums are likelymore expensive and more suitable for a sellingstrategy such as short verticals or short nakedputs, for example. If the SVI is trading at themean or lower, you may want to consider longstrategies such as purchasing calls and puts orlong verticals.

One caveat before you sell option pre-mium based on high SVIs: the SVI for equitiestends to cycle so that it peaks just ahead of

earnings reports and bottoms betweenreports. So by selling premium near SVIpeaks, you may well be taking on some major

event risk within a few days.

Q: What is open interest, and where can Ifind it?

BERNIE:Open interest (OI) tracks thenumber of positions opened in an option.Each contract has a unique level of OI thatchanges as investors buy or sell. If I buy 10September 350 puts on Apple to take a newposition, open interest might increase by 10contracts if the option seller is also opening. Ifthe other party is closing (while I open), thenet result is no change in open interest. Later,

when I offset the trade by closing 10 AppleSeptember 350 puts, open interest declines by10 contracts if the other party exits the tradeas well. Buying, selling, exercise, and expira-tion affect OI. When an option contract islisted and when it expires, open interest iszero. You can find the current open interestfor any options contract using options quotesat schaeffersresearch.com.

Q: If an options position is tied to shares,was the stock position bought or sold short?BERNIE:Options positions are often tied tostock in increments of 100 shares per option.For example, in a covered call strategy, aninvestor is buying 100 shares of stock per callsold. In a protective put, 100 shares of stockare bought and tied to one put option. Tied

simply means that the options are part of acombination play in which the investor istrading options along with shares or futures.

Some strategies are tied to long stock orfutures, but not all. Many institutionalinvestors use tied trades to make bets onvolatility. A recent example was a trade insoftware maker Electronic Arts (ERTS). On

May 13, 2011, a block of 20,000 December 27calls was bought against a short position in660,000 shares of ERTS. The deltathe rateat which the options move when the stockdoeson the calls is 0.33, and on 20,000 con-tracts, the total delta is roughly the same asbeing short 660,000 shares (or 0.33 x 100 x20,000). Since 660,000 shares were sold, thedelta of the total position is zero or neutral.Tied positions are often designed to profitfrom options time decay or changes in volatil-ity. Shares may be long or sold short. The keyto long-term profitability of tied trades is oftenin the adjustments made along the way.

Let Volatility BeYour Guide

EQUITY VOLATILITY CAN MEAN ALLTHE DIFFERENCE WHEN CHOOSINGYOUR STRATEGY>> 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 limited timeto learn how to tradeoptions?Go tosentiment.com/HSP9

Q:

The Man withthe Answers:

BernieSchaeffer

www.schaeffersresearch.com S U MM E R 2 0 11 Ask Bernie 13

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

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

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


14/32


15/32

www.schaeffersresearch.com SUMMER 2011 Technical Focus 15

SOME TRADERS CHOKE A CHARTS DATA UNTILIT CONFESSES WHAT THEY WANT IT TO SAY.

OTHER, MORE SUCCESSFUL TECHNICIANS RELY ONTRIED AND TRUE SIGNPOSTS TO TELL THEM

WHERE A STOCK MIGHT BE HEADED.USING PRICE LEVELS AS YOUR GUIDE CAN

REVEAL A LOT ABOUT A STOCKS DIRECTION WITH LESS TORTUROUS MEANS.

BYBernieSchaeffer

ILLUSTRATIONS BYJOE MORSE


16/32

of the extent of its usage by the investmentcommunity?

Just as buying a momentum stock univer-sally loved by the entire analyst communitycarries the danger of a crowded trade (inwhich there is a rapidly diminishing pool ofpotential new buyers, rendering the stockvulnerable to peaking or to declining sharplyon any hint of disappointment in companyoperations), buying a stock based on a pricelevel that is widely touted by market punditsand the technical analysis community can behighly problematic.

I will discuss four general categories ofactionable price levels in this article:

1. Long-term moving averages2. Non-standard moving average units3. Half-high and double-low levels4. Round number levels

Smooth AveragesThe logic of using moving averages as sign-posts or key levels on the charts is quite com-pelling. The simple moving average(computed by summing the closing prices fora specified number of data points measuredin common units of time and then dividingthis sum by the total number of data points)is a smoothing tool designed to eliminate aportion of the noise in the price fluctuationsand retain a greater portion of the pure priceinformation underlying the data (also knownas the signal).

If a stock closes five days ago at $97, andthen proceeds to close at $98, $102, $104,and $99 over the next four days, a logicalexpression of the true stock price over thisfive-day period would be $100the simpleaverage of the daily closing prices. If the nextdays closing price is $97, the five-day mov-ing average will remain at $100 (the averagenow of $98, $102, $104, $99, and $97), andso you can see that the five-day moving aver-

Technical Focus16 S E N T I M E NSUMMER 2011

A

ccording towww.goodwords.com,

those who built the greatcathedrals of Europe cen-turies ago used levels

(usually with bubble gauges) to prove hori-zontals in foundations and floorings. Thelevel indicated that things were as theyshould be, and on the level eventuallybecame synonymous with truthfulness.

One of the great challenges in successfultrading is identifying price levels that canindicate potential areas of support and resist-ance. This is particularly important for tradersassessing whether a pullback in an uptrend is

normal and indicates the prevailing bullishaction is likely to resume, or whether its suffi-cient to indicate a trend reversal. In the for-mer case, existing long positions should beheld or perhaps sized bigger and new longpositions can be considered. In the latter case,existing long positions should be liquidatedand new short positions can be considered.

In addition, for those who trade nakedlong call or put options, there is a timing ele-ment associated with contact between astock price and a significant support or resist-ance level. By this I mean there is often a

chemical reaction of sorts between theshare price and the support or resistancelevel that results in a rapid price resolution inone direction or the other. This rapid priceresolution is gold for the call or put optionbuyer, whose reward, risk, and ultimate suc-cess are defined by the old time-is-moneyadage. In fact, for the option buyer, avoidingextended periods of sideways price action is aclose second in importance to being correcton the direction. In this sense, trading onthe level can be considered a critical successfactor for naked long option buyers.

The Level Litmus Test

There are two factors Ive found to be criticalto developing levels on the chart that areactionable in the sense that paying attentionto them can significantly improve your trad-ing performance and ignoring them will oftenbe at your peril.

1. Is the process for determining anactionable level strongly grounded in thelogic of stock price action and/or in the logicof human emotions and behavior?

2. If the answer to #1 is stock priceaction, is the process uncrowded in terms

There are other great articles discussing levelson our website. For one on options strikes servingas short-term support and resistance, go tosentiment.com/level1


17/32

age is more stable compared to daily prices.A comparison of the daily closing prices andthe five-day moving average can show thetrader where the current stock price standsrelative to a smoother representation ofrecent price action. Todays closing price hasthe advantage of being the most current; themoving average has the advantage of beingless noisy.

Another benefit of the moving averageand its smoothing property is that it is veryclear visually on a stock price chart, allowing

the trader at a glance to compare daily (orweekly, or monthly) prices to various movingaverage levels. If the trader deems a particu-lar moving average to be significant, in gen-eral, a closing price above this movingaverage is considered bullish and a closebelow bearish. It is also considered bullish ifthe moving average is rising (has a positiveslope) and bearish if it is falling (has a nega-tive slope).

The Four Levels

LONG-TERM MOVING AVERAGESThe standard moving averages on a dailychart are the 50-day and 200-day movingaverages. These are followed by just aboutevery market technician and are frequentlyquoted in financial media articles discussingstock market action. Thus, these arecrowded tools and are best used as areminder of what the crowd is looking at, notas tradable indicators. The crowded equiv-alent on the weekly chart of the 200-daymoving average is the 40-week moving aver-age. Figure 1 (upper chart) displays the S&P500 index over the past 17 years with its 40-week moving average. As you can see, the

19952000 bull market was pretty muchdefined by support from the 40-week movingaverage, though there were significant

downside penetrations in 1998 and 1999. Ingeneral, the 40-week moving average hasprovided a nice, smooth framework for theS&Ps price action over this period, and is alevel that should be on the radar of all seri-ous traders.

The advantage of creating moving aver-ages longer than 40 weeks is two-foldtheyprovide a smoother representation of priceaction (more signal and less noise) and theyare on the radar of only a fraction of thosewho follow the standard averages and canthus be used as trading tools in addition to

reference points. The disadvantage oflonger-term moving averages is that anexcessive degree of smoothness means it canbecome staleit covers such a long timeperiod that it can become irrelevant to cur-

rent price levels.Ive found the 80-week moving average

to be near-ideal as a trading toollongenough to provide a strong signal compo-nent, but not so long as to create a major riskof staleness, and off the screens of mosttradersand this is displayed on the 17-yearchart of the S&P (Figure 1, bottom chart).Note how the 80-week moving average per-fectly defined the 19952000 bull market as

support, with just a single closing weekly barbelow the 80-week (and this close was quitemarginalwithin one point). The close

below the 80-week moving average in mid-November 2000 heralded the bear marketdecline into the 2002 and 2003 bottoms.Once the 80-week was retaken in June 2003,it was smooth upside sailing for the marketuntil the downside penetration in January2008. And the markets inability to re-takethe 80-week moving average on the mid-2008 rally defined a textbook failed bearmarket rally that was followed by the sicken-ing declines into the 2008 and early-2009bottoms. Finally, the market rallied and re-took the 80-week in October 2009, and it

has not looked back since.

NON-STANDARD MOVING AVERAGESAs mentioned, the 50-day moving average iswidely followed (as is the 40-week). But

what if you were to examine the 40-day mov-ing average? You may find attractive tradingopportunities that escape many traders, inparticular on stocks that are in stronguptrends. The pullbacks in such stocks tendto be brief and shallow, and those who wait

17Technical Focus

FIGURE 1: Long-term moving average.S&P 500 with a 40-week moving average (upperchart) and 80-week moving average (lower chart),July 1994May 2011.

THE ADVANTAGEOF CREATING MOVINGAVERAGES LONGERTHAN 40 WEEKS ISTWO-FOLDTHEYPROVIDE A SMOOTHERREPRESENTATION OFPRICE ACTION (MORESIGNAL AND LESSNOISE) AND THEY AREON THE RADAR OFONLY A FRACTION OFTHOSE WHO FOLLOWTHE STANDARD AVER-AGES AND CAN THUSBE USED AS TRADINGTOOLS IN ADDITION TOREFERENCE POINTS.

S&P 5001600

1400

1200

1000

800

600

400

1600

1400

1200

1000

800

600

400

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

40-week MA

80-week MA

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11


18/32

returns for the S&P showing that beyondthis current period, we have seen a double inthe S&P over 102 weeks on just two other

occasions1934 and 1937. The S&P has infact struggled at the 1333 doubling level, asis well illustrated in Figure 2. Since firstreaching 1333 in mid-February, the S&P hascrossed above and below this level on eightseparate occasions and has closed within apoint of it six times.

A similar phenomenon can operate on50% declines off a major peak, at whichpoint buyers begin to establish positions onthe theory that the share price has beenpunished enough by being cut in half. And

with similar reason-

ing, shareholderswho have suffered allthe way down andwho have beentempted to sell alongthe way might dig intheir heels andresolve to hold.

ROUNDNUMBERSA rallying marketencounters resist-

ance or speed bumpsat round numberlevels through a sim-ilar process. Round

number levels (such as $100 for a stock or1000 for a market index) naturally tend toattract extra attention, and can remindinvestors that a rally may have reached thepoint at which it would be a good idea totake some money offthe table.

The 17-year epicstruggle by the Dow

Jones IndustrialAverage at the 1000mark is legendary.According toWikipedia, theDow first exceeded1000 during thetrading day on Janu-ary 18, 1966, butdropped back beforeclosing that day. Itwould be nearlyseven years laterbefore it closed

above 1000 for the first time. And it was nountil February 24, 1983, that the Dow finallyclosed above the 1100 level.

A great example of this round numberhex is occurring right now in the S&P 400Mid-Cap Index (MID), which has poweredto all-time highs this year. But the rally hasstalled atyou guessed itthe 1000 mark,as shown in Figure 3. This is a far cry fromthe Dows 17-year struggle, but it is certainlyno surprise that this round number levelwould at the very least attract short-termprofit taking.

NOTE THAT YOU WILL ENCOUNTER

significant moving average levels much more

frequently than you will doubling points andhalf-highs and major round number levels,though you may be able to identify some off-the-beaten-path variations of such levels (particularly over shorter time frames) that canadd value to your trading. Just remember toapply the two major guidelines for developingactionable levels, and you will consistentlybenefit from the road maps they provide.

Technical Focus18 S E N T I M E NSUMMER 2011

for the decline to reach the 50-day movingaverage are often left at the gate as the pull-back falls shy of this level. Many times,

though, these pullbacks will touch the 40-day moving average, providing excellententry points for alert traders. Similarly, thereare pullbacks that penetrate the 50-daymoving average and shake many traders outof long positions, only to be supported at the80-day moving average and once again pro-vide non-standard but solid entry points forbuyers. Constructing non-standard movingaverage units for your trading plays verystrongly to the power of the uncrowded (butwell grounded) indicator.

HALF-HIGHS AND DOUBLE LOWSOver the years, Ive found that when a stockor stock index doubles from a major low, thestock price level associated with the doubleoften becomes a speed bump or a resistancearea. This is likely because many holders ofthe security decide it is time to take some orall of their investment off the table because ithas already doubled, which raises concernsthat it could be vulnerable to a reversal offortune. This phenomenon also plays to thenatural (and self-defeating) tendency forinvestors to be more fearful of giving up prof-its on successful trades than of incurringadditional losses on unsuccessful trades.

An excellent illustration of the double asspeed bump principle at work is the actionof the S&P 500 in 2011 at and around the1333 level, which is double the intraday lowat the March 2009 bottom. My esteemedcolleague Paul Montgomery (see ProPearls, page 30), published a chart earlierthis year of 102-week (two-year) rolling

FIGURE 2: Double low. The S&P 500 has struggled to trade above 1333, which isexactly double the intraday low from the March 2009 bottom.

FIGURE 3: Resistance at 1000. The S&P 400 Mid-Cap Index is a great exampleof the round number hex occuring in real time. While it traded at all-time highsearlier this year, the 1000 level is proving to be formidable resistance.

BUYERS BEGIN TOESTABLISH POSITIONSON THE THEORY

THAT THE SHARE PRICEHAS BEEN PUNISHEDENOUGH BY BEINGCUT IN HALF. SHARE-HOLDERS WHOHAVE SUFFERED ALL

THE WAY DOWNMIGHT DIG IN THEIRHEELS AND HOLD.

S&P 500 1360

1340

1320

1300

1280

1260

11 FEB MAR APR MAY

11

990

970

950

930

910

11 FEB MAR APR MAY

S&P 400 Mid-Cap


19/32

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Trader Mindset20 S E N T I M E NSUMMER 2011

Caught in a

trading funk?Break the bad habits,forget about what youvebeen doing wrong, and

focus on what you shouldbe doing right.

Here are seven habitsthe best traders

use to getbackon their

feet again.

SevenHabitsofVerySuccessfu

TradersBy

PHILLIPSWIEGAND, JR.

and KEVIN LUNDPhotograph by Fredrik Brodn


21/32


22/32

Trader Mindset22 S E N T I M E NSUMMER 2011

They have theright attitude

As in most aspects ofour lives, having the right attitude is impera-tive to successful trading. This may seemobvious, but most of us possess potential thatfar exceeds what we ordinarily imagine; yet,too often we place limitations on ourselveswithout even realizing it. We blame a failedstrategy or a losing streak on someone otherthan ourselveswhich only works to seedmore failure. Its been said that successfuloptions trading is 10% strategy and 90% psy-chology. That said, one thing you can counton is that youre going to have setbacks.

Dont underestimate the significance of howyou handle your next loss. It could set thecourse of your future as a trader.

They dont ignoredue diligenceThe business of trading has always been lit-tered with folks who think they can make afortune because theyre smarter than themarkets. Ultimately, most of these peoplewash out because theyre not willing to putforth the necessary effort to succeed. Butdont think its enough to simply subscribe toa couple of newsletters. Such tools shouldserve to complement your own due dili-gence. Over the long haul, two minds thatarrive at the same con-clusion are typicallybetter than onepar-ticularly if one of themis your own and theother has a proventrack record. If yourejust starting out,newsletters such asSchaeffers Option

Advisor are great

resources to help you sift through the moun-tains of information available and learn how

to put it to use.

They keep it simpleThe advent of the personal computer andoptions trading software in the last twodecades has been both a blessing and a curse.On the upside, its leveled the playing field byallowing the average Joe to make a livingtrading the stock market with analysis tech-niques that were previously available only toinstitutional traders. Ironically, this is also itsdownside. Simply put: Less is more. Dont getcaught in the indicator trap by using too

many of these tools,or you may becomeprone to analysisparalysiswhentraders use too manyindicators and findthemselves at animpasse, unable toenter good trades orget out of bad ones.Its possible to get socaught up in devel-oping a system,tweaking a strategyjust a bit more, orcramming that last

data point into a search, that itbecomes nearly impossible tocapture the information neededfor a clear and concise tradingidea. Too much information canblur the mind and lead youdown the wrong path to indeci-sion or missed opportunities.Keeping it simple is the best wayto remain lucid and avoid a con-voluted thought process.

They have

a planIf you find your-self taking moredrawdownsthan profits,step back andlook at yourplan to see where you may have gone wrong.Oh, you dont have a plan? Make one. If youwant to succeed long-term, this is critical.Doubling down on losers or resorting to pray-ing for a rebound are not part of a valid plantheyre recipes for disaster. A carefully

developed (and simple) plan that getsyou in when the timings right anddictates what to do when things gowrong is essential. Something as sim-ple as (1) having predetermined entryand exit points, (2) determining theright options strategy (see Confes-sions of a Trader, page 25, on how todetermine a strategy based on trendand volatility), and (3) deciding howmuch risk to allocate for each trade,are all thats really needed to create abasic options trading plan. If your planhas too many parts, take another lookat Habit 3.

MOST PEOPLE SPEND A LOT OF TIME FOCUSING ON MISTAKES theyve made in the past,hoping to avoid the same undesirable results in the future. Although this can be helpful, perhaps itwould be even more useful to take the focus off yourself and examine what other highly successful

options traders are doing right instead of what youre doing wrong. By focusing on the actions nec-essary for success, you will program your mind to achieve your goals and objectives, while allowingfor mistakes to be made without wiping you out. So what exactly are the best traders doing differ-ently? Here are seven of the most important habits that youll need for a successful trading mindset


23/32

23Trader Mindset

Having a proper mindset is key to your tradingsuccess. Read the article Four Questions to AskBefore Tradingonline atsentiment.com/habits1

They trade their planHabit 5 is the implementation of Habit 4, andit dictates one of the oldest tenets in trad-ingplan your trade and trade your plan. Theobjective in this business is to remain in thegame. The more often you walk to the plate,the greater the chance you have of smacking

the ball out of the park. Each time you place atrade, youre taking on risk, and there ispotential for loss. A solid plan anticipateswhat can go wrong and includes options forwhat to do about it.

They protect theirdownside and upsideWhen executed appropriately, even anoption trading plan that employs only apremium-buying strategy (buying calls andputs) can offer built-in protections thatstock traders dont enjoy. To some extent,

option trading lossesare controlled forthe premium buyerby the smaller up-front dollars and thereward/risk equa-tion, which is con-trolled by convexityof options on theprofit side versus anabsolute dollar losslimit on the lossside.

Further, optionbuyers need an

equalif not greateramount of disciplinewhen they have a profitable trade as whenthey have a losing trade. They need the dis-

cipline to hold on and achieve the outsizedprofits that are necessary to offset the morefrequent losing trades. In other words, dontbe excessively nervous aboutgiving back profits or toocomfortable allowing a losingtrade to get bigger.

They adapt to changeIt may sound like a clich, butin fact the only thing inoptions trading that stays thesame is change. The financial

markets are dynamic beaststhat have a funny way of hum-bling you just when you think

you have it all figured out. Itsreally not possible to have asolid grasp of everything thatthe market discounts while it moves, andwhat makes it all so interesting and complexis the multitude of variables that affect theprices of securities, and subsequently, theprices of options.

Generally, as a trader, youll need to drawon hindsight in order to understand the true

reasons why the marketbehaves the way it does.Since the variables areconstantly changing, youcan rarely find an exactmatch when comparingone period of time toanother. Instead, success-ful traders simply adapttheir options tradingstrategies to the ever-evolving market. Whatsworking now may notwork tomorrow, and itsalways important to be

flexible enough toadjust to such changes.For example, whenlow-volatility environ-ments suddenlybecome high-volatility,

you might switch your

premium-buying strat-egy to a premium-sell-ing strategy.

Whats most impor-tant is to be nimble(and perhaps humble) enough to act quicklywhen you begin to recognize that your per-fect system is breaking down. And when itdoes, you should be ready, willing, and able toswitch gears with a new plan (see Habit 4),instead of being paralyzed by losses when itsalready too late.

Optionstraders

needdiscipline

to holdon and

achievethe out-

sizedprofits

necessaryto offset

the morefrequent

losingtrades.

ConclusionOptions trading is both an exciting and challenging vocation. But its important to remember that it is just one aspect of ourlives. Keeping everything in perspective is part of living a balanced, healthy, and happy life. Whether youre performing well orin a trading funk, emotions can run high at your trading desk. Its important to mitigate this as best you can and attempt tooperate with a calm and collected mindset. In addition to these seven habits, you should always maintain a reasonable per-spective of the market. It owes you nothing and doesnt care whether you win or lose. After you wholeheartedly accept thistruth and implement some basic good habits into your regimen, you too can be a highly successful trader.


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www.schaeffersresearch.com SUMMER 20 11 25

MOST OPTIONS TRADERS DONT START

out trading spreads or selling premium. Youtypically learn how to trade by simply buyingcalls in bullish markets and puts in bearish

ones. After a while, you realize long calls andputs dont always work as they should, partic-ularly in moderate trends or when volatilityaccompanies strong trends.

So if youre only buying calls and puts,heres a scenario thats probably familiar:Youre bullish on a stock after a small pull-back, so you buy some calls. The stock moveshigher, but your options dont. Oops. You mayhave picked the perfect entry point on price,but you neglected the high-volatility premiumbuilt into the price of those calls because ofthe pullback. When the stock moved back up,the volatility premium was taken out. Ohwell. Better luck next time, right? Not really.Lady Luck has nothing to do with it, but yourchoice of option strategy does. The questionis, which one do you choose?

Building a Box

If youre stumped, there are many optionsstrategies to choose from that accommodatevarious market conditions. In the last issueofSENTIMENT, we laid out some spread-trading basics and described four core strate-gies, each with their own qualities that makethem well-suited for a particular trend and

volatility backdropthe long vertical, shortvertical, butterfly, and calendar spread. In

addition to buying calls and puts, as a start-ing point, you can plug all of these strategiesinto a strategy box to help you pick theperfect trade. (See Figure 1.)

The box only requires trend and volatilityas inputs, both of which you can get atschaeffersresearch.com. Use your choice ofcharts and indicators to determine trend.Then gauge where current volatility isagainst the stocks historical implied volatil-ity using Schaeffers Volatility Index, or SVI(see Ask Bernie, page 13, for more onSVI). Once youve figured out trend and

volatility, just plug them into your strategybox and voila! Your decision is made.

Putting it Together

How does this work in practice? Supposeyoure looking at the hypothetical describedaboveyoure trying to buy on a dip whenvolatility is higher than normal. Simply lookat the Bullish cell in the top row, and lineup the strategy with High Volatility in theleft row. Instead of buying a call, perhaps a

higher-probability strategy would be to sell a

put vertical spread.

OF COURSE, THERES NO GUARANTEE

the strategy the box will be right every time,but if you choose a strategy designed for theconditions youre facing, you stand a muchbetter chance of profiting versus blindly buy-ing calls just because youre bullish. All thatsleft now is to decide how much risk you wantto take on and pull the triggertwo topicsbetter left for future issues.

Think Inside the Box

BUILD A STRATEGY BOX TO OVERCOME YOURINDECISION ABOUT WHAT TO TRADE.

>> By Kevin Lund / PHOTOGRAPH BY FREDRIK BRODN

M

Confessions of a Trader

FIGURE 1: Plug and play.To build a simple strategy box, just plug in the strategies youunderstand that typically fare best under certain trends and volatility scenarios.

StrongBullish

Bullish Neutral Bearish Strongly Bearish

DIRECTIONAL BIAS

VOLATILITY

Low

Volatility

High

Volatility

Buy CallBuy CallVerticalSpread

CalendarBuy PutVerticalSpread

Buy Put

Sell PutSell PutVerticalSpread

Butterfly,Iron

Condor

Sell CallVerticalSpread

Sell Call


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past three months. The

score is then calculatedbased on the followingfour components:

1. HV vs. IV. First, welook at the three-month historicalvolatility (HV) on thestock and compare it tothe implied volatility(IV) of the stocksoptions. Has the stockbeen more volatile over

the last three months compared to whatoption prices are predicting going forward?

2. Gaps. Theres nothing better than buyingan option and then having the stock make amajor gap in your direction soon after. We lookat the number of gaps up or down that thestock has made in recent history.

3. Big Daily Moves. This component simplycounts the number of big moves made by thestock. However, looking at percentage returnsalone isnt good enough. To define a big

move, we use the implied volatilities onoptions to find the stocks expected dailymove. Then, we measure the daily return instandard deviations based on the expecteddaily move.

4. Average Daily Standard DeviationReturn. Using options to determine thestocks expected daily move, and measuringstock returns in standard deviations, we findthe average stock move each day. We use theabsolute value, so it doesnt matter whetherthe shares went higher or lower. Only themagnitude of the move is considered.

HYPOTHESIS CONFIRMEDAfter developing the SVS, we tested it onthree types of premium buying strategies

WHEN MOST EXPERT

analysts love a particu-lar stockrun! Theyreusually wrong. Welooked at stock returnsin the first and secondhalf of each year since2000, and broke thestocks into three

groups depending onthe percentage of buyrecommendations. Thegroup of most-lovedstocks had an averageof 76% buy ratingsfrom brokerage firms.Those stocks per-formed the worst, up

just 0.81% on averageover a six-monthperiod. The least-lovedstocks had an averageof just 34% buy rat-ings, yet these under-dogs performedhead-and-shouldersabove the analysts

IdeaLab26 S E N T I M E N TSUMMER 2011

TO AVOID LOSSES, A STOCK TRADER SIMPLY

needs to be right on the direction of the stocksprice. However, trading options is more complex,

as option contracts carry a time value compo-

nent. The more volatile the underlying stock,

the more time premium is included in the option

price and the more the underlying stock needs to

move in order for the trader to turn a profit.

For example, with a stock priced at $100,the 95-strike call option may cost $8. Thispremium consists of $5 of intrinsic value and$3 of time value. For the option trader tomerely break even on expiration day, thestock needs to rise to $103. A 95-strike callon a more volatile stock may be priced at$10 ($5 intrinsic and $5 time value), inwhich case the option trader would need thestock to rise as high as $105 in order to reachbreakeven. In other words, its not enough

for the stock to move in the right direction.It must make a directional move that exceeds thevolatility-based assumptions of the option pric-ing model. As Bernie Schaeffer likes to say:In options tradingyou pay for volatility but

your payoffis in directional price move-ment. Thats why we created the Schaef-fers Volatility Scorecard (SVS), which is aproprietary ranking system that compares astocks price action against the volatilityexpectations reflected by that particularstocks options. A stock that tends to makebigger moves than its options pricing would

indicate is said to have relatively cheapoptions. The cheaper the options, the easierit will be to make money when buying them.

HOW IT WORKSAll stocks are ranked from zero to 100, withhigh scores suggesting the stock has relativelycheap options and low scores indicating rela-tively expensive options. The idea, of course,is to buy cheap options, and avoid buyingormaybe even sellexpensive options. To cal-culate the SVS, we look at stock data over the

T

TURNINGTRADITIONAL

MARKETR&D ON ITS

HEAD

SCHAEFFERS

VOLATILITY

SCORECARD

GAUGING THE COST OF

VOLATILITY AT A GLANCE

idea #1

favorites, with an aver-age six-month returnof 7.6%. This is just oneexample as to why itpays to take these rat-ings with a contrariangrain of salt.

TABLE 1: Relative cheapness.When it comes to option-buying strategies,stocks with a relatively high SVS (options are cheap) offer greater successthan those with low SVS.

Most Loved Stocks 76% 0.81% 50%

Moderately Loved Stocks 58% 5.34% 58%

Least Loved Stocks 34% 7.61% 58%

WHEN

STOCKS ARE

OVER-LOVED

F Y I

Average

Percent ofBuy Ratings

Average

6-MonthStock Return

Percent of

PositiveReturns

Call Options Put Options Straddles

PERCENTAGE OF DOUBLES

Bracket

Lowest SVS 18.4% 10.7% 7.3%

Moderately Low 20.6% 12.1% 8.8%

Middle 21.7% 12.9% 10.1%

Moderately High 21.1% 13.6% 9.8%

Highest SVS 21.7% 14.2% 10.8%


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www.schaeffersresearch.com SUMMER 2011 Idea Lab 27

long calls and puts and long straddles. Starting

at the beginning of 2010, we assumed purchas-ing at-the-money options twice during eachexpiration cycleonce on the day of the priormonths expiration, and then again two weeksbefore expiration. The options were assumedto be held until expiration and closed at intrin-sic value. We then broke the stocks into fivebrackets based on their SVS (see Table 1).Those with the lowest SVS scores (expensiveoptions) are at the top, while the highest SVSscores (cheaper options) are at the bottom.

LONG CALLS & PUTS To measure whether

were really capturing hidden volatility, wefound the percentage of options that doubleddepending on their SVS score. The first twocolumns of the table reflect the data for simplecall and put purchases. There is, in fact, a bet-ter chance at a double for stocks with highSVS scores as opposed to low SVS scores.Focusing on puts, the equities with the highestSVS scores saw options that doubled 14.2% ofthe time, compared to a 10.7% double rate atthe low end of the SVS spectrumtranslatinginto 30% more doubles at the high end.

LONG STRADDLESSince the SVS doesnot consider the direction of a stocks move,we tested our theory with straddles as well.A straddle is the purchase of a call and a putat the same strike, with the idea that you canmake money on any major stock move,whether its up or down. Again, the resultsshow the SVS to be proficient at findingstocks with a propensity to make big movesrelative to their option prices. When tradingequities with higher SVS scores, 10.8% ofstraddles doubled in value, compared to just7.3% for the lowest-ranked stocks. Thats45% more doubles on stocks with high SVSscores.

Again, when playing options, getting thestocks directional move right is not alwaysenough. To bank big profits, the magnitude ofthe move must be greater than what theoption prices are predicting. Its easier to makemoney buying stocks with relatively cheapoptions, and the SVS is one valuable tool weuse to do this.

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

>> Rocky White Senior Quantitative Analyst,Schaeffers Investment Research/ / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / /

CHAEFFERS CHAIRMAN AND CEO, Bernie Schaeffer, is a widely recognized name

on Wall Street, having made his mark as a leading authority on equity options, investor sentiment,

and market timing. For nearly three decades, Bernie and his staff of analysts have utilized his Expec-

tational Analysis methodology to help investors exploit option trading oppor tunities based onthis unique combination of technical, fundamental, and sentiment analysis.

Most often, Bernie opines via his From the Top column on SchaeffersResearch.com, where he

discusses individual stocks, commodities, the broader equities market, and everything in between.

As a result, the Schaeffer's home page has become a frequent pit stop for active traders looking for

a fresh contrarian spin on the hot investing topics of the day. Below is a run-down of some of his

most recent contributions:

Option Advisor CommentaryEach month, Bernie addresses subscribers of his renownedOption Advisor newsletter, where he divulges whats currently on his proverbial radar, offers his

two cents on the current market environment, or relays investing tips for contrarian traders.

The Argument Against a Market TopThe recent turmoil in the commodities pits, alongwith escalating concerns about the fiscal health of the euro zone, have prompted more than a few

analysts to wax pessimistic on the market. But considering the S&P 500 Indexs (SPX) progress on

the charts andmore importantthe linger ing skepticism among mainstream investors, theres

still plenty of buying power on the sidelines that could propel the major market indexes even higher

this year.

Not All Black Swans are Black SwansThe price action of the CBOE Market VolatilityIndex (VIX)otherwise known as the fear gaugesuggests the market has become less volatile

on pullbacks, which could be the direct result of amplified put buying by an increasingly active black

swan brigade.

Keeping It SimpleWhile dissecting the technicalities of option delta hedging, volatility, andhedge-fund put buying can help you predict and understand the markets movement, sometimes

it pays to keep it simple, as Bernie explains in this two-part installment.

SITEFEATUREFROM THE TOP

idea #2

FROMTHETOPFor nearly three decades, Bernie Schaeffer has beenone of Wall Streets leading market timing and options authorities.You can access his latest commentary by going to schaeffersresearch.com. From the Top is at the top right.S
http://www.schaeffersresearch.com/


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When it comes to earn-

ings, not only does it helpto know what the analystexpectations are, but thehistory of the marketsreaction before and afterprior earnings announce-ments. Trading is all about

probabilities, so when a stock reactsone way after earnings more thananother, you can speculate with greater

confidence or hedge your positionswhen things arent so certain.To access earnings commentar y from Midnight Trader, go tosentiment.com/mt9

INSIDE OPTIONS

Schaeffers newestvideo series, InsideOptions, offers aground-up optionseducation for rookiesand experts alike.Each week, Financial

Writer Jim Cunning-ham highlights a dif-ferent options tradingconcept or strategy,and provides aninside-out explana-

tion to build yourbase of tradingknowledge. With top-ics like Five Reasons

Why Options AreAttractive InvestmentTools, A History ofOptions, and Defin-ing Derivatives, basi-cally, its the best freeoptions educationyou can get for threeminutes a week.

To view Jims InsideOptions videos and

others, go tosentiment.com/videos

PRODUCING OUTSIZED RETURNS CAN BE ACHALLENGE WHEN THE MARKET IS UNCERTAINAND CHOPPY, OR EVEN BULLISHLY COMPLACENTTHATS WHEN YOU HAVE TO START THINKING LIKA HEDGE FUND AND CONSIDER OPTIONS PAIRSTRADING. FOR EXAMPLE, BY BUYING CALLS ON ACOMPANY POISED FOR A BREAKOUT MOVE WHIALSO BUYING PUTS ON A DISTRESSED COMPANIN THE SAME SECTOR (OR THE SECTOR ITSELF),YOUR PROBABILITY OF SUCCESS CAN DRAMATI-CALLY IMPROVE. IN THIS SCENARIO, YOU CANPROFIT ON THE CALL IF YOUR STOCK GOES UP INVALUE. IF THE SECTOR SHOULD MOVE AGAINST

YOU, YOUR PUTS CAN ACT AS INSURANCE,HELPING REDUCE YOUR LOSSES. THE TRICK TOTRADING THE PERFECT PAIR IS TO BE EQUIPPEDTO IDENTIFY STOCKS THAT CAN OUTPERFORMOR UNDERPERFORM AND HAVE THE SKILLS TOFIND POTENTIAL VOLATILITY SITUATIONS.To learn more about pairs trading, read Hunting forHedges in the Summer 2009 issue ofSENTIMENT:schaeffersresearch.com/sentimentTo get pairs trading ideas, subscribe to Hedge HunterTraderat: sentiment.com/HedgeHunter

FROM THE WINTER

2011 ISSUE

How to Fix a

Broken Trade Buying acall is not merely theheads you win, tails youlose scenario as it iswith stocks. There areseveral other critical fac-

tors that could workagainst you, such asdirection, time, andvolatility. Depending onwhich of these variableswreaks havoc on yourtrade, your adjustmentcould take on severalshapes.

Blogs from the Pros

.COM28 S E N T I M E NSUMMER 2011

SENTIMENTARCHIVES

A sampling of our bestSENTIMENT articlesthat youll find atSchaeffersResearch.com/SENTIMENT

commentary

HISTORICAL VOLATILITY VS. IMPLIED VOLATILITY:

A CASE STUDY ON SLV

>If you net-buy options, you have one simple goal. You want the actualvolatility of the underlying instrument to exceed the implied volatility

you paid for the options.That is, lets say you buy a front-month, at-the-money straddle in

Hypothetical Stock XYZ at a 30 volatility. If XYZ itself moves at a 40-volatility clip over the next month, odds are you put on a winning trade.

So with that in mind, look at a chart of the iShares Silver Trust (SLV)from March to May 2011 with 30-day implied volatility (IV) versus 20-day historical volatility (HV). Options here look like a steal, right? Imean, you can buy options at a mid-40s volatility, while SLV itself hasmoved around at an 80-volatility clip over the last 20 trading days.

But alas, theres the rub. HV looks backward, while IV looks forward.And if you look a bit further, you might notice that before SLV moved atan 80-volatility pace, it moved at a 20-volatility clipall of one monthago. In fact, over a longer course of time, options here are slightly high.

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

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

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

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

Real-TimeAlerts:

MUST SEE

VIDEOCAST

MUST-USE

TRADINGTOOLS

MIDNIGHTTRADEREARNINGSCOMMENTARY/ / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / /

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

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

Adam Warner

Outside the BoxFinding opportunitieswhere others cant

To read more of Adams commentary, go to: sentiment.com/adam9

Finding articles and stock commentary atSchaeffers is easy. Use the KEYWORD searchlocated at the top right of our home page atSchaeffersResearch.com. For example, type inOptions 101 or another subject heading from thissection, and view a list of recent articles.

S MA R T OP T I ON S

F OR TOD A Y S I N VE S TOR

SPRING 2011

BERNIE SCHAEFFERS

,12/ WEEKLY OPTIONSQUICK PROFITS

11/MONSTER STOCKS ORFOOLS GOLD?

18/ SPREADS PRIMER: A TRADEFOR ALL SEASONS

>>

////////////////////////////////////////////
http://www.sentiment.com/videoshttp://www.sentiment.com/videoshttp://www.sentiment.com/videoshttp://www.schaeffersresearch.com/sentimenthttp://www.schaeffersresearch.com/sentimenthttp://www.sentiment.com/HedgeHunterhttp://www.sentiment.com/HedgeHunterhttp://www.sentiment.com/HedgeHunterhttp://www.schaeffersresearch.com/sentimenthttp://www.schaeffersresearch.com/sentimenthttp://www.schaeffersresearch.com/sentimenthttp://www.schaeffersresearch.com/http://www.schaeffersresearch.com/http://www.schaeffersresearch.com/sentimenthttp://www.sentiment.com/videoshttp://www.sentiment.com/HedgeHunterhttp://www.schaeffersresearch.com/sentiment


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