Download - BERNIE SCHAEFFER’Szeninvesting.wdfiles.com/local--files/upload:schaeffer/schaeffer_201… · BERNIE SCHAEFFER’S SIR04_cover.rd3:pages.layout 12/29/09 3:31 PM Page 1. Interactive

SMAR T OPTIONS FOR TODAY’S INVESTOR

WINTER 2010

12/ OPTIONS EXPIRATION WEEK: A TIMELY OPPORTUNITY

16/ DEMYSTIFYING VIX OPTIONS23/ EXPECTATIONAL ANALYSIS:

INVESTOR SENTIMENT—THE SMOKING GUN

> >

BERNIE SCHAEFFER’S

SIR04_cover.rd3:pages.layout 12/29/09 3:31 PM

Interactive Brokers LLC is a member of NYSE, FINRA, SIPC — †Lowest cost broker 2005 through 2009 according to Barron’s online broker review. *Source: The Transaction Auditing Group Inc. (TAG) a third party provider of transaction audit services. For US stocks (53 cents per 100 shares better), the analysis included all market orders of 100 shares or more, up to 10,000 shares from January - June 2009. The analysis for US options (22 cents per contract better) included all market orders with order sizes of 1 to 50 contracts from January - June 2009. **According to Barron’s The 25 Leading Online Brokers - March 16, 2009. Barron’s is a registered trademark of Dow Jones & Company, Inc. Criteria included Trade Experience, Trading Technology, Us-ability, Range of Offerings, Research Amenities, Portfolio Analysis & Report, Customer Service & Access, and Costs. Supporting documentation for any claims and statistical information will be provided upon request.

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12Expiring with Profit If you think trading during expiration week is dangerous, think again. Not only do opportunitiesabound, but they can come with very little risk. The trick is knowing exactly what to do when there’s no time to lose. /

16Taking the Fear out of the Fear Index While popular financial media often quote theCBOE’s VIX when markets fall, the index is morethan just a barometer of market mood– it’s also tradable. Learn the nuts and bolts of trading VIXoptions straight from the folks who created them. /

SPECIAL SECTION

23Expectational Analysis SeriesTHE SMOKING GUN While analyzing charts andcompany financials are the preferred methods formaking trading decisions, market sentiment is dismissed by many as subjective and unreliable.Here’s why they’re wrong.

6The Sentiment ReportIf investing lexicon setsthe stage for what’s tocome, the words “NewEconomy” from 1999lead us to think “NewNormal” is a better fit—for now, anyway. /

8Making News, Etc.A serving of highs, lows,and relevant news foroption traders. /

11Ask BernieOption symbols arefinally getting amakeover. And youdon’t even need a trans-lator./

29Confessions of aTraderHow many times haveyou left money on thetable after exiting atrade? Maybe you’llnever have to again./

30Idea LabTurning sentiment intoan objective (and prof-itable) part of your trad-ing system. + SITEREVIEW: Schaeffer’sWatch List/

Photographed by Fredrik Brodén /

4At the Open2010 promises to be theyear of positive changefor the option industry./

32.COMWhere to go and whatto see right now at Scha-effer’s Research online. /

0 (34)Page ZeroPRO PEARLS If youwant to “follow themoney,” option orderflow analysis providessome clues as to whereyou might want to look./

SMAR T OPTIONS FOR TODAY’S INVESTOR

WINTER 2010

12/ OPTIONS EXPIRATION WEEK: A TIMELY OPPORTUNITY

16/ DEMYSTIFYING VIX OPTIONS23/ EXPECTATIONAL ANALYSIS:

INVESTOR SENTIMENT—THE SMOKING GUN

> >


FEATURES COLUMNS

COVER

REGULARS

PUBLISHERT3 Publishing LLCEMAIL: [email protected]

ADVERTISING CONTACTSadia Ashraf 513.589.3800 [email protected]

Schaeffer’s Investment ResearchMAIN 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 this publication, please call 800.327.8833.

To view SENTIMENT online, go to schaeffersresearch.com/sentiment

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


SENTIMENT

EDITORIAL DIRECTORKevin Lund

CONTRIBUTING WRITERSTodd Salamone, Bob Kraft,Nick Perry, Rocky White, Elizabeth Harrow

ART DIRECTORTom Brown, TBA+D

ASSISTANT EDITORJennifer Agee

DESIGNERJennifer Roberts

CHIEF PHOTOGRAPHERFredrik Brodén

CONTRIBUTING ILLUSTRATORJoe Morse

www.schaeffersresearch.com WINTER 2010 Contents 3

SIR04_Contents.rd3:pages.layout 12/29/09 3:37 PM

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IT STRUCK ME AFTER ATTENDING THE fourth annual FIA/OIC Equity Options Con-ference in New York this fall that numerousfactors have contributed to the equity optionsindustry’s astounding 36% compound annualgrowth rate since its inception more thanthree decades ago. Yes, the concept ofexchange-traded equity options was “an ideawhose time had come,” but it required anongoing commitment to continuouslyimprove the options product and transform agreat idea into a monumental success story.

Two shining examples were featured at thisconference. Elizabeth King of the Securitiesand Exchange Commission announcedapproval of an expansion of the industry’s“penny pilot program,” whereby selectedoptions classes trade in penny incrementsinstead of nickels and dimes. This greatlyreduces the transaction costs for individualinvestors by reducing the slippage created bythe difference between the bid and the ask.The program has now been expanded from 60to over 300 option classes that account formore than 80% of total options volume.

This huge expansion in penny increment

Letter fromBernie

HOW FAR WE’VE COME

NICK PERRYExecutive Website Directorfor Schaeffer’s since 1996,he’s an expert market sentimentician and has been featured in The WallStreet Journal, USA Today,Reuters, Investor’s BusinessDaily, and SFO Magazine.

ROCKY WHITE Senior Quantitative Analystand contributor to the Mon-day Morning Outlook. Heholds a master’s degree infinancial engineering, and hisresearch is quoted onBloomberg TV, CNBC, andFox Business News.

Schaeffer’sContributorsto This Issue

TODD SALAMONESenior VP of Research and author of the MondayMorning Outlook. His market insight is featuredregularly on CNBC,Bloomberg, The Wall StreetJournal, and Fox BusinessNews.

At the Open4 S E N T I M E N TWINTER 2010

IBernie 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/OpAd4

options (and the corresponding growth in theuniverse of stocks whose option strikes tradein $1 increments) provides another majorbenefit to investors by significantly increasingthe attractiveness of trading during optionexpiration week. While expiration week trad-ing has a “Wild West” reputation—the thinand fast-decaying option premiums result inhuge opportunities and huge dangers foroption buyers and sellers—we at Schaeffer’stake a more conservative approach inexchange for a healthy win percentage andprotection from sharp, adverse moves (seepage 12 for more!).

You should also be cheered that those oftenvery arcane and illogical symbols used to des-ignate individual option series will soon bereplaced with symbols that are much moreintuitive and easy to understand. The industrycreated the Option Symbology Initiative(OSI)—a plan that calls for the current, oftenenigmatic 4- and 5-character option symbolsto be replaced with a new 21-character Sym-bology Key. See “Ask Bernie” on page 11.

Rounding out yet another great issue ofSENTIMENT, don’t miss our Special Focus onsentiment analysis (page 23), and check outpage 16 to learn how to trade the hottestoption contracts on the planet—those on theCBOE Volatility Index (VIX)—straight fromthe folks who invented them!

Bernie SchaefferFounder and CEO, Schaeffer’s Investment Research

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

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

ELIZABETH HARROWSenior Equities Analyst and contributor to MarketRecap. She writes OptionActivity Alert, hosts the Scha-effer’s Daily Q&A videoseries, and is a regular contributor to BloggingStocks.com.

SIR04_AtTheOpen.rd3:pages.layout 12/29/09 3:15 PM

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

T E N Y E A R S AG O, T H E P H R A S E“New Economy” entered the investing lexi-con as a way to describe above-average, non-inflationary, perpetual economic growthdriven by advances in technology. This upbeatmantra caught hold not long before a gruelingbear market in 2000 –2002 that turned into ahorrendous 10-year period for stocks.

A decade later, the current buzz phrase isthe “New Normal.” This mantra has decid-edly bleak undertones, with expectations forbelow-average economic growth and highunemployment caused by massive deleverag-ing of consumers and banks.

Adherents of the “New Normal” cite agrim litany of economic worries heading into2010: Unemployment is at its highest levelssince the early 1980s; consumers areretrenching; analysts are sounding the alarmfor a commercial real estate bust; centralbank officials have raised the notion of stimu-lus withdrawals; and skeptics claim that thestock market has rallied “too far, too fast.”

Plus, we’ve been treated to an abundanceof magazine cover stories that broadcast astubbornly negative outlook. For example:

• October 5, 2009: BusinessWeek, “Why the Market is Going Nowhere”

• October 19, 2009: TIME,“Why It’s Time to Retire the 401(k)”

• November 21, 2009: The Economist,“Dealing with America’s Fiscal Hole”

Investors have reacted with extreme cau-tion to the huge rally off the March lows. Dur-ing the first 10 months of 2009, individualmutual fund investors redeemed $21.4 billionin equity funds, plowed $312 billion into bondfunds, and, amazingly, invested $10 billion inbear-market and long-short mutual funds.

A Contrarian Refresher From a contrarian perspective, this relentlesspessimism comes as welcome news. Bearishfund flow activity, predictions for an immi-nent market crash, various doom-and-gloompronouncements from the mainstream andfinancial media… these are characteristic ofmarket troughs, not market tops. There arefour stages of investor sentiment as we movefrom a market bottom to a market top:despair, disbelief, acceptance, and euphoria.(For a review of these four stages, see “The

Extra Edge,” SENTIMENT, Spring 2009).Disbelief, or the period in which the rally offthe bottom is simply not believed, is where wecurrently appear to be. This suggests there isample sideline money to perpetuate the mar-ket’s uptrend until we approach acceptance,and ultimately, euphoria.

This skepticism has powerful contrarianimplications because it flies in the face of dataindicating a strong economic recovery andruns counter-trend to the powerful marketrally since last March 2009. For example, the

prescient EconomicCycle Research Insti-tute’s leading indica-tors continue toforecast a steady eco-nomic recovery afterfirst signaling arebound last spring.

Looking AheadWhat does this meanfor the stock marketin 2010? We seem tohave all the makingsof continued market

strength. As in 2009, technical resistancelevels linger overhead and could create short-term speed bumps, but those pullbacksshould be short-lived.

Already, the S&P 500 Index (SPX) hasrallied powerfully from a historic oversoldcondition in early 2009, and it’s tradingabove its 80-day and 200-day moving aver-ages–a pair of trendlines that acted as resist-ance during the 2007–2008 retreat. (As acaveat, the bullish case will diminish shouldthese trendlines be violated in 2010.)

Our S&P 500 (SPX) target for 2010 is1,332, double the index’s March 2009 low.Interestingly, the SPX’s peak in 2007 wastwice its October 2002 nadir. However, thereare overhead resistance levels that the SPXwill have to overcome on the road higher,including 1,155 and 1,200, which are thesites of the index’s 160-month and 80-monthmoving averages, respectively. The 160-month moving average previously acted assupport at the SPX’s 2002 bottom, while the80-month trendline marked a brief low inOctober 2001.

Assuming the Fed maintains its dovishstance, the persistent pessimism on WallStreet suggests there’s plenty of cash on thesidelines to keep the bull charging this year.

The Rally That No One Believed

DESPITE THE NEW LANGUAGE OF INVESTING THE NEXT DECADE BRINGS, CLASSIC CONTRARIANANALYSIS IS FLOURISHING. >> By Todd Salamone

FIGURE 1: SPX with 80-month and 160-month moving averages

For free weekly market insight, new trading ideas,and education from Schaeffer’s top analysts, signup for the Monday Morning Outlook at:www.sentiment.com/mmo4

1600

1400

1200

1000

800

600

400FEB-99 DEC-00 NOV-02 AUG-04 APR-06 JAN-08 NOV-09

<sma 80 <sma 160

SIR04_SentimentReport.rd3:pages.layout 12/29/09 3:52 PM

SIR04_SentimentReport.rd3:pages.layout 12/29/09 3:52 PM

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

Gold Bugs Beware? Gold was a bright spot in 2009, havingrallied all the way to $1,200 by December. Now, however, putoption premiums on the SPDR Gold Trust (GLD) are becom-ing more expensive than those of calls. The recent shift sug-gests that, compared to call options, demand for puts on thegold fund is increasing substantially. In other words, bubblingbelow the surface, the “smart money” is betting that goldmight lose luster in 2010.

Dollar Woes. One reason for this year’s surge in gold pricesis dollar weakness. Since the yellow metal is dollar-denomi-nated, it tends to move inversely to the buck. Plus, the dollarperformed miserably in 2009. The PowerShares DB US Dollar Bullish ETF (UUP), which is an exchange-traded fundthat tracks being long the USD against the euro, Japaneseyen, British pound, Canadian dollar, Swedish krona, and Swissfranc, suffered a six-month 17.3% slide beginning in earlyMarch. UUP hit 20-month lows of $22.02 on November 25.Since then, however, the dollar bounced somewhat. Begin-ning in early December, the Dollar ETF recaptured 2.5% in alittle over a week, which raises the question: Is UUP ready tostop moving down in 2010?

OPTION MARKETDATESYOU SHOULDKNOW

1 2NEW PRODUCTS

News @Schaeffer’s

NEW HIGHS AND LOWS

Zero. Three hundred bil-lion into bond funds. Tenbillion into short-sellingfunds. People have stillnot jumped on the band-wagon. “

Bernie was also askedabout the weakness inthe dollar and whetherthe Fed will raise interestrates. “I don't think theFed is going to boostinterest rates in, as theysay, the foreseeablefuture—for a year ormaybe a couple of years,”Bernie replied. “Andthat’s why the dollar has aproblem. I don't thinkthey’re worrying aboutthe dollar.”

Bernie’s appearanceon Nightly BusinessReport came the sameday the market pulledback on the news of thecredit crisis in Dubai.Bernie joked about anunusual similaritybetween Dubai and anearlier crisis, saying, “Theywere just constructingthe world's tallest build-ing in Dubai. If you recallback to the Asia crisis in1997, in Malaysia in KualaLumpur, they were con-structing the world'stallest building (for thetime). So there's kind of atallest building jinx there.” >Financial media rou-tinely turn to the expertsat Schaeffer's InvestmentResearch for insight andanalysis on the markets. Ifyou missed RichardSpark’s Novemberappearance on Fox (see“SIR in the Media”, right)sentiment.com/medap. >The Daily Option Blognow focuses exclusivelyon options trading andactivity.

Media appearances>Bernie Schaefferargued that “the marketis in excellent shape”when he appeared onPBS’ Nightly BusinessReport on Friday, Novem-ber 27, 2009, adding that“it’s a picture-perfecttechnical rally off the bot-tom in March.”

When asked aboutinvestor sentiment,Bernie responded,“Investor sentiment iscounter-trend. Investorsentiment is not believingthe rally off the bottom.[There are] lots of exam-ples of it … The TIMEmagazine cover saying it'stime to retire the 401(k).A Newsweek cover called‘Boom and Gloom,’which basically says therally is bogus. … This is anindication there is side-line money that canpower the market higher.No inflows into equitymutual funds this year.

JANUARY

14SPX, RUT, DJXIndex OptionsStop Trading

JANUARY

15Equity & OEXIndex OptionsStop Trading

3Schaeffer's InvestmentResearch has added anew product to itswide array of real-timealert and bulletin serv-ices for options traders.>Schaeffer’s WeekendTrader offers newoption-buying ideasevery Sunday evening,allowing the subscriberto digest and evaluatethe trade driversbefore the tradingweek begins. Eachtrade is delivered viaemail at 7:00 p.m. ET.The service gives sub-scribers everythingthey need to know inorder to place a trade,including the recom-mendation, a maxi-mum entry price,complete exit parame-ters, and trade drivers.For more information,please visit: www.sentiment.com/WeekendTraderSeries.

JANUARY

22Schaeffer’s

Option Advisor

Released

FEBRUARY

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(Presidents’ Day)

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17Volatility IndexOptions Expire(VIX, VXN, RXV)

FEBRUARY

18SPX, RUT, DJXIndex OptionsStop Trading

FEBRUARY


JANUARY

20Volatility IndexOptions Expire(VIX, VXN, RXV)

JANUARY

18Trading Holiday

(Martin Luther

King, Jr. Day).

SIR04_MakingNews.rd3:pages.layout 12/29/09 3:50 PM Page 10

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

MARCH

18SPX, RUT, DJX

Index Options

Stop Trading

MARCH


MARCH

26Schaeffer’s

Option Advisor

Released

Sizing Up the CBOE’s Future. The Chicago BoardOptions Exchange (CBOE) reached a settlement withthe Chicago Board of Trade (CBOT) in early Decem-ber–a move that paved the way for a long-awaited ini-tial public offering (IPO) announcement. The dispute,dating back to 1973, was between CBOT membersabout an ownership stake in the CBOE. CBOT mem-bers funded the start-up CBOE.

Shortly after settling the matter, the Chicago BoardOptions Exchange announced on December 10 that itsBoard of Directors approved plans for an IPO. Thatoption wasn’t open to the CBOE until it settled thematter. The offering is expected toward the end of thesecond quarter of 2010.

Ironically, the settlement and a stock offering couldpave the way for the CBOE to merge with CME Group,which also owns the CBOT. According to Reuters,CME has approached the CBOE in the past about a $5billion buyout, but the talks stalled due to the CBOTlitigation. By settling the long dispute over their separa-tion with CBOT, the table could be set, not only for anIPO, but for the two exchanges to come together again.

50-Cent Strikes?Have you heard aboutthe $0.50 strike program? Under thenew plan, optionsexchanges can list$0.50 strike prices on a handful of low-priced stocks. Toqualify, the underly-ing stock must closeat $3 or less on theprevious trading dayand have averagedaily volume of 1,000options contracts during the previousthree months. Onceadded to the program,the exchanges can list50-cent strikes like$1.50, $2.50, and$3.50. Examples ofrecently eligiblestocks include AmbacFinancial (ABK), CIT Group (CIT),and Evergreen Solar(ESLR), which cur-rently have options at the 1, 1.5, 2, 2.5,and 3 strikes.

VIX Volume SetsNew Record.Now might be a goodtime for a CBOE IPO.Business has beenpretty good on theexchange. On Decem-ber 4, the exchangesaid that options vol-ume in the CBOEVolatility Index (.VIX)hit a new one-day vol-ume record: 712,315VIX options traded onDecember 3, whicheasily surpassed theprevious record of426,661 set on Sep-tember 16, 2008. (You can read all aboutVIX options in “Takingthe Fear Out of theFear Index,” page 16.)

4 5SIR IN THE MEDIA

Senior Equities Ana-lyst Richard Sparkshas frequently pro-vided market com-mentary for FoxBusiness TV's dailynoon segment, but onWednesday, Novem-ber 11, he was invitedby hosts CherylCasone and Tom Sulli-van to sit in as a guestpanelist for the entirehour. During the final“around-the-horn”segment, the hostsasked panelists fortheir "Best Guess"—abold prediction—onany subject. Fox’s EricBolling predicted theNew York Giantswould not lose thatweek (they had a byethat week and didnot). Richard pre-dicted the Dow wouldbe at 11,500 by theend of the year andthen perhaps take atumble at the begin-ning of 2010. Andthen Richard made aneven bolder predic-tion—that the Cincin-nati Bengals will godeep into the playoffs.Both predictions werestill in play as of thiswriting.

Option Bits

MARCH

17Volatility IndexOptions Expire

(VIX, VXN, RXV)

6

MARCH

31Quarterly

Options Expire

How Is Our Driving? After bringing you SENTIMENTfor over a year now, we want to make sure we’re pushing all the right buttons. Please provide yourfeedback by going to www.sentiment.com/survey

Xs

FEBRUARY

26Schaeffer’s

Option Advisor Released

SIR04_MakingNews.rd3:pages.layout 12/29/09 3:50 PM Page 11

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Lately I’ve been hearing a lot about theOptions Symbology Initiative (OSI). Whatchanges to the industry can I expect, andwhen will they be implemented? —FranBERNIE: Under the current Options PriceReporting Authority (OPRA) code, whichhas been in effect for 25 years, typical equityoption symbols are limited to three alphacharacters for the root symbol and two char-acters that identify the expiration month,call/put indicator, and strike price. As veteranoption traders know, these limitations oftenresult in enigmatic option symbols that fail todistinguish the underlying stock to the nakedeye. For example, who would guess that “IKGBI” is the symbol for AIG’s February 35 call?

In addition, due to the exponential growthof the options industry over the past fewdecades, the current option symbol formathas presented unavoidable compatibilityissues. The OPRA-formatted call/put andmonth identifiers assume a single expirationday, which clashes with some Long-termEquity AnticiPation Securities (LEAPS),Flexible Exchange (FLEX) options, and short-dated options with multiple expiration dates.

That’s why, beginning February 12, 2010,

U.S.-listed option symbols will undergo amonumental facelift. Under the OSI plan,the four- and five-character OPRA codes willbe replaced with a new, more easily dis-cernible Symbology Key. For example, AppleInc.’s (AAPL) April 250 put is currently listedas AJL PE. Following the switch, the sug-gested symbol for the same option will looklike this: AAPL 10 04 17 P 00250 000. Thiswill make it easier for option players to decodethe underlying stock, specific expiration date,type of option, and detailed strike price (seechart). The consolidation process is expectedto be complete in May 2010.

It’s important to note that brokers aretreating the new option codes as advisoryrather than mandatory. While all are includ-ing the four required elements—the rootsymbol, the specific strike, the expirationdate, and the type of option (put or call)—they are sequencing these elements accordingto their own preference. For example, CharlesSchwab will render the Apple April 2010 250put as AAPL 04 17 2010 250 P (ticker, expira-tion month, expiration day, expiration year infour digits, strike price, call/put indicator).

Meanwhile, Fidelity will call that same optionAAPL 10 04 17 P 250, while the folks atOptionsXpress have devised the elegant sim-plicity of AAPL April 10 250 Put.

Q: Should I be worried that the OptionsSymbology Initiative could create “Y2K-type” problems for options traders?—HenryBERNIE: There’s no need for anyone to panic.Any comparison you may have heard to thepre-millennium turmoil is in reference to theextensive technical prep work required bybroker/dealers, exchanges, utilities, and mar-ket data vendors ahead of the February 12conversion. However, all of the testing indi-cates the transition will be glitch-free.

In September 2009, the OCC conducted avoluntary beta test for clearing members andexchanges, designed to highlight any techni-cal speed bumps ahead of a round of man-dated industry tests. The participation ratewas “better than expected,” according toOCC Vice President of Member ServicesDavid Harrison, with 6,000 mock trades sub-mitted by 32 OCC clearing members.

The Future ofOption Symbols

AFTER 25 YEARS, THE INDUSTRY WILL OVERHAUL ITS ENIGMATIC OPTION SYMBOLS.>> By Bernie Schaeffer

Bernie Schaeffer isfounder and CEO ofSchaeffer’s 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-winning SchaeffersResearch.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 the WallStreet Journal, Business-Week, and USA Today.

For a white paper on the OSI plan, go to sentiment.com/OSI

Q:

The Man withthe Answers:Bernie Schaeffer

www.schaeffersresearch.com WINTER 2010 Ask Bernie 11Ph

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

Current OPRA Configuration Apple Inc. (AAPL) April 250 put AJLPEOption Root Symbol (3 characters) AJLExp. Call/Put Indicator (1 character) PStrike Price Symbol (1 character) EPost-OSI CONFIGURATIONApple Inc. (AAPL) April 250 put AAPL100417P00250000Symbol (up to 6 characters) AAPLYear (2 characters) 10Month (2 characters) 04Day (2 characters) 17Call/Put Indicator (1 character) PStrike/Dollar (5 characters) 00250Strike Decimal (3 characters) 000

SIR04_AskBernie.rd3:pages.layout 12/29/09 4:06 PM

SIR04.Expiring_Feature.rd3:pages.layout 12/29/09 3:59 PM

13

EVERY ATHLETEKNOWS THATGAMES ARE WONAND LOST IN THEFINAL MINUTES OFPLAY. LIKEWISE,OPTION TRADERSUNDERSTAND THATOPPORTUNITIESABOUND IN THEFINAL DAYS TOEXPIRATION. IF YOUPLAY BY THE RULES,THERE’S PLENTY TOGAIN, EVEN FORTHE RISK AVERSE.

Expiring with Profit

www.schaeffersresearch.com SPRING 2010 Expiration Week Trading

By Bernie Schaeffer and Todd SalamoneILLUSTRATIONS BY JOE MORSE


14 S E N T I M E N T

trivial developments,they lower transactioncosts and add flexibility,creating opportunitiesthat would not existotherwise—particu-larly for those whotrade during expirationweek.

Pinching PenniesOne-point strike incre-ments enhance theability of the trader toconstruct favorablerisk/reward scenariosthat might not beavailable with tradi-tional, five-point strikeincrements. For exam-ple, on the Tuesday ofNovember expirationweek, GameStop(GME) was trading atsupport at $24.00. TheNovember 20 call wasoffered at $4.10, andthe November 25 callwas offered at $0.30. Ifyou purchased the 25

call, you’d experience a 100% loss if thestock declined, stayed flat, or rallied up to$25. The 20-strike call was more conserva-tive, but with a premium of $4.10, you wouldneed a huge rally to achieve worthwhilegains. However, the 22-strike call—offeredat $2.10—was attractive. This option pro-duced a healthy 65% gain when GMEclimbed to $25.49 by expiration Friday. Italso allowed for a comparatively smaller lossin the event that GME stayed flat or movedmodestly lower.

“Penny pricing” refers to options priced inpenny increments. In the fall of 2009, theSecurities and Exchange Commission (SEC)announced that it would expand its pennypricing pilot program to options on 300 addi-tional companies. Withpenny pricing, it’s pos-sible for the bid/askspread of an option tobe only 1 or 2 cents,versus 5 or 10 cents.Reduced bid/askspreads minimize the illeffects of “slippage” on

transaction costs, which is particularlyimportant when trading multiple positionsand engaging in multi-legged strategies—theoptimal approach during expiration week.

How It’s DoneSo, now we know that expiration week offersgreat opportunities for option traders, andrecent initiatives in the options industry havegiven traders a new edge. But how can a typi-cal trader pinpoint prime expiration-weekopportunities?

At Schaeffer’s, we like to buy calls onstocks that have pulled back to intermediate-term or longer-term moving averages andthat coincide with levels of heavy front-month put open interest. If the underlyingstock respects this double-barreled support,the unwinding of short positions related tothe out-of-the-money put open interestcould act as a tailwind as the puts approachexpiration. The concept is similar for putbuying, except that we recommend puttrades as the underlying approaches theintersection of heavy out-of-the-money callopen interest and longer-term resistance.

The gamma-weighted SOIR (see Q&A,page 27) is another indicator we rely onheavily during expiration week. The SOIR isSchaeffer’s put/call open interest ratio, whichdivides an equity’s near-term put open inter-est by its comparable call open interest, pro-viding a quick glimpse of investor sentiment.Gamma is one of the option “greeks”—itmeasures an option’s sensitivity to move-ments in the underlying stock price. Thus,the gamma-weighted SOIR is a refined ver-sion of the SOIR that places greater weighton open interest at or near the money. Theseare the options that have the biggest influ-ence on a stock’s behavior during expirationweek. For example, an equity with a gamma-weighted SOIR above 1.0 has heavy put openinterest near the current stock price relativeto call open interest. (You can read all aboutthe gamma-weighted SOIR in “Idea Lab,”SENTIMENT Fall 2009.)

FIGURE 1:A good deal on GameStop (GME)—buy an in-the-money call during expiration week (November 17) versus four weeks beforeNovember expiration (October 26).

Expiration Week Trading

THE HOLIDAY SHOPPING SEASON ISbehind us, but the hunt for an outstandingdeal never ends. Whether it’s a plasma TV foryour basement, a smart phone, or a cashmeresweater for your significant other, you alwaysstrive to get the biggest bang for your buck.The pursuit of “the deal” extends into trading.For option buyers, expiration week comesalong once a month and presents an excellenttime to shop for attractive option plays.

During expiration week, you can purchasein-the-money options on volatile stocks forlittle or no time premium—options that canachieve high, double-digit or even triple-digitgains in a week or less. Time decay is theenemy of the option buyer, but in expirationweek, option buyers can minimize the dollarsthey have exposed to this threat. That means,potentially, higher win rates and bigger profitson a given stock move, with only a negligiblepenalty if the stock stays “flat” (see Figure 1).

In addition, recent changes in option pric-ing have enhanced the edge for expiration-week traders. Although the introduction ofpenny option pricing and one-point strikeincrements on many equities may seem like

WINTER 2010

PurchaseDate

GMEClosingPrice

Nov22-CallIntrinsic

Value

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Movement atExpiration

% StockGain

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% StockGain

Needed toAchieve

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Oct 26 $24.08 2.08 $2.60 -20% +7.6% +13.0%

Nov 17 $24.00 2.00 $2.10 -5% +4.9% +9.3%

For more on expiration weektrading,watch thevideo atwww.sentiment.com/EWCvideo


Steel-ing CallsFour days prior to October2009 expiration, U.S. Steel(X) was trading at $42.52(see Figure 2), and we rec-ommended the October 39call for an average entryprice of $3.50. X was movingout of a short-term “over-sold” condition within thecontext of an intermediate-term trend higher. Theshares were trading justabove their 80-day movingaverage, which acted as sup-port in July, and above the42 strike, which was hometo heavy put open interest.In fact, the front-monthgamma-weighted SOIR reg-istered very high at 1.30. Wethought there was a fairlyhigh probability that Xwould pop higher over thefour-day period until expira-tion Friday, driven in part bytechnical support and theunwinding of short positions related to thesoon-to-expire 42-strike put open interest.

The move occurred quickly, as X ralliedup to the call-heavy 45 strike the next day.We recommended that our subscribers exitthe position at an average of $6.05, ringingthe cash register for a 73% gain in just oneday. The one-point strike increments allowedus to recommend an in-the-money optionthat would provide healthy profits if we werecorrect, while also giving us the opportunityto exit the trade at breakeven if the stock did-n’t move. Even if X broke through chart andoptions-related support, the trade couldlikely have been exited with only a modestloss.

In addition to all these benefits, the short-ened holding periods associated with expira-tion-week option buying allow you to takeadvantage of mean-reverting market envi-ronments such as those we experiencedthrough most of 2009, where big moves wereincreasingly vulnerable to reversals. Theproper mindset for this type of trading is tokeep your exposure to the market confined toshort intervals and take what the marketgives you—that is, potentially sizable gains inshort periods, with tight stop-losses whenyour view is not validated by the market.

reverse quickly in this mean-reverting mar-ket—we chose a strangle play (see Figure 3).The combined offer price of the September 18call/September 20 put strangle was $2.36.

Starbucks September 18 call = $2.03 Starbucks September 20 put = $0.33 Total outlay for strangle = $2.36

The strangle trade had a bullish bias, sincemore dollars were invested in the purchasedcall option than in the purchased put option,and the call option had a significantly higherdelta. Thus, it would take a smaller move bythe stock to the upside to achieve profits.

The trade would move into profitable terri-tory above $20.36 and higher (18-strike call +$2.36 [total premium] = $20.36). If SBUXshares fell sharply, profits would be realizedbelow $17.64 (20-strike put - $2.36 =$17.64). The minimum value of the strangleposition at expiration would be $2.00, equiva-lent to the difference in the strike prices. Sothe maximum loss was only $0.36, or 15% (-$0.36/$2.36 * 100 = -15%).

Profit zone for SBUX “strangle” = below $17.64 or above $20.36 Maximum loss = -15% (occurs between $18 and $20)

We held the SBUX strangle into Friday’sexpiration. The shares traded at $20.83 onexpiration day, and the call option was sold foran average of $2.81. The shares did notachieve our upside target of $22, but welocked in a 20% gain without losing sleep.

Calling All Bargain HuntersSo, if you’re hunting for bargains in the optionsmarket, expiration week offers some door-buster deals that are hard to turn down.Selected in-the-money expiration-week tradesprovide a once-a-month opportunity foroption buyers to dodge the wrath of time decay,maximizing their leverage and profit potential.And, thanks to the SEC’s new buyer-friendlyinitiatives, there’s never been a better time toimplement these expiration-week strategies.

Strangling StarbucksExpiration-week trading also gives you theability to play multi-directional strategies withdefined, minimal risk. Strangle trades—whichinvolve the simultaneous purchase of a putand a call option at nearby strikes—are typi-cally “on sale” during expiration week, becausethey command lower premiums late in theexpiration cycle, and the penalty for buying“double premium” is minimal. With one-pointstrike increments and penny pricing, you cancalibrate the strangle trade with very smallrisk, profiting on a small move in your antici-pated direction or even on an explosive moveagainst your view. The ability to profit fromeither upside or downside volatility is a majoradvantage of expiration-week trading. Youcan’t be certain whether the typical bullish biasof expiration week will come into play, or if abig expiration-week decline is lurking, such asthe 5% setback in May 2009.

Four days before September 2009 expira-tion, we uncovered a trading opportunityinvolving Starbucks (SBUX), a highly shortedstock with big put open interest about toexpire. At $20.01, we thought the sharesmight be poised for a breakout higher. Theshares were trading near their highs, and so—remembering that moves to new highs can

www.schaeffersresearch.com WINTER 2010 15Expiration Week Trading

FIGURE 2: X with 80-day moving average and 9-day Relative StrengthIndex (RSI).

FIGURE 3: Starbucks strangle P&L. This deal is possible only duringexpiration week—little time value in options, penny pricing, and one-point strike increments. What’s not to like?

To receive real-time expiration weektrading alerts, sign up for our Expiration WeekCountdown service atwww.sentiment.com/EWC

Stock Price at Expiration

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VIX Options16 S E N T I M E N TWINTER 2010

WHEN MARKETS SELL OFF, THECBOE VIX IS THE DE FACTO GAUGEOF INVESTOR UNCERTAINTY. AND WITH OPTIONS NOW TRADABLE ON THE INDEX,INVESTORS ARE EXPOSED TO AWHOLE NEW ASSET CLASS. BUT BEFORE JUMPING IN WITHBOTH FEET, THERE ARE A FEWTHINGS YOU OUGHT TO KNOW.

Taking the Fear Out of the Fear Index

By Russell RhoadsPHOTOGRAPHS BY FREDRIK BRODÉN

SIR04_VIX_Feature.rd3:pages.layout 12/29/09 3:56 PM

www.schaeffersresearch.com WINTER 2010 VIX Options 17


in sight. In a similar way, volatility rises whenthere’s a perceived higher risk in equities.Insurance can be expensive when you thinkyou need it most. Sometimes this is true foroptions, as well.

A LITTLE HISTORY The idea of creating an index to benchmarkshort-term market volatility stemmed fromthe work of Dr. Robert Whaley, VanderbiltUniversity, who wrote a paper on calculatingvolatility in 1993. His original methodologywas to measure the market’s expectation of30-day volatility, which was implied by thepricing of at-the-money OEX options. At thetime, S&P 100® options (OEX®) were a

more actively traded option series than SPXoptions, so the original VIX was based on theS&P 100.

In 2003, CBOE worked with GoldmanSachs to revise the VIX to focus on the S&P500. More institutions started to choose SPXoptions for hedging purposes rather than theOEX, which resulted in volume and openinterest on SPX options that outpaced theOEX options.

In 2004, CBOE introduced the all-elec-tronic CBOE Futures Exchange (CFE®)and began offering trades on VIX futurescontracts. The idea of trading volatility inthis way was pretty novel at the time, but itcaught on.


OFTEN WHEN THERE IS A BIG DOWNday in the U.S. stock market or, more specifi-cally, in the S&P 500®, the financial presscites the level of the Chicago Board OptionsExchange’s CBOE Volatility Index® (VIX) asan indication of the level of fear in the mar-ketplace. Now, although the VIX typically hasan inverse relationship to the direction of theS&P 500, it is more than an index of fear. Andit is definitely more than just something forthe talking heads on TV to get excited aboutevery once in a while.

The VIX is commonly called the investor’s“fear gauge” because investors tend to bemore fearful when market volatility is highand less so when volatility is low. While it maybe a handy nickname, the “fear gauge” isreally a bit of a misnomer and, when taken tooliterally, may lead to some confusion.

It is important to remember that the VIXmeasures the market’s perceived futurevolatility (read: risk and uncertainty), mostoften associated with a fear that the marketwill drop. More specifically, the VIX measuresthe market’s expectation of future volatilityimplied by S&P 500 stock index (SPX)options prices. While technically it does notmeasure the probability that the market isgoing to drop in the near future, at times itdoes represent a measure of fear that it will.

THE WILD CARD: VOLATILITY Since the VIX measures implied volatility onSPX options, a quick refresher on volatility isprobably in order. There are two general typesof volatility: historical and implied. Historicalvolatility is measured by what a stock or mar-ket has done in the past; for example, themovement of the SPX over the past 20 dayswould be the foundation for the calculation ofthe 20-day historical volatility. Impliedvolatility—what the VIX measures—is asnapshot of SPX options, and it indicateswhat traders believe the future market volatil-ity may hold. As volatility in the marketsincreases, particularly in the SPX, thedemand for options increases, along withtrading volume—and thus, implied volatilityincreases as well.

Volatility rises as a function of perceivedrisk in the marketplace. We all know thatinsurance costs rise based on the risk of lossassociated with the insured person or asset.Homeowners insurance in Florida the daybefore a hurricane hits landfall will alwayscost more than when there are no hurricanes


Options on the VIX were introduced byCBOE in 2006, and have been one of theexchange’s fastest-growing products. Just ayear after their introduction, open interest onVIX options approached a million contracts.

VIX OPTIONS IN A NUTSHELLBecause of its substantial daily trading vol-ume, VIX options have proven to be one ofthe best ways to gain exposure to the VIXindex as an asset class. However, there are afew things to be aware of before placing atrade. Specifically, you should know aboutthe unique pricing of VIX options (they’renot directly related to the cash VIX), expira-tion dates (not on Fridays!), and how they aresettled.

Pricing With most indexes, the underlyingindex level is used to value the correspondingoptions. However, the proper underlying forpricing VIX options is the corresponding VIXfutures contract. Why? To put it simply, thereis no underlying basket of securities that canbe purchased to replicate the VIX. The clos-est thing would be VIX futures. In compari-son, a trader taking a position in SPX optionscould theoretically purchase a basket ofstocks to replicate the S&P 500.

Both VIX options and futures are 100%anticipatory in their pricing. This means thatsometimes VIX futures may trade at a pre-mium to the VIX index, and other times thefutures may trade at a discount. Basically, thelevel of VIX futures reflects where tradersbelieve the VIX index will be at some expira-tion in the future. When futures are at a pre-mium, this indicates traders believe the VIXindex will go higher into expiration. Whenthey’re at a discount, the marketplace isanticipating a drop in the VIX. This isanother reason the futures are the bestunderlying pricing instrument for VIX putsand calls.

Suppose the VIX December 25 call ispriced at 2.50 and the VIX index is quoted at28.15. There appears to be a mispricing of theDecember 25 calls—it seems the minimum

intrinsic value should be 3.15 (28.15–25.00).But look again—if you use the VIX futurescontracts that expire in December as theunderlying instrument, the calls may appearmore reasonably priced if the December VIXfutures contract is anticipating a lower VIXthan the current level.

Settlement & Expiration VIX options, likeother index options, are cash settled. Cashsettlement upon exercise involves a cashtransfer from the seller of an in-the-moneyoption to the owner of that option. In thecase of VIX options, this involves $100 foreach point an option is in the money at expi-ration. For example, the holder of a 20 callwould receive $500 at expiration from theholder of a short position in the 20 call if thesettlement value for VIX options is 25[($25–$20) * $100 = $500].

Remember that when holding VIX

options through expiration, there are someintricacies involved in VIX a.m. (morning)settlement. VIX options officially expire onthe Wednesday 30 days (or closest to 30days) prior to the third Friday of the next cal-endar month. For instance, November VIXoptions expired on November 18, 2009, 30days prior to the December option expirationof December 18. Although expiration is on aWednesday, the options actually stop tradingat the close of the Tuesday before settlement.The settlement level of the VIX is a specialcalculation based on the opening prices of allSPX options that contribute to the VIX cal-culation the following day.

What else do you need to know about thesettlement price for VIX options?

The VIX level that results from the open-ing SPX option prices may vary substantiallyfrom the closing VIX index level the eveningbefore. Part of this comes from normalovernight activity in the global equity mar-kets. Also, since the VIX settlement level isdetermined with opening prices as opposedto the bid/ask used to calculate the real-timeVIX, it may take some time for the actualsettlement level of the VIX to be deter-mined—as much as a few hours. As soon asthe VIX settlement price has been deter-mined, it is quoted by CBOE under theticker VRO.

Here’s a prime example of how the settle-ment price on a Wednesday morning canchange from the closing VIX index level

from the previousafternoon: theAugust settlementfor VIX options andfutures, whichoccurred August 19,

Schaeffer’sTake: Whenthe VIXTrends

www.schaeffersresearch.com WINTER 2010 VIX Options 19

no longer provide a goodroad map.

At Schaeffer’s, wefocus on longer-termmoving averages that haveshown historical signifi-cance, but are oftenignored by technical ana-lysts. In 2009, the VIX hadan uncanny knack forrespecting its 80-day and160-day moving averagesas it trended lower (seeFigure 1). During the firstquarter, the VIX was beingsupported by its 160-day

tion, as tends to occuraround periods of marketinstability? In such envi-ronments, one can usesimple moving averagesto anticipate the VIX’snext move, as formersupport/resistance levels

pivot points. Through2007 and most of 2008,the VIX chopped aroundaimlessly between 16 and32, and didn't offer muchin the way of clear insight.But what if the VIX istrending in a clear direc-

>>The CBOE VolatilityIndex (VIX) is oftenreferred to as a “mean-reverting” index. There-fore, traders typicallyfocus on historicallyimportant absolute levelsto pinpoint potential

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FIGURE 1:VIX with 80-day and 160-day movingaverages, August 2007 – November 2009.

ALTHOUGH VIX HAS A GENERALNEGATIVE CORRELATION WITH THES&P 500, AND SOME USE IT WITHOTHER INDICATORS TO ASSESS THEMARKET, VIX WAS NOT DEVISED AS ACRYSTAL BALL TO PREDICT STOCKPRICES, THE DIRECTION OF THE MAR-KET, OR MARKET HIGHS AND LOWS.INSTEAD, THE VIX WAS CREATED TOPREDICT THE MARKET’S EXPECTA-TION OF FUTURE FLUCTUATIONS.

Mean Reversion

Trending

85

75

65

55

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15

08/06/07 01/28/08 07/18/08 01/08/09 07/01/09

< sma 80

< sma 160



2009. The final trade for VIX futures on theTuesday before a.m. settlement on Wednes-day was 26.35, with the final VIX spot indexprint being 26.18. The following morning,due to overnight volatility, the August VIXsettlement value for option positions was28.76. That’s 2.58 higher than the indexclose Tuesday evening.

To put this in context, a holder of anAugust 27.50 call likely would have expectedhis call to expire worthless based on the VIXindex closing at 26.18 Tuesday afternoon.However, with August VIX settlement forfutures and options priced at 28.76 onWednesday morning, the holder of the 27.50call, who went home Tuesday with a worth-less option position, would now receive $126in cash for his option. There’s nothing like aworthless option suddenly popping up in themoney! As with every trade, though, there isanother side—the person who believed hisshort position in an August 27.50 call hadexpired worthless. The result of the settle-ment print for this trader was a $126 debit.For every good surprise, there is a bad one.

It’s important to be aware of the intrica-cies of Wednesday morning settlement andthe method used to calculate this level. If youhave a profit in a VIX options position goinginto expiration, the wisest choice may be tosimply close the position and take the profit.There may be some risk involved in holdingVIX options until the settlement price isdetermined. Consider yourself warned!

BASIC BEAR STRATEGY: BUYING CALLS ON VIXAlthough it’s not purely a fear index, aninverse relationship does exist between theS&P 500 and the VIX, especially in times ofextreme negative moves in the S&P 500(see fall 2008). As such, VIX options may beused when a trader has an opinion about thedirection of the S&P 500, especially whenshe believes a big down move is comingsoon. A trader bullish on stocks may con-sider a bearish strategy with VIX options,but more bang for the buck comes when theS&P 500 experiences a hard and fast fall.Let’s look at an example of trading VIXoptions to benefit from a quick pullback inthe S&P 500.

Suppose it’s March 19, and you thinkthat the S&P 500 is overbought at 1150.Your guess is that a dramatic pullback is onthe horizon. During the index’s rise, the VIXhas dropped from 30 to 21. In your opinion,stocks will fall in the next 60 days and theVIX should return to at least 30. As Mayexpiration for VIX options is 60 days off, this

works perfectly for your sce-nario. You also note that theMay VIX futures are tradingat 22.25—a slight premiumto the underlying VIXindex. Trading May VIXoptions, you would be usingMay VIX futures as theunderlying for valuationpurposes. Finally, the VIXMay 25 call is trading at$2.10 (or $210 cash percontract, which is also yourmaximum risk).

Fast-forward 60 days—your market scenario turns

out to be correct, and the S&P 500 dropsmore than 15% to 975. As predicted, theVIX climbs and VIX settlement for Maycomes in at 31.50. As a holder of the May 25call, you receive a credit to your account of$650 [($31.50 – $25.00) * $100]. Subtract-ing the option cost of $210 nets you a profitof $440 (see Figure 2).

SUMMARYThe VIX has become the standard measureof market volatility by focusing on the futurevolatility implied by a variety of SPX options.The VIX reflects the overall market’s opin-ion of how stock prices may move in thefuture. Dubbed the investor’s “fear gauge,” itis more accurate to think of VIX as a yard-stick of investor uncertainty. Uncertaintymay equal fear at times—but not always.

Although VIX has a general negative cor-relation with the S&P 500, and some tradersuse it in conjunction with other indicators toassess the market, VIX was not devised as acrystal ball to predict stock prices, the direc-tion of the market, or market highs and lows.Instead, the VIX was created to predict themarket’s expectation of future fluctuations.As seen in late 2008 and early 2009 amidone of the most turbulent and uncertainperiods since the Great Depression, for themost part, the VIX continues to accuratelymeasure anticipated future volatility and towork just as intended.

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

>> Russell Rhoads, CFA, is an instructor for The Options Institute at the Chicago Board OptionsExchange. Before joining the CBOE, his 17-yearcareer involved positions at a variety of firms as a trader, quantitative and fundamental analyst, and financial programmer./ / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / /

moving average on pull-backs, but the trendlinewas finally breached inmid-March. In hindsight,this was a “tell” thatvolatility was entering adeclining trend (an indi-cation that the marketwas poised to rally), andit was confirmed by thefact that the 80-day mov-ing average was turningsharply lower. Prior tothe breach of the 160-day moving average, theVIX's mini-rallies in the

first quarter had beencapped at the 80-daymoving average, a trend-line that subsequentlycontained all VIX ralliesinto October 2009. Then,in late October 2009, theVIX broke decisivelyabove the 80-day movingaverage—a potentialwarning sign that volatil-ity was on the rebound.But the 160-day movingaverage lingered justoverhead, capping theVIX's spike. And in the

blink of an eye, the VIXagain retreated sharplyand a threat to the mar-ket’s continued recoverywas avoided.

While it is possiblethat the VIX could expe-rience another mean-reverting periodbetween 20 and 30, wewould advise addingmoving averages to yourVIX analysis tool box, asthey are helpful in deci-phering trends andpotential trend reversals.

Want to know more about the VIX and VIXoptions? Visit the website for CBOE at:www.sentiment.com/CBOE

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FIGURE 2:A payoff diagram for a long May VIX 25 call at expiration.You can calculate your breakeven by adding the call strike to thepremium paid. In this case, it’s 27.10.

Max Loss 2.10 @ 25.00

Breakeven Point 27.10

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www.schaeffersresearch.com WINTER 2010 Special Focus 23

WHEN IT COMES TO MARKET ANALYSIS, TECHNICALS AND FUNDAMENTALS ARE ONLY

PART OF THE PICTURE. TO COMPLETE IT, YOU NEED TO ASSESS INVESTOR SENTIMENT.

AND YES, IT CAN BE VERY OBJECTIVE.

The Smoking Gun

By Elizabeth HarrowPHOTOGRAPH BY FREDRIK BRODÉN

Expectational Analysis Series:Part 3


or BusinessWeek features a pessimistic coverstory on the troubles of XYZ Company, it verylikely means that these negative factors arealready priced into the stock. Even moretelling is when a general-interest, non-finan-cial publication devotes its cover to an invest-ment-related issue. Naturally, our antennaewent up in spring 2009 when Vanity Fair fea-tured a series of covers on the financial crisis.

Surveys: We regularly review the sentimentsurveys conducted by organizations such asThe American Association of IndividualInvestors (AAII) and Investors Intelligence.As with magazine cover stories, these surveyscan offer excellent contrarian readings atextremes. For example, in the midst of themassive March-through-November rally of2009, the AAII poll published November 5found only 22% of those surveyed were bull-ish on the market. The next day, the DowJones Industrial Average closed above 10,000on a weekly basis for the first time since Octo-ber 2008.

Analyst rankings provide a quick snap-shot of Wall Street’s current outlook for astock. If a security boasts 17 “strong buys,”five “buys,” just two “holds, “ and no “sells, “it’s safe to say that brokerage firms are pre-dominantly optimistic. If the shares are trend-ing higher, that’s great—but if they’restagnating beneath technical resistance, orperhaps the fundamentals are a bit shaky, itopens the door for potential downgrades.Analyst downgrades frequently incite freshselling pressure, while upgrades often bringnew buyers to the table. As a result, we’realways on the lookout for scenarios wherethese ratings don’t seem to jibe with theequity’s performance.

Short interest offers a quick-and-dirtysnapshot of investor sentiment by measuringhow many traders (often of the hedge-fundvariety) have sold the stock short. As moreplayers place their bets against the stock,short interest will rise. So, a high volume ofshort interest generally indicates a bearishoutlook. From a contrarian viewpoint, we seethis pessimism as bullish for the stock if it is inan uptrend. That’s because a substantial accu-mulation of short interest can unravel in theform of a “short-squeeze rally,” as pessimisticplayers are forced to repurchase the sharesthat they “pre-sold” to control their losses.

WHAT’S UP WITH BARRON’S LOVE affair with Amgen? Does Forbes really thinkthat Google will be unseated by its Chineserival, Baidu? Option traders are snapping upcalls on United States Natural Gas Fund—sothey’re optimistic, right?—but short intereston the exchange-traded fund is near anannual high. What do the shorts see that callbuyers are missing? Could they possibly belooking at the same things? And why on earthare traders buying puts on Macy’s after its bet-ter-than-forecast earnings report?

Welcome to the wild, wonderful field of sen-timent analysis. In previous editions of SENTI-MENT, we introduced you to ExpectationalAnalysis®, our three-tiered methodology foranalyzing stocks, and we reviewed some basicconcepts of fundamental and technical analy-sis (two of those three tiers).

But, to revisit a metaphor we used in thefirst part of this series, funda-mental analysis and technicalanalysis together are like atwo-legged stool: it won’tstand up very well withouthelp from a third leg.

That’s where sentimentanalysis comes in. Fundamen-tal analysis and technicalanalysis can provide a wealthof information about a com-pany’s financial health and itspast performance on thecharts. But they both over-look one critical factor:investor psychology. Thisfinal element is our “X Fac-tor”—it not only helps to fillthe gaps left by technical andfundamental analysis, but itcan also provide you with an entirely newinsight into the market.

Any serious trader can probably recall atime when he made an investing decisionbased not on intellect, but on emotion—whether it was panic, greed, fear, or AlanGreenspan’s personal pet peeve, irrationalexuberance. In fact, this probably happensmore often than most of us would like toadmit. And with traders around the globemaking emotional decisions on a regularbasis, the price of any given stock can be con-sidered nothing more than investors’ collec-tive perception of reality. Those perceptionscan change with blinding speed.

Our view of sentiment analysis is strongly

colored by our contrarian philosophy. Simplyput, our antennae are up when the investingcrowd appears to be reaching an extreme ineither bullish or bearish sentiment, especiallywhen this sentiment runs counter to thedirection of the stock. For example, pes-simism would be an expected reaction to adowntrending market, and would thereforenot be a valuable contrarian indicator. On theother hand, skepticism amid a rising market isa potentially powerful bullish combination, asmarket tops are usually not reached untiloptimism reaches extreme levels.

In other words, we’re not knee-jerk con-trarians—that is, we don’t go against thecrowd just to be difficult. Instead, we try topinpoint opportunities where Wall Street’sprevailing attitude toward a stock or sectorseems out of line with the technical and fun-damental prospects for that equity. Only then

can we capitalize on a gradual reversal of sen-timent, as traders are forced to capitulate tothe stock’s trend.

SENTIMENT INDICATORS Let’s look at some of our favorite sentimentindicators. Taken in context, these tools pro-vide successively more sophisticated guidance.

Media: Magazine cover stories are one of ourfavorite sentiment indicators, partiallybecause of the time lag involved in print pub-lications. By the time a stock garners a coverstory—whether bullish or bearish—it’s likelythat the trend has been in place for quite awhile. For example, if the latest issue of Forbes

Special Focus: Expectational Analysis24 S E N T I M E N TWINTER 2010

FIGURE 1: Weekly chart of AAPL from July 2006 – January 2008, with 10- and 20-week moving averages.

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the Expectational Analysis picture. But becareful not to make snap judgments based onextreme sentiment independent of its coun-terparts if they’re telling a different story. For ahigh-profile example, let’s hearken back tomid-2007 and the highly anticipated debut ofApple’s iPhone (see Figure 1). The device wasso relentlessly hyped that it garnered the nick-name “Jesus Phone” before it even hit storeshelves—suggesting rather lofty expectations.I remember watching the stock’s SOIR hit asuccession of new annual lows around thistime, indicating that option players were lean-ing heavily toward buying calls and confirm-ing that bullish sentiment was running wildtoward Apple shares.

It’s important to note that in this particu-lar case, this raging optimism didn’t backfire,and those who positioned themselves for acontrarian decline in the shares were blownaway. Apple extended its uptrend on thecharts through the end of 2007, capitalizingon solid technical support from its 10-weekand 20-week moving averages. It also didn’thurt that the iPhone was well-received byconsumers—in fact, research firm StrategyAnalytics recently reported that Applebecame the top cell phone maker by profitwithin just two years of the device’s launch.In this case, bullish sentiment had reachednear-epidemic levels on Apple stock… butbecause the upbeat attitude was justified bythe strong technical and fundamental per-formance, there was no backlash from disap-pointed investors. This is also an excellentillustration of the importance to contrariansof focusing on counter-trend sentiment fortheir actionable ideas.

ONE FINAL POINTER:While it's easy to get caught up in the excite-ment of sentiment sleuthing, it's importantnot to get carried away. As Freud famouslyobserved—albeit on an entirely differenttopic—sometimes a cigar is just a cigar. Inshort, you don't need to lose too much sleepworrying about the contrarian implications ofBeyonce’s June 2009 Forbes cover. On theother hand, there is that infamous jinx forathletes who appear on the cover of SportsIllustrated…

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

>> Coming Up: For the ultimate step-by-step guide to applying Expectational Analysis, check out the next issue of SENTIMENT./ / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / /

stantial put openinterest can act as afloor for the stock.

Taking thisoption open interestanalysis one stepfurther, we devel-oped the Schaeffer’sput/call open inter-est ratio (SOIR).The SOIR com-pares total put openinterest against totalcall open interestamong options setto expire withinthree months,because theseshorter-term betstend to be morespeculative innature. Readingsabove 1.00 indicatethat puts are moreprevalent, whilereadings below 1.00reveal that calls arepredominant. Theidea is to assign asingle number to thesentiment of optiontraders, with aSOIR above 1.00indicating unusualpessimism.

“Buy-to-open” option volume ratios areamong the newer tools in our sentimentanalysis arsenal. The Chicago Board OptionsExchange (CBOE) and the InternationalSecurities Exchange (ISE) provide us withdaily statistics on how many puts and callshave been bought to open over various timeframes. In other words, this represents theactivity of option buyers, and excludes theopening activity of those who are sellingoptions. As a result, we obtain a muchclearer view of the sentiment of everydayoption traders who are speculating by buyingcalls or puts, which can be very helpful in acontrarian analysis.

PUTTING IT ALL TOGETHEROf course, the most important context for anysentiment indicator is the equity’s fundamen-tal and technical backdrop, which completes

Open interest configurations—or, thelevel of open option positions at the variousstrike prices for the various expirationmonths—can provide a glimmer of insightinto option players’ attitudes. When tradersare favoring out-of-the-money calls, forexample, it could mean that the bulls arebanking on a major rally. It’s also importantto note heavy accumulations of near-the-money call and put open interest, becausethese build-ups can affect the price action ofthe underlying equity. Specifically, heavy callopen interest can exert options-related resist-ance as expiration draws closer, while sub-

www.schaeffersresearch.com WINTER 2010 Special Focus: Expectational Analysis 25

Learn all about Expectational Analysis and geta complete guide to trading options using the Schaeffer Method with our home study kit, availableat: www.sentiment.com/HSP4


Step 2: Check the Open Interest Configuration Think of the open interest configuration (Fig-ure 2) as the “traffic report” for your stock. Itshows where option players are piled up, andgives you an idea as to where you mightencounter support and resistance. Pay partic-ular attention to large buildups of overheadcalls—Bernie Schaeffer describes these strikesas “speed bumps,” and they’re especially rele-vant to short-term call buyers who may nothave the luxury of waiting on a rally. In fact,

call buyers should consider entering positionswhen a stock has pulled back to a strike withlarge and supportive put open interest. Ofcourse, these “speed bumps” can also high-light potential premium-selling opportunitiesfor advanced option traders.

Step 3: Check Buy/Sell/Hold RatingsAnalysts’ ratings offer you a glimpse into themood on Wall Street. As contrarians, we espe-cially like to find situations where the Streethasn’t yet caught onto a trend. Upgrades anddowngrades can drive daily trading activity,and looking at the ratings can help you find sit-uations where analysts may be behind thecurve. There is nothing more satisfying thanseeing a flurry of upgrades for a stock on whichyou’re already holding calls, or seeing down-grades after you bought puts on an over-loved,downtrending stock.

Step 4: Check the Short InterestThe classic interpretation is that high levels ofshort interest can lead to a powerful rallyknown as a short squeeze. However, this indi-cator is far from one-dimensional. The initia-tion of new short positions essentially addsnew selling pressure to the stock, creating aheadwind that must be overcome. Addition-ally, short sellers may buy call options tohedge their short stock positions, so knowingthe relative level of short interest can alsohelp you better interpret option activity.

Step 5: Check the Schaeffer's Volatility IndexVeteran option traders are well aware thatimplied volatility spikes ahead of knownevents, and it also ticks higher in times ofincreasing investor anxiety. Rising impliedvolatility can push an option’s premiumhigher, so every trader needs to be aware ofthese ebbs and flows. At a glance, the Schaef-fer’s Volatility Index (SVI) allows you togauge whether a stock’s options are becomingmore or less expensive. (For more, see “Backto Basics,” SENTIMENT, Summer 2009.)

Step 6: Return to Home BaseBelow the charts on the Quotes & Tools page,you’ll find even more tools to explore, such asimplied volatilities, greeks, and gamma-weighted SOIR. Once your stock has success-fully passed the sentiment test, you can checkout the option chain to see where you mightwant to place your bets.

Checking the Pulse on Sentiment

A WALK THROUGH THE PROCESS>> By Nick Perry

Tools of the Trade26 S E N T I M E N TWINTER 2010

FIGURE 1: Tracking SOIR against price reveals cluesabout what options players might be thinking.

FIGURE 2: Open interest configurations by strikesuggest potential support and resistance points.

P R E V I O U S LY, I N T H I S C O L U M N,we focused on the steps you can take toresearch the technical and fundamental dataavailable at SchaeffersResearch.com. Whatfollows is a bit of a “how-to” for putting astock through its sentiment paces.

Step 1: Check the Schaeffer's Put/CallOpen Interest Ratio (SOIR) When looking at the Schaeffer’s put/call openinterest ratio (SOIR), you want to considertwo things—history and trend. Starting fromour Quotes & Tools page, clicking on theSOIR thumbnail chart takes you to a detailedpage with information on both of these keypoints. Getting a handle on the history is easy:the page ranks the current SOIR on a scalefrom zero to 100%. A reading near zero meansthe SOIR is at the low end of the last year’sworth of readings, while readings closer to100% indicate a relatively high SOIR. Youcan track the trend of the SOIR with a graph(Figure 1) that plots the ratio against thestock’s price. As contrarians, we’re primarilyinterested in situations where the sentimentruns counter to the price action. For example,a SOIR that is rising to an annual high amidstrong price action might suggest that optionplayers haven’t yet bought into the stock’strend, as they are accumulating put positions.

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www.schaeffersresearch.com WINTER 2010 27

The buy-to-open put/call vol-ume ratio measures howmany puts were bought toopen, relative to calls, during

a given time frame. A “buy-to-open” transac-tion is one in which an option is purchased toopen a new position (rather than to close anexisting position), and is established by a spec-ulator or a hedger to profit from a directionalmove by the underlying stock. Meanwhile, ourSchaeffer’s put/call open interest ratio (SOIR)compares put open interest (the total numberof open put positions) against call open inter-est among options set to expire within threemonths. When used in tandem, these toolscan help determine the prevailing sentimentof option traders.

While the SOIR provides a general ideawhether traders are gravitating toward callsor puts, it doesn't tell the whole story—itdoesn’t distinguish between contracts thatwere bought to open and those that were soldto open. Clearly, call sellers have differentexpectations for the underlying equity thancall buyers.

On the other hand, thebuy-to-open put/call andcall/put volume ratiosfrom the Chicago BoardOptions Exchange(CBOE) and the Interna-tional SecuritiesExchange (ISE) havebeen filtered to removesell-to-open activity, aswell as any option volumeinitiated by market mak-ers. As a result, we get aclear picture of how retail-level option buyers arepositioning themselves.Are they buying far morecalls than puts (bullishpositions), or many moreputs than calls (bearishpositions)? By examining

these volume ratios over one-day, 10-day, 20-day, and 50-day time frames, we can keep aneye on sentiment trends as they develop.

The caveat? While it’s easy to see howmany puts were purchased relative to calls, it'simpossible to tell—without looking at theopen interest configurations by strike—exactly which puts were purchased. Werethese contracts highly speculative, out-of-the-money (OTM), front-month options? Or werethey more conservative, deep in-the-moneyLEAPS?

Additionally, it's critical to consider thepotential for hedging activity when assessingbuy-to-open volume ratios. When a stock orsector is trending steadily higher, it means thatmore and more investors are buying into theequity. As a result, put activity might increaseas these players look to hedge against adverseprice movement. Conversely, a stock with ahigh level of short interest could attract awealth of call volume—not necessarilybecause traders are bullish, but because theshorts are trying to protect themselves againstan unexpected rally.

Each of these put-call ratios have theirplace in sentiment analysis, but—as noted inthe accompanying feature article—they’llprove to be most useful when analyzed in con-text with additional sentiment indicators,including short interest and open interest con-figurations.

Q: How is the gamma-weighted SOIR different from the traditional SOIR?A: Our garden-variety Schaeffer’s put/callopen interest ratio (SOIR) compares put openinterest against call open interest amongoptions that expire within three months, pro-viding a general snapshot of short-term optionsentiment. The gamma-weighted SOIR fol-lows the same basic premise, but with onemajor difference: The SOIR gives equalweight to open interest across all strikes, nomatter how far from the stock’s current perch. But the gamma-weighted SOIR places muchgreater weight on at-the-money options,which have a higher gamma than their deepout-of-the-money and in-the-money counter-parts. (Gamma, one of the option “greeks,” is ameasure of an option’s sensitivity to the pricemovement of the underlying stock.)

By focusing on ATM open interest, we geta much more relevant sentiment picture. Sup-pose a bearish speculator bought to open aslew of April 35 puts on Generic Companyback in October, when the stock was tradingnear $45. Four months later, those puts are still“open”—but Generic shares have rocketed upto $75. Rather than sell to close those deepOTM puts, the trader will most likely chooseto save a few bucks on brokerage fees andleave them to expire worthless. A look at theequity’s traditional SOIR will fully reflect thisunderwater put open interest, potentially pro-viding a false indication that option traders arebearishly positioned—but the gamma-weighted SOIR will filter out these left-for-dead puts, as their gamma is effectively zero.

ExpectationalAnalysis Q&A

DIGGING DEEP INTO THE OPTIONS DATA WILL PROVIDECLUES FOR MARKET DIRECTION.

What is the buy-to-open put/call volume ratio, and how is it differentfrom the put/call open interest ratio?

A:

Q&A

GAMMA CURVE: An option’s sensitivity to pricemovement is highest at-the-money.

Q:Gamma

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www.schaeffersresearch.com WINTER 2010 Confessions of a Trader 29

POP QUIZ: WHAT’S WORSE, EXITING ATRADE TOO SOON OR TOO LATE?It’s a familiar scene: You plan a profit targeton a long call trade, say, 50%. The target hits,but something keeps you from selling. Thenext morning you wake up to find the markethas reversed and those profits you had inyour grasp vanished overnight. You vow,“Never again!” and the next time a trade hitsyour profit target, you dutifully exit. It is, ofcourse, at this very point that the underlyingskyrockets without you, and you’re countingevery dollar left on the table as the stockticks upward. Damned if you do. Damned ifyou don’t.

The ProblemIf you’ve traded options long enough, youknow that the one luxury you don’t have as anoption buyer is time. Combined with the fearof either losing profits or missing out ongreater ones, the threat of rapid time decayoften triggers emotional decision making thatcan render even the most seasoned vet withthe overwhelming desire to kick himself.

Let’s look at the following all-too-familiarscenario and work through a couple of exitstrategies that will not only keep you in thegame, but with a lot less to lose: Suppose XYZwas trading at $40 when you bought ten of the40 strike call options at $2. Your profit target is50%. With XYZ now at $42, those calls arefetching $3. Your target is hit and you’re sit-ting on a 50% gain. What do you do? Take themoney and run, or roll the dice? The answer:both!

The SolutionAt the point in which you’re thinking that youought to exit the trade, but your alter ego istelling you to stay in, try one of these twostrategies out:

Simply sell enough contracts to take off theoriginal risk, lock in some gains, but also leavesome on the table. This way, you’re only play-ing with profits. (But don’t confuse this with a“risk-free” trade. As long as money is involved,there’s no such thing!)

For our hypothetical trade, you might sell 8of the calls and take in $2,400, leaving youwith a nice 20% profit guaranteed ([$2,400 –$2,000] = $400/$2,000 = 20%), and a chanceof making even more on the two contracts thatare left in the trade. But don’t let these calls goto zero. Develop a new exit strategy for theremaining contracts as if you were entering thetrade for the first time. At this point, so long asyour remaining 2 calls don’t go to $0, any priceis you sell them for is additional profit.

Another way to get a littlemore bang for your buck on thistrade is to spread the remaining 2calls by turning them into longverticals (see “The Long VerticalCure,” SENTIMENT, Fall 2009for more info). By selling the nexthigher strike call against each ofthe remaining 2 contracts, youwould take in more premium tobring you even closer to your ini-tial 50% target, and still enjoy theupside juice the stock might haveleft. How? Suppose the nexthigher strike call is the 45 strike,and it is trading at $1. By selling 2of them against your 2 long 40calls, you take in a credit of $200,or an additional 10% of your origi-nal cost of $2,000, for a total of30% realized profit on the trade.

The remaining 40/45 call ver-tical trade has a chance of mak-ing another $5 for you. So yourworst-case scenario if the stockfalls off a cliff is that the remain-ing options go to zero, and youkeep a 30% profit (hurray). The

best-case scenario is that the vertical spreadsare cashed out at maximum value of $5 eachand you take in another $1,000, for a total of80% on the trade (double hurray).

Whether your problem is selling too soonor too late, it hurts all the same. Having madethese mistakes on more occasions than I careto admit, at some point, I figured out that tak-ing your profits doesn’t have to mean gettingentirely out of the trade. The beauty of trad-ing options is that when it comes to develop-ing an exit strategy, you really can have yourcake and eat it too.

Solving the Trader’sDilemma

THE ART OF TAKING PROFITS IS ABOUT GETTING WHAT YOU WANT ... AND THEN SOME. >> By Kevin Lund / PHOTOGRAPH BY FREDRIK BRODÉN

SIR04_Confessions.rd3:pages.layout 12/29/09 3:17 PM

--ELSEWHERE IN THIS

ISSUE, Bernie Schaefferand Todd Salamone writeabout trading opportuni-ties during expirationweek (see “Expiring withProfit,” page 12). Here’smore motivation for youto be in the market dur-

ing these weeks. The per-ception is that expirationweeks—and especiallytriple-witching expira-tion—are very volatileand prone to manipula-tion. Despite these fears(or, if you ask contrarians,because of them), expira-

tion weeks tend to beconsiderably more bullishthan non-expirationweeks. Not only do theyaverage a higher returnthan non-expirationweeks, with a higher per-centage of positivereturns, but they do so

IdeaLab30 S E N T I M E N TWINTER 2010

F YOU'VE BEEN FOLLOWINGthis magazine, you're probably already famil-iar with Expectational Analysis®, our three-pronged approach to evaluating stocks hereat Schaeffer’s Investment Research. Funda-mental analysis and technical analysis arejust two of the three factors we considerwhen seeking out trade opportunities. Thethird leg of Expectational Analysis involvesinvestor sentiment. As contrarians, we lookfor scenarios where investors’ prevailingopinion runs counter to the price trend.

For example, an ideal setup for a bullishcontrarian trade would be a company withstrong fundamentals, a solid uptrend on thecharts, and a wealth of skepticism surround-ing the shares. From our perspective, thisnegative sentiment reveals that many havenot yet bought into the equity's uptrend–in

other words, there's still plenty of cash onthe sidelines. As the stock continues tomove higher, these pessimists will eventuallybe forced to capitulate to the upbeat funda-mental and technical outlook, supplying thestock with a fresh burst of buying power.

Quantifying SentimentSome critics claim that sentiment analysis istoo subjective. How can you really tell whenthere is too much love or too much skepticismtoward a stock? How can you measure it?Admittedly, some aspects of sentiment analysisare anecdotal. For example, we consider how astock is portrayed in the media: We watchwhat the TV pundits are saying about the com-pany, what actions they recommend investorstake, and what newspapers, magazines, andwebsites are reporting. In fairness, interpretingtheir words to have a bullish or bearish bias canoften be a matter of personal opinion.

However, measuring sentiment is ourlifeblood here at Schaeffer's, and we havedeveloped a complete toolbox of objective,quantitative indicators that we use to gaugethe market’s feelings toward a company (manyof which are explained in “The Smoking

Gun,” page 23 ).We've found usingthe proper tools toquantify sentiment isessential for findingstocks that have thepotential to deliveroutsized returns.

In this article, I'llexplain how to use agrouping of severalcritical sentiment

indicators to find uptrending stocks that aresurrounded by counter-trend skepticism –andthus, may be poised to rocket higher.

For this analysis, I went back about a yearand looked for stocks that met two basicbenchmarks. First, their options traded at least500 option contracts bought to open over thepast 50 days. Second, I looked for stocks trad-ing above their 80-day moving average, inorder to ensure that the stocks were not in asteady downtrend. (We expect there to be acertain level of doubt toward a company whosestock price is falling. What is important to us isa preponderance of skepticism on a stock that’smoving consistently higher on the charts.)

With our basic technical requirementsnailed down, I analyzed three quantified senti-ment measures that we routinely utilize atSchaeffer’s to determine whether theyrevealed a high level of pessimism towardthese equities. First, I looked at analysts’ rat-ings, which we receive from Zacks InvestmentResearch. In order to get a sufficiently broadsurvey of Wall Street’s opinion, only stockswith 10 or more analysts’ ratings made the cut.I also considered how many traders were bet-ting on the stock to fall by looking at the per-centage of the stock's float that was sold short.Finally, I determined how option players werefeeling by looking at the number of putsbought to open during the last 50 days com-pared to the number of calls bought to open(based on data from the International Securi-ties Exchange and the Chicago Board Options

I

TURNING TRADITIONAL

MARKETR&D ON ITS

HEAD

FIGURE 1: Grouping sentiment indicators together can provide the boost you need.

BULLISHON EXPI-RATIONS

THE SKINNY ON SENTIMENTTO UNDERSTAND THE MARKET’S MOOD, YOU NEEDTO QUANTIFY IT.

idea #1

F Y I

S&P 500Weekly Returns Since 2006

with less volatility asmeasured by their stan-dard deviations. Con-versely, the week mostlikely to generate a nega-tive return is the weekafter expiration. Theseweeks have been positiveless than 40% of the time.

No. of Average Percent StandardResults Return Positive Deviation

Any Expiration 46 0.27% 67% 3.00%

Triple-Witching Expiration 15 0.80% 73% 1.85%

Week After Expiration 46 -0.07% 39% 2.92%

Non-Expiration 155 -0.11% 48% 3.30%

3-Month 6-Month 3-Month 6-Month

Average Return Average Positive ReturnNo. ofCriteria Met

No. ofReturns

0 675 10.4% 18.2% 18.4% 28.6%

1 346 13.6% 24.4% 24.3% 39.2%

2 182 15.3% 24.3% 27.4% 38.7%

3 46 15.6% 28.3% 30.1% 50.7%

Grand Total 1249 12.2% 21.3% 21.8% 34.0%

SIR04_IdeaLab.rd3:pages.layout 12/29/09 3:47 PM

www.schaeffersresearch.com WINTER 2010 Idea Lab 31

Exchange). The criteria used to determinesuch healthy skepticism is:

Analyst Percent Buys: <25%Short Interest Percentage of Float: >7%50-Day Buy-to-Open Put/Call Ratio: >1.20

I evaluated the stocks each month based onthe criteria outlined above, and summarizedtheir price return three months and six monthslater. Out of roughly 1,250 total returns, only46 of them met all three sentiment criteria.The top row in Figure 1 shows price returns forstocks in which none of the sentiment criteriawere met. We can conclude that there was ageneral lack of pessimism toward those stocks.Row 4 of Figure 1 shows data for stocks meet-ing all three of the sentiment criteria, suggest-ing a heavy amount of negativity frominvestors and analysts.

Though the returns for all of the groups arerespectable, take a closer look at the returns inrow 4: The stocks with the most pessimismshowed the biggest average returns. The aver-age six-month return of stocks where none ofthe sentiment criteria were met is about 18%,versus 28% for stocks that met all three.

The last two columns in the table measurethe size of the average positive gain. Whenyou limit the analysis to positive trades only,you’ll see an even bigger discrepancy. Theaverage positive stock move in three monthsfor companies showing a lot of skepticism isover 30%, and these same stocks had a six-month average positive move of just above50%! With leverage, trading options on theseequities could have led to even larger gains.

So, it seems that gauging sentiment is notentirely subjective. At Schaeffer’s, we’vedevised a number of ways to objectively quan-tify the level of optimism or pessimism towarda specific stock, in order to zero in on the besttrading opportunities. After all, when youtrade options, you’re looking for stocks thathave the capacity to make a rapid and sub-stantial move higher on the charts. By com-bining these sentiment indicators withtechnical and fundamental analysis, as well asanecdotal sentiment evidence, you have anextremely effective toolkit to uncover poten-tially explosive trading opportunities./ / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / /

>> Rocky White Senior Quantitative Analyst, Schaeffer's Investment Research/ / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / /

N LIGHT OF THE VOLATILEinvesting environment we’ve expe-rienced over the past couple ofyears, more and more traders haverealized the importance of investorexpectations in determining whichstocks to buy and to hold. In a world where fundamental stories can practically change overnight, a stock’ssentiment is a useful barometer to help gauge entry and exit points ahead of the curve. For example,overly optimistic sentiment can be a warning sign that a stock is priced for perfection. Meanwhile,extreme skepticism can set the stage for an upside surprise. Both can be early detectors of imminent fun-damental shifts in the market.

While there are plenty of sites that incorporate technical and fundamental data, sentiment data issorely deficient in most places. So, if you’re a sentimentician, it stands to reason that at any given time, you(1) probably follow a basket of stocks, and (2) frequent two or three places to track your data. With Scha-effer’s Watch List (www.schaeffersresearch.com/watchlist), not only can you track your favorite stocks,but also their most popular sentiment indicators—all in one convenient place.

To access the Watch List, you simply log into your account at SchaeffersResearch.com, and from theMy Account page, select Watch List under the Tools menu. (If you don’t have an account, sign up! It’s notonly an essential sentiment resource, but it’s also free!) There is also a link at the top of the Quotes pagethat allows you to add stocks to your Watch List. From the list, add and remove symbols you’d like towatch. Once you’ve bookmarked that page, you can quickly scan your portfolio every day to see whichstocks are showing potential warning signs of excess optimism or encouraging signals of skepticism.

While you’re there, play around with all of the settings and features. You can sort the list by clicking oncolumn headings and many of the data points, revealing more detailed information for each indicator. Forexample, clicking on the SOIR data for a particular stock takes you the Schaeffer’s Put/Call Ratio (SOIR)page so you can see the graph and recent data.

The Watch List gives you an opportunity to quickly assess the sentiment picture for the stocks you areinterested in. Most sites that offer watch lists and scanning features only give you the ability to look ateither technical or fundamental indicators, but the Watch List combines sentiment indicators as well forthe extra edge you need. (For more information on the role of sentiment in your own trading, be sure to readPart 3 of our Expectational Analysis® series on page 23.)

I

SCHAEFFER’SWATCH LISTSENTIMENTICIANS,SAY GOODBYE TOSTICKY NOTES ANDCHICKEN SCRATCH.

idea #2

FIGURE 1: Schaeffer’s Watch List is a convenient place to track all ofthe stocks you follow, along with the most important sentimentindicators. Just go to www.schaeffersresearch.com/watchlist.

SIR04_IdeaLab.rd3:pages.layout 12/29/09 3:47 PM

WHO SHOULD TUNE IN? The iron butterfly strategist usually anticipates mini-mal movement from the underlying stock, somost iron butterfly traders avoid equitieswith potential momentum-inducing catalystson the calendar, like an upcoming earningsreport or sales release. HOW DOES IT WORK? It’s the combinationof a short put spread and short call spread,with the sold options meeting in the middle.More specifically, the investor buys one out-of-the-money put and one out-of-the-money

call, while simultaneously writing one at-the-money put andone at-the-money call with the same strike. All of the optionsshould have the same expiration date, with the play estab-lished for a net credit.For more on the Iron Butterfly strategy, go to: www.sentiment.com/IronButterfly

OPTIONS STEWWhat’s cookin’ in theoption pits? Eachweek, Schaeffer’sanalyst AndreaKramer serves upsome food forthought by focusingon three differentstocks experiencingunusual option activ-ity—“Spicy Calls” forpotential bullish

trades, “A Pinch ofPuts” for the bears,and “The SweetSpot,” a decipheringof one of the week’sbig block optiontrades to help yousee what the traderwho placed it mightbe thinking. If there’sa hidden gem in apile of rubble, we’llfind it for you. Youjust need to knowwhere to look.—To view the OptionsStew series and more, go to sentiment.com/videos

INDICATOR OF THE WEEK: ImpliedVolatility Skew on SPY Options GIVENTHE RECENT MARKET ACTION, [OUR]ANALYSIS AND THE FACT THAT SPYOPTIONS ARE OFTEN USED BY INSTITU-TIONS TO HEDGE THEIR PORTFOLIOS,WE CAME TO TWO POSSIBLE CONCLU-SIONS ON WHAT IS DRIVING DOWNCALL OPTION PREMIUMS: (1) HEDGEFUNDS ARE COVERING THEIR SHORTPOSITIONS AND IT HAS CAUSED CALLBUYING TO DRY UP. (2) HEDGE FUNDSARE SELLING CALL OPTIONS TO GENER-ATE INCOME. THE MECHANICS OFHEDGE FUNDS SELLING CALL OPTIONSIS BEARISH FOR THE MARKET (MARKETMAKERS SHORT THE STOCKS TO HEDGEAFTER BUYING THE CALL OPTIONS).THAT EXPLAINS WHY THE MARKET HASPAUSED...From Monday Morning Outlook, 12/5/09. Listen to the podcast or subscribe free at www.sentiment.com/mmo

>OPTIONS 101The Collar Think youmight be able to squeezea few more dollars onyour stock position, butfear a reversal is immi-nent? A collar can keepyour risk at bay and yourmoney on the table.

The Principles of Put Selling Whetheryou’re looking to buystock at a discount, orprofit from inflatedoption premiums, putselling could be an inte-gral part of your invest-ment strategy.

Blogs from the Pros

.COM32 S E N T I M E N TWINTER 2010

Joce

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Dra

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A+

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MUST-KNOWEDUCATIONA sampling of our best option content thatyou’ll find at SchaeffersResearch.com

commentary

TRADER OPENS MASSIVE SPREAD ON ISHARES MSCI JAPAN INDEX FUND (EWJ)

> The iShares MSCI Japan Index Fund (EWJ) appears to have been thefocus of a new credit spread position, as traders flocked to the equity’s callsand puts. Digging into the action, the exchange-traded fund’s (ETF) Janu-ary 2011 12 call traded 62,500 contracts this morning on open interest of131,904 contracts. At just before 10 o’clock, two blocks of 31,250 con-tracts traded at an ask price of $0.24 for a total cost of $1,500,000.> At the same time, the March 10 put has seen more than 62,500 con-tracts change hands on open interest of 137,552 contracts. At just before10 o’clock, two blocks of 31,250 contracts changed hands at the bid priceof $0.53, resulting in a credit of $3,312,500. The total credit received forthis spread is $1,812,500.

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

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

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

Must HearPodcast

MUST SEEVIDEOCAST

MUST-READARTICLE

ADVANCEDOPTIONS:DISSECTINGTHE IRON BUTTERFLYWithout spot-onaccuracy, this multi-tiered strategy can sting like a bee. / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / /

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

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

Jocelynn DrakeSchaeffer’s DailyOption Blog Finding opportunitieswhere others can’t

To visit Schaeffer’s Daily Option Blog, go to: www.sentiment.com/DailyOptionBlog

Finding articles and stock commentary at Schaeffer’s is easy. Use the “KEYWORD” searchlocated at the top right of our home page at SchaeffersResearch.com. For example, type in“Options 101” or another subject heading from this section, and view a list of recent articles.

SIR04_.COM.rd3:pages.layout 12/29/09 2:10 PM

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Page Zero0 S E N T I M E N TWINTER 2010

range below $100 pershare (GLD = 1/10 spotgold price).

Moreover, it appearedthat at least one institu-tion was accumulating asubstantial position inthe GLD December 100– 120 – 135 butterflyspread. While the detailsof the strategy lie out-side the scope of thispiece, the conclusionwas this: some bigmoney was implement-ing an advanced optionsposition and looking forthe gold fund to move to$120 (the middle strike)by December. For GLDto hit the $120 target, itwould need to rally 20%in about two months.That, in turn, would alsorequire gold to movetoward $1,200 an ounce.It seemed unlikely.

But by early Decem-ber, the financial newswas spattered withheadlines about gold hit-ting new record highs of$1,200 an ounce. As ofthis writing, the butterflyspread is a huge winner.

Of course, not all“smart-money” tradesare winners, and optionsorder flow analysis is nota standalone tool forfinding winning trades.It’s best used in conjunc-

Pro Pearls

DIGGING DEEPER INTO THE WORLD OFOPTIONS DATA CAN PROVIDE THE PERFECT STARTING POINTS FOR NEW OPPORTUNITIES.

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Schaeffer’s Investment ResearchMAIN OFFICE: 513.589.3800MAIN FAX: 513.589.3810CUSTOMER SERVICE:800.327.8833 prompt #2E-MAIL: [email protected]: 800.448.2080 prompt #4

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

SENTIMENT is published quarterly by Schaeffer’s Investment Research, Inc. (SIR). SIR is not a registered investment adviser. SIR relies upon the publishers exclusion from the definition of investment adviser under Section202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws. As such, SIR does not offer or provide personalized advice. We publish information about companies in which we believe ourreaders may be interested and this information reflects our sincere opinions. The information that we provide is not intended to be, and should not be construed in any manner whatsoever as, personalized advice. Also, theinformation provided by us should not be construed by any reader as SIR’s solicitation to effect, or attempt to effect, any transaction in a security. The information contained in SENTIMENT is not intended to be investmentadvice and is for illustrative purposes only.The investment strategies or the securities may not be suitable for you. The information provided herein has been obtained from sources believed to be reliable, but there is noguarantee of accuracy. Some of the articles and material in SENTIMENT have been written by third-party authors. In such cases, their views are those of the author, but are not necessarily the views of SIR. The risk of loss intrading securities, options, futures, and forex can be substantial. Readers should consider all relevant risk factors, including their own personal financial situation, before trading. Options involve risk and are not suitable for allinvestors. Readers should restrict commitments to funds that can be lost without undue financial hardship. Prior to buying or selling an option, an investor should read and understand the booklet “Characteristics and Risksof Standardized Options.” You can access and download a copy of the booklet on The Options Clearing Corporations (OCC) website at www.theocc.com/publications/risks/riskchap1.jsp. This link reference is provided as acourtesy and does not imply that the OCC is endorsing SIR or its products. This booklet is also available for free from your broker or from any of the U.S. options exchanges, or you can call SIR toll-free at 1-800-327-8833and we will send one to you. Prior to buying or selling a future, an investor should read and understand the booklet “Security Futures: An Introduction to Their Use and Risks.” You can access and download a copy of thebooklet at the National Futures Association website at www.nfa.futures.org/investor/security_futures/security_futures.pdf. This link reference is provided as a courtesy and does not imply that the National Futures Associa-tion is endorsing SIR or its products. This booklet is also available from your broker or from any of the U.S. Futures Exchanges, or you can call SIR toll-free at 1-800-327-8833 and we will send one to you. The security port-folio of our employees, officers, affiliated companies, and third-party writers may, in some instances, include securities mentioned in this issue. No part of this material may be reproduced in whole or in part without explicitpermission from a duly authorized officer of SIR, except by established news media that wish to quote brief passages for purpose of review. Copyright 2010, Schaeffer’s Investment Research, Inc.

The options market is arich source of valuableinformation. Just as pat-terns, volume, and his-torical data can be usedto analyze stocks andcommodities, they canalso be used to analyzeand better understandsentiment and markettrends. With options, it’spossible to isolate otherfacts—trade size, expira-tions, and strike prices—that provide a uniqueedge for finding action-able trading ideas.

The process, some-times called optionsorder flow analysis, hasbecome much easierthanks to new technol-ogy. A number ofoptions-related websitessuch as SchaeffersRe-search.com offer newtools to analyze options

data, making it possibleto identify and interpretsignificant optionstrades, large “smart-money” positions, andcomplex spreads in atimely manner.

The premise is simple:if an institution, whethera hedge fund or a portfo-lio manager, is placingmillions of dollars in anoptions position, they’veprobably done some sig-nificant due diligence,research, and analysis.Why not use that infor-mation as a starting pointfor finding opportunitiesof your own?

A Golden ExampleA recent example mighthelp. In September, someinstitutions were accu-mulating bullish posi-tions in the SPDR GoldTrust (GLD), anexchange-traded fundthat holds gold stored inbank faults. At that time,gold was just under$1,000 an ounce andGLD was trading in a

tion with other optionindicators, plus funda-mental and technicalanalysis. Nevertheless,by looking at the size ofthe trade, the expirationmonth, and the strikeprice, options orderflow analysis canuncover interestingopportunities thatmight have been other-wise overlooked.

/

Frederic Ruffyis an experienced optionstrategist and co-founder ofwww.WhatsTrading.com, awebsite devoted to real-time interpretation ofoptions order flow.

Henry Schwartzis President of Trade AlertLLC, a market data firmspecializing in Option FlowAnalytics for leading WallStreet desks.

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per US $

USD/AUD

USD/GBP

USD/CAD

USD/EUR

USD/JPY

USD/MXN

USD/NZD

USD/SEK

USD/CHF

SYMBOL

AUX

BPX

CDD

EUI

YUK

PZO

NZD

SKA

SFC

in US $

AUD/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

British pound

Canadian dollar

Euro

Japanese yen

Mexican peso

New Zealand dollar

Swedish krona

Swiss franc

PRSRT STDUS Postage PaidPermit #799Bolingbrook, IL

Schaeffer’s Investment ResearchMAIN 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

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