Contr ary O pi ni on & Opt ions S tr ate gi es Fo r a V olat ile M arke t

Price Headley, CFA, CMT President & CEO May 26, 2004
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Contrarian Philosophy
• The majority of investors are usually wrong, being too Reactive in taking positions • Contrarians profit from the UNEXPECTED – what is expected is already priced into the market • Spotting these reversals is the key – most people see Contrary Opinion as too subjective. My aim is to quantify investor emotion so that we can assess it in an analytical, non-emotional method. • This allows for a Proactive approach to take advantage of other investors’ emotional over-reactions.
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Contrary Opinion Indicators
• Contrarian Investing – Capitalize on the Emotional Reactions of Other Investors
– Techniques: CBOE Equity Put/Call Ratio CBOE Volatility Index (VIX)

• Options Indicators are especially useful to measure Fear & Greed – why? Because option traders use Leverage, and they feel the swings of the market more quickly and more dramatically
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What is the VIX?
• A: The CBOE Volatility Index (VIX) plots an average “implied volatility” in put and call options. The irony is that at extremes, these market expectations often signal a reversal. __________________________________ • Puts increase in value when a stock declines • Calls decrease in value when a stock declines • Calls increase in value when a stock rises • Puts decrease in value when a stock rises
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Using the VIX
• Extremes in the VIX reading indicate a likely beginning or end of a trend • Readings above 40 indicate much fear – Usually comes at a market bottom – a buy signal • Readings below 20 indicate much confidence – Usually comes at a market top – a sell signal

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History of the VIX

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VIX dropped to 20 at the market top

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VIX spikes to 40 and 50 at lows

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When VIX signal fails after 4 weeks, GET OUT!!!

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VIX now staying under 20 – Is that Bullish or Bearish?

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VIX Relative Extremes with Bollinger Bands

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VIX Relative Extremes with Bollinger Bands

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CBOE Put/Call Ratio
• A measure of how many puts are traded relative to the number of calls traded on any given day • High put volume, relative to call volume, indicates bearish sentiment • High call volume, relative to put volume, indicates bullish sentiment
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Extremes in the Put/call ratio
• Put/call ratios under 40 indicate TOO much bullishness and optimism – a sell signal
– A market top

• Put/Call ratios over 80 indicate TOO much bearishness and pessimism – a buy signal
– A market bottom
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CBOE Equity Put/Call Ratio – Daily New - CBOE Equity Put/Call Ratio – Daily

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OPTIONS TERMS
Call - right to buy stock at a specific price good through a specific date Put - right to sell stock at a specific price good through a specific date Strike Price - price you can own stock Expiration - date the option ceases to exist Volatility - % movement in the stock
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OPTIONS TERMS
In-The-Money (ITM) - Option Has Intrinsic Value At-The-Money (ATM) - Strike = Stock Out-of-The-Money (OTM) - Option is All Time Value
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Buying a Call
When buying a Option: XYZ December 60 Call call, you believe Price: $2.00 the price of the stock will increase in value. Here we Quoted price $2.00 have bought the x 100 shares x 100 right to BUY 100 Total purchase = $200 shares of XYZ at $60 per share, and we have that right until December
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BUY CALL

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Buying a Put
When buying a put, you believe the price of the stock will decrease in value. Here we have bought the right to SELL 100 shares of XYZ at $60 per share, and have that right until December.
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Option: XYZ December 60 Put Price: $2.00 Quoted price $2.00 x 100 shares x 100 Total purchase = $200

BUY PUT

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TIME DECAY
TIME PREMIUM

MONTHS UNTIL EXPIRATION

EXPIRATION

In The Moneys as a Stock Substitute
• Buy In the Money Options to Reduce Time Value => Focus on Intrinsic • Sell 100 XYZ shares @ 56.60 = $5660 • Buy 1 June 60 PUT @ 4.70 = $ 470
– XYZ goes to 50 before mid-June: – Short Shares gain $660, or 11.7% – ITMs gain $530, or 112%
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• You can reduce your cost in the LEAPS by selling short-term calls • Buy 1 Jan. 2006 45 call @ 20 = - $2000 • Sell 1 3-month 60 call @ 4 = + $400
– Do this 5 times and you have no cost effectively in your LEAPS position – Benefit: Time decay on the short-term out-of-the-money much greater – Risk: Sharp rally may require buying in the short-term call due to gamma risk
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Buy LEAPS, Sell Short-Term Calls

• • • • •

The Credit Spread Strategy Profit from Time Decay IF Bullish: Instead of buying calls, be a net seller of puts 100 QQQ shares @ 36 Sell 10 June 35 puts @ 1.25 = +1250 Buy 10 May 34 puts @ 0.85 = - 850 Net Credit Collected = + 400
– Options expire if QQQ closes over 35 on third Friday in June, you keep the $400

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Using Puts for Portfolio Protection
• When Should You Buy Puts for Protection?
– Technical Indicator says SELL – Options are Cheap – Low Volatility Levels – Concerned about Giving Back Big Gains

• How Big Should Your “Deductible” Be?
– Usually 1 strike out-of-the-money

• Advantages: Keep Tax Basis, Lessen Pain on Major Pullbacks, • Disadvantages: Cost, Hurts in Flat Market
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Creating a Low-Cost Collar
• A Collar accomplishes the goal of Put Protection, but often at minimal to no cost, by also selling a call against the stock • XYZ shares at 60
– Buy 3-month 55 Put for - $300 – Sell 3-month 65 call for + $275 – Net Cost = - $25

• This lowers your cost dramatically to protect a stock, while giving up appreciation above a certain level (like a www.BigTrends.com 1-800-BigTrends covered call)

How to Stay with Big Winners
Give yourself a chance to stay with a Big Trend by taking HALF of your position profits at 100% or more This allows you to release the fear of giving up profits, as you recoup your initial investment and guarantee at least a breakeven Ride the other half position until it gives back half its gains, or exit half again if it later doubles once more
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Percentage Gain to Breakeven After a Loss
Percentage Loss -10% -20% -33% -50% -75% -90% Gain Required to Breakeven 11% 25% 50% 100% 300% 900%

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The Concept of Efficiency
• On which of these trends would you rather buy a bullish position?

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A Flaw in the Options Pricing Model Q. Which is more important in the Options Model?
A 20% Rise in Price or a 20% Rise in Volatility? (Assume: XYZ shares at 119-1/2, Volatility starts
at 25.00%, Expiration in 70 days, Strike price is 120)

Scenario 1. 20% Volatility Rise (25% to 30%) instantly –XYZ August 120 call 5.50 => 6.48 … an 18% gain Scenario 2. 20% Stock Price Rise (119.50 to 143.38) instantly – XYZ August 120 call 5.50 => 24.63 … a 348% gain

A. Trend impact is 19 X greater than Volatility here
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Why Option Charts ?
• Options are NOT the stock – they can and do move independently of the underlying security • Options DO move in patterns that can be forecasted with traditional technical analysis techniques

STOCKS VERSUS OPTIONS
• Most options traders look at the stock chart to determine the trend of the underlying security, and then decide whether they will buy an option What if you also looked at an Option Chart? Is that any different than the stock chart? YES! The additional factors of Time & Volatility often make the option’s chart look quite different than the stock chart 1) If the stock stays flat, your option will expire and you lose due to Time Decay
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eBay

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20-Day Acceleration Bands

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Option Scans – Manage Info Overload

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Stochastics Cross Over 80

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NFLX Dec. 30 Call (QNQLF)

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QQQ Jan. 36 Call Options Chart

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