SMAR T OPTIONS FOR TODAY’S INVESTOR

SPRING 2012

BERNIE SCHAEFFER’S

14/ TRADING STYLES:MORE IS MORE

18/ TARGET SHOOTINGWITH BUTTERFLY SPREADS

24/A DAY IN THE LIFE OFAN OPTION> >

SIR12_Cover_RD3.qxd:pages.layout 12-05-21 5:02 PM Page 1

Trade up to the effi ciency today’s market requires with SPXpm. With a notional size 10X greater than SPY options, you benefi t from lower transaction costs. With cash settlement, you never have to take or make delivery of shares, so you can minimize trading expenses. Plus, SPXpm options settle after the close, like stock options and ETF options, so you can trade throughout the day on expiration Friday. Learn more at www.CBOE.com/SPXpm

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation at www.theocc.com. C2 and SPXpm are service marks of C2 Options Exchange, Incorporated (C2). S&P® and S&P 500® are trademarks of Standard & Poor’s Financial Services, LLC and have been licensed for use by C2. SPXpm is not sponsored, endorsed, sold or promoted by Standard & Poor’s, and Standard & Poor’s makes no representation regarding the advisability of investing in SPXpm. Copyright © 2012 C2 Options Exchange, Incorporated. All rights reserved.

Introducing SPXpm,SM traded exclusively on the all-electronic C2 Options Exchange.

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FOR THOSE WHO LIKE THEIR

OPTIONS WITH

MORE OPTIONS.

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SIR12_Contents_RD3.qxd:pages.layout 12-05-21 5:07 PM Page 2

14Diversify Your DisciplineWhen was the last time you made a life-changingdecision by yourself? You probably sought out a second opinion…or a third…and so on. When itcomes to investing styles, more is more. But surpris-ingly, investors generally stick to just one. Here’s why that’s a bad idea. /

18Come Fly With MeThe butterfly spread isn’t just for range trading. It makes for a great “target”trade in lieu of an option-buy strategy as well. And to boot, you can lock in profitswithout leaving money on the table. /

6The Sentiment ReportHomebuilders continueto be dismissed bynaysayers, but contrari-ans should find reasonto love the suppliers ofthe American dream. /

10Making News, Etc.Options industry bits,highs and lows, andimportant options dates to mark on yourcalendar./

13Ask BernieAnswers to your burningquestions about after-hours options tradingand just how manyoptions expire worthless. /

24Back to BasicsEver wonder whereoptions come from andwhat happens to themafter you send in yourorder? Wonder no more. /

26Idea LabDespite the roar, there’sevidence bears don’talways have it right.+ TOOL REVIEW: the new and improvedSchaeffersResearch.com

Photographed by Fredrik Brodén /

4At the OpenTop five delusionsoption traders fall prey to.

/

28.COMWhere to go and whatto see right now at Schaeffer’s Researchonline.

/

30Pro PearlsVeteran author andtrader Michael Sincereshares some preemptivestrikes for optionstraders. /

SMAR T OPTIONS FOR TODAY’S INVESTOR

SPRING 2012

BERNIE SCHAEFFER’S

14/ TRADING STYLES:MORE IS MORE

18/ TARGET SHOOTINGWITH BUTTERFLY SPREADS

24/A DAY IN THE LIFE OFAN OPTION> >

FEATURES COLUMNS

COVER

REGULARS

PUBLISHERT3 Publishing LLCEMAIL: info@t3publishing.comwww.t3publishing.com

ADVERTISING CONTACTKatie Schaeffer513.589.3800 X1145kschaeffer@sir-inc.com

Schaeffer’s Investment ResearchMAIN OFFICE: 513.589.3800MAIN FAX: 513.589.3810CUSTOMER SERVICE:800.327.8833 prompt #2E-MAIL: service@sir-inc.comSALES: 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 Sentiment@sir-inc.com.

BERNIE SCHAEFFER’S

SENTIMENT™

EDITORIAL DIRECTORKevin Lund

CONTRIBUTING WRITERSTodd Salamone, Rocky White, Elizabeth Harrow, Andrea Kramer,Jim Cunningham

ART DIRECTORTom Brown

ASSISTANT EDITOREileen Sutton

DESIGNERJennifer Roberts

CHIEF PHOTOGRAPHERFredrik Brodén

CONTRIBUTING ILLUSTRATORJoe Morse

www.schaeffersresearch.com SPRING 2012 Contents 3

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Letter fromBernie

4 S E N T I M E N TSPRING 2012

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IN LIEU OF MY NORMAL “LETTER,” I thought I’d share my recently developed list of4 major delusions that can plague option buy-ers. Readers of SENTIMENT have likelyavoided many of these situations, but it alwayshelps to be reminded.

Delusion 1: You are buying volatility andtrading multi-directionally by buying astraddle (or strangle) using weeklyoptions—As time till expiration diminishes,the total dollars you need to purchase a strad-dle at a particular strike decreases. Note,though, that your cost reduction is not propor-tional to the reduction in days till expiration (a5-day at-the-money straddle will cost you halfas much as a 20-day). And due to the hugetheta of your position, any benefit you mayachieve as a “volatility buyer” from risingimplied volatility will almost certainly be morethan offset by time decay. Perhaps of greatestimportance, due to the rapid time decay of theweekly options, a directional move of any sig-

nificance in the underlying stock will bias yourposition almost completely in the direction ofthe in-the-money side.

Delusion 2: You are “playing the funda-mentals” of a major stock move by buying acall (or a put)—Some of the more volatilestocks, with modest share prices and modestmarket capitalization, can easily double overthe course of a year. But the typical higher-priced, large-cap stock to which most calloptions buyers gravitate, would be very hard-pressed to post a 10% gain in the month ortwo till expiration they typically buy. Mostoptions buyers are “playing the noise and notthe signal” — they are betting on outliermoves over very short time frames rather thanon “the big ones.” This is fine, but such betsrequire a strong understanding of technicaland sentiment analysis, as well as a specula-tor’s mentality.

Delusion 3: You are being a“contrarian”—Almost all investors have arudimentary sense that “going with the crowd”is not the right way to trade successfully. Butthey are often not aware of a number of indica-tors that might be signaling they are taking acrowded trade. For example, many investorsdo not track the degree that speculators arebetting on further upside through call buying,or that heavy short interest (normally consid-ered a bullish contrarian indicator) might behedged with long call positions.

Delusion 4: You are buying a highlyleveraged vehicle—While most options buy-ers typically buy too much leverage within the

Bernie Schaeffer has been bringing you trading tips and market-timing insight with the Option Advisor newsletter for 30 years. For a free copy, go to: www.sentiment.com/opad12

context of also not buying enough time, it ispossible by going too far out in time and goingtoo far in the money you are obtaining lever-age insufficient to justify the trade. A conven-ient tool overlooked by most is the “leverageratio,” calculated by multiplying the stockprice by the option’s delta, and then dividingthis product by the option’s premium. You’dgenerally like to see a leverage ratio of at least5 to 1 in the trades you take.

Bernie SchaefferFounder and CEO, Schaeffer’s Investment Research

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

>> Please let us know your thoughts. Send your feed-back to Sentiment@sir-inc.com./ / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / /

At the Open

ARE YOU A GOODOPTIONS TRADER, ORJUST DELUSIONAL?

ELIZABETH HARROWDigital Content Develop-ment Manager for SchaeffersResearch.com She writesthe Trading Floor Blog, edits the Monday Morning Outlook, and contributes to SFO Magazine.

ANDREA KRAMERSenior Equities Analyst andEditor for SchaeffersResearch.com. She writesthe Daily Option Blog, hoststhe Options Stew video series,and contributes to Stock-house.com and StockTwitsU.

Schaeffer’sContributorsto This Issue

ROCKY WHITE Senior Quantitative Analystand contributor to MondayMorning Outlook. He holdsa master’s degree in financial engineering, andhis research is quoted onBloomberg TV, CNBC, and Fox Business News.

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

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The Sentiment Report6 S E N T I M E N TSPRING 2012

“A MONTHS-LONG RALLY IN HOUSING-related stocks dating back to October hasmore and more investors eyeing the space,but recent signals out of the housing marketare some cause for concern,” began a March29 Forbes article, entitled “Housing HiccupsCast Shadow on Rebound Hopes.” It’s hardto find a more clear-cut summary to encap-sulate the market’s mood toward builders.Despite a steady trend of improving priceaction, traders continue to expect the worstfrom this group.

It was roughly a year ago in this spacethat we discussed our bullish stance onbuilders (see “A New Housing Boom?,”SENTIMENT, Spring 2011). While senti-ment toward these names was fairly down-beat at the time, the housing sector is now indanger of becoming the Rodney Dangerfieldof Wall Street. No matter how well buildersare faring on the charts, these stocks justcan’t win any respect.

Sentiment: The Contrarian TakeFor starters, let’s take a look at the analystratings. Last year at this time, housing-sec-tor components had attracted fewer than40% “buy” ratings from brokerage firms. Asof this writing, the SPDR S&P Home-builders ETF (XHB) is resting on a 52-weekgain of roughly 16%, with 96% of builderstrading atop their respective 200-day mov-ing averages. Nevertheless, the percentageof “buy” ratings on the group has barelybudged, edging up to just 43%. In otherwords, Wall Street’s opinion toward home-builders hasn’t exactly risen in step withXHB’s technical performance.

Likewise, short sellers continue to betagainst builders in droves. Equities such as

D.R. Horton (DHI), Lennar (LEN), Mer-itage Homes (MTH), and Toll Brothers(TOL) are all perched within striking dis-tance of annual highs, having followed suitwith the broader sector uptrend. Neverthe-less, the short-to-float ratios remain ele-vated on these technical standouts, rangingfrom a “low” of roughly 8% to a high near21%. This is encouraging from a contrarianperspective, as these shorts could be forcedto buy back their bets as the positive priceaction continues. This represents a healthysupply of future buying power.

Changing MindsHowever, a few signs have emerged that sen-timent might be shifting, at long last, towardthis underdog sector. Economic reports onhome sales and prices have been mixed oflate, but XHB has been able to shrug off theodd downbeat data point without any trou-ble. Along the same lines, MTH was initiallyhit hard after its January 31 earnings miss,but the stock then proceeded to reboundfrom support near its 50-day moving aver-

age. This technicalresilience tells us thatthe market has alreadypriced in plenty of neg-ative news, which is apositive sign for thesector going forward.

That said, Barron’soffered up a bullishcover on housing inmid-March (“HomePrices: Ready toRebound”). Regularfollowers of our analy-sis likely already knowthat we often followmagazine cover storiesas potential contrarianindicators. While

we’re keeping a cautious eye out for addi-tional bullish coverage, as a possible sign ofoptimism heating up too quickly, we don’tsee this as cause for concern just yet. Giventhe uptrend in XHB, along with the negativeanalyst ratings and high short interest leviedagainst builders, this relatively optimisticcover story could actually be a signpost thatsentiment is beginning to shift toward thebullish end of the spectrum.

That said, XHB is trading just below the$24 area, while the iShares Dow Jones U.S.Home Construction Index Fund (ITB) is fac-ing off with $16—levels that represent dou-ble each fund’s October low. With potentialsticking points overhead, and options premi-ums on the low side, a pairs-trade strategy isa perfect way to play this sector.

No Love for Housing…Good Times

THE GREAT FALLEN ANGELS COULD BE MAKING A COMEBACK, SO LONG AS NOBODY ELSE THINKS SO>> Todd Salamone and Elizabeth HarrowA

FIGURE 1:Weekly Chart of SPDR S&P Homebuilders ETF (XHB) The stocksof homebuilders are flying, but analysts aren’t buying the story. At 43%"buys," it's barely a nudge above last year’s “buy” ratings.

THE BIG IDEA SEE PAGE 8 FORMORE IDEAS ONHOMEBUILDERS

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Important Note: Options involve risk and are not suitable for all investors. Multiple-leg options strategies involve multiple commission charges. For more information, please read the Characteristics and Risks of Standardized Options available by visiting etrade.com/options disclosure, calling 1-800-ETRADE-1 or writing to E*TRADE Securities LLC, P.O. Box 484, Jersey City, NJ 07303-0484.1. Due to the higher leverage offered, Portfolio Margin accounts should only be opened by those investors who have a higher risk tolerance to support the potential risks associated with this greater leverage ability. Trading on margin involves risk, including the possible loss of more money than you have deposited. In addition, E*TRADE Securities can force the sale of any securities in your account without contacting you if your equity falls below required levels, and you are not entitled to an extension of time in the event of a margin call. Please read more information regarding the risks of trading on margin at etrade.com/margin. When trading on margin, an investor borrows a portion of the funds he/she uses to buy stocks to try to take advantage of opportunities in the market. He/she pays interest on the funds borrowed until the loan is repaid. For each trade made in a margin account, we use all available cash and sweep funds fi rst and then charge the customer the current margin interest rate on the balance of the funds required to fi ll the order.2. All customers will be charged an additional $45 for broker-assisted trades. The options customer service team can be reached at 1-866-222-6124 from 8:30 a.m. to 5:00 p.m. EST.Securities products and services are offered by E*TRADE Securities LLC, Member FINRA/SIPC.System response and account access times may vary due to a variety of factors, including trading volumes, market conditions, system performance and other factors.©2012 E*TRADE Financial Corporation. All rights reserved.

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The Sentiment Report8 S E N T I M E N TSPRING 2012

THE RATIONALE OPTIONS PRICES AREREMARKABLY CHEAPAT THE MOMENT,MAKING THIS A PRIMETIME FOR STRATEGIESTHAT INVOLVE BUY-ING DOUBLE PRE-MIUM.

PROS: A PAIRS TRADEALLOWS YOU TO ACTON A BULLISH IDEA INTHE SECTOR, WHILEPROVIDING A BUILT-IN“HEDGE” AGAINSTUNEXPECTED HEAD-WINDS.

CONS:BECAUSE YOUR PUTOPTION IS NOT ADIRECT HEDGE,LOSSES ON THE CALLWILL NOT NECESSAR-ILY TRANSLATE INTOGAINS ON THE PUT.

THE TRADE PAIRS TRADE ON TWOHOMEBUILDER ETFS.

THE SETUPBUY A CALL ON AHOUSING STOCK YOULIKE, AND A PUT ONONE YOU DON’T. (OR,ALTERNATELY, BUY ACALL ON A FAVORITESTOCK,AND A PUT ONA SECTOR-BASED ETF.)

What It Should

Look Like:

THE PAIRS TRADE

HYPOTHETICAL EXAMPLE:Stock A

$50 Stock B

$53Buy the 45-strike call of

Stock A for $8.00. Buy the 55-strike put of

Stock B for $3.60. The net debit is $11.60.

Both legs are managed as one trade.

Maximum potential loss is limited to the initial net debit of $11.60,

which is realized if both legs of the trade move against you.

Paths to profit: When either the call or the put outperforms the other.

Plus, if your forecast was dead-on, youcan make money on both the call and

the put. The maximum potential profitis theoretically unlimited on the

call, and limited to the strike priceless the net debit on the put.

THE HOMEBUILDERSETF PLAYERS:

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

SPDR S&P Homebuilders ETF

(XHB)25%

(17th annual percentile)

USG Corp. (USG)

Masco Corp. (MAS)

Owens Corning Inc.(OC)

Lennar Corp. (LEN)

iShares Dow JonesU.S. Home

Construction IndexFund (ITB)

Lennar Corp. (LEN)

D.R. Horton, Inc. (DHI)

Toll Brothers Inc. (TOL)

NVR, Inc. (NVR)

–PowerSharesDynamic Building & Construction Portfolio (PKB)

Lowe’s Companies, Inc.(LOW)

D.R. Horton, Inc. (DHI)

Tractor Supply Co.(TSCO)

Home Depot, Inc. (HD)

ETF TOP HOLDINGS SVI*

SCHAEFFER’SVOLATILITY INDEX (SVI)The SVI helps you tellwhether options prices fora stock are relatively“cheap” or “expensive”based on prior impliedvolatility. It measuresimplied volatility relative to itself and plots it overtime. A run-up in the SVImight pose a risk to options premium buyers,for example, but could be an opportunity for premium sellers. CurrentSVI readings are at schaeffersresearch.com/svi.

STRATEGYWATCH

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

To see what other sectors Todd and Elizabeth aretalking about each week, follow along in Schaeffer’sMonday Morning Outlook. Sign up at sentiment.com/mmo12

27%(3rd annual percentile)

STOCK PRICE AT EXPIRATION

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PUT OPTION VALUE$6.00

$4.00

$2.00

$0.00

-$2.00

-$4.00

42 46 50 54 58

STOCK PRICE AT EXPIRATION

OPT

ION

VALU

EA

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RA

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N CALL OPTION VALUE$4.00

$2.00

$0.00

-$2.00

-$4.00

-$6.00

-$8.00

40 44 48 52 56

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JUNE

15Equity & OEXIndex OptionsStop Trading

MakingNews, Etc.10 S E N T I M E N TSPRING 2012

To the BATS Cave! BATS, the third-largest stock exchange inthe U.S., had its initial public offering at the end of March. Thestock traded without much fanfare for $16 per share, until anapparent glitch in one of the exchange’s servers led to an erro-neous price in, of all things,Apple (AAPL). Panic ensued andBATS' own stock price traded as low as $0.04 per share on itsown exchange! This led the company to prudently cancel its IPOin an attempt to regroup and to revisit the possibility of goingpublic another day. While there’s not an options trade here yet,investors may want a side order of puts to go with that stock!

If You Can’t Sue ‘Em, Buy ‘Em In March, Microsoft (MSFT)filed a lawsuit against Barnes & Noble (BKS) for using theGoogle Android operating system. In April, MSFT bought a17.6% stake in their Nook and college bookstore businesses.Microsoft realized that buying part of the BKS fledgling e-bookbusiness made more sense than bringing the Nook housedown. And so goes the never-ending saga of the tablet com-puter market. So what's the play? Since BKS gets to stay in thegame a little longer, the fundamental picture has changed, andbuying puts may not make much sense. But keep your eye onthe technicals. If it finds support after its recent pop on theannouncement, selling puts could be the trade.

OPTION MARKETDATESYOU SHOULDKNOW

1> Volatile overnight priceswings have become thenorm, but that’s no rea-son to stay on the side-lines with a bottle ofantacid. In fact, Schaeffer’snow offers an alert serv-ice that allows you toprofit from just thesekinds of drastic stockmoves. Each OvernightTrader options recom-mendation targets 100%gains, using calls or putsthat are due to expire inseven trading days or less— effectively curbing theill effects of time decay.Plus, you’ll be in and outof each position in nomore than eight tradinghours, so you can collectyour profits and move onto the next opportunity..

3>In a January round-up of “GoodResources for OptionsInvestors,” Barron’shad some positiveremarks about ourfounder and CEO.“Bernie Schaeffer ofSchaeffer’s Invest-ment Research (scha-effersresearch.com)provides a contrariantake on the market,”wrote columnistSteven M. Sears.“...He offers individ-ual investors a sophis-ticated yet accessibleapproach, usuallyreserved for institu-tional investors.”

And when theDow Jones IndustrialAverage (DJIA)crossed the 13,000barrier in late Febru-ary, the media camecalling to solicit theexpert opinions of ourresearch team. Whenasked for a commentby the AssociatedPress, our senior tech-nical strategist notedthat the significanceof 13K is primarily

JUNE

21Schaeffer’s

Option Advisor Released

JUNE

29Quarterly

Options Expire

2COOL TOOLS

SIR IN THE MEDIA

psychological. “Amajor milestone like13,000 wakes up a lotof investors who havemissed a lot of thisrally,” explained RyanDetrick, even as hewarned that round-number levels canserve as temporaryspeed bumps forstocks.

The “speed bump”theory was secondedby Senior VP ofResearch Todd Salam-one in a conversationwith Reuters. “Youhave a reluctance tobuy knowing we’reright up at formerhighs,” he noted.

Meanwhile,Steven Russolillo ofThe Wall Street Journalcited data from ourweekly “MondayMorning Outlook”column. “Yes, over theshort term these so-called ‘psychological’levels have materiallyimpacted trading,”wrote Russolillo. “Butwhen stretching thereturns out to threemonths or longer,‘these levels have hadlittle effect,’ saysRocky White, seniorquantitative analyst atSchaeffer’s.”

NEW HIGHS AND LOWS

JUNE

14SPX, RUT, DJXIndex OptionsStop Trading

JULY

18Volatility Index

Options Expire

(VIX) JULY

4Trading Holiday(U.S. IndependenceDay)

JUNE

20Volatility Index

Options Expire

(VIX)

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AUGUST

23Schaeffer’s

Option Advisor Released

www.schaeffersresearch.com SPRING 2012 Making News, Etc. 11

Make time for the super LEAPSIn case standard LEAPS options do not offer enough time for your particu-lar investment horizon, the folks in Chicago have set out to change that.On March 1, 2012, the Chicago Board Options Exchange’s (CBOE) sisterExchange, C2, introduced SuperLEAPS on SPXpm options. While stan-dard LEAPS contracts offer expirations of up to 3 years, these Super-LEAPS will offer expirations of up to 5 years. The first round of contractswill exhibit December expiration dates, and will expire in the years 2012,2013, 2014, 2015, and 2016.

What’s your favorite strategy?The CBOE just made answering that question a little easier by commis-sioning a study that compares various common investment strategies. Thename of the study is, “An Analysis of Index Options Writing for LiquidEnhanced Risk-Adjusted Returns,”and it can be obtained at the followinglink: www.cboe.com/benchmarks.

The study judges the performance of four indices: > The CBOE S&P 500 BuyWrite Index (BXM)—This is an index thatpurchases the actual index at a certain level and sells at-the-money cov-ered calls against it on a monthly basis. >The CBOE S&P 500 PutWrite Index (PUT)—This is an index thatbuys the index at a certain level and sells at-the-money, cash-secured putsagainst it on a monthly basis. >The CBOE S&P 500 2% OTM BuyWrite Index (BXY)—This is anindex that buys the index at a certain level and sells out-of-the-money cov-

4SIR 0N THE WEB

>Looking to get yourtrading day started onthe right foot? Thenstop by SchaeffersRe-search.com right afteryou pour that first cup ofcoffee. Every morning,Senior Technical Strate-gist Ryan Detrick isready and waiting foryou with a new install-ment of our “DailyMarket Warm-Up”video. As you preparefor the day ahead, Ryanwill take a few minutesto share the stocks, sec-tors, and indicators thatare on his contrarianradar. With this uniqueperspective on the mar-ket, you’ll have a leg upon the rest of the invest-ing herd before theopening bell even rings.To get there, go to scha-effersresearch.com>Articles & Commen-tary> Trader TV.

Options Bits

ered calls against it on a monthly basis. >The CBOE S&P 500 95-110 Collar Index(CLL)—This is an index that buys the index ata certain level, buys a put option that is 2% outof the money, and sells a call option that is 2%out of the money on a monthly basis.

Emerging markets, anyone?In early 2012, the CBOE introduced the CBOEEmerging Markets Index (EEM). Soon after,they began listing options on the Emerging Mar-kets Volatility Index (VXEEM). The calculationof the VXEEM follows the same methodology asthat of the CBOE’s VIX. Because of the veryhigh, and very negative, correlation of VXEEMto either EEM or even SPX (the actual valuewas –0.81 on both counts), the VXEEM alreadyshows great potential to serve as a hedge againstlong positions in portfolios that are heavy oneither S&P 500 stocks and/or in emerging-mar-kets holdings.

Along these lines, one of the current posterchildren for emerging markets is Brazil, and theCBOE has been busy there. The CBOE, incooperation with Barclays Capital, will launchthe Brazil ETF Volatility Index Futures (VXEW)and the accompanying options (VXEWZ).

These two endeavors represent an attempt atallowing the average investor to provide emerg-ing market exposure to their portfolio, withoutthe direct concern of exchange-rate risk, andcredit risk, that may result from foreign invest-ment products.

The volatility of the volatilityBy now, most traders are aware of the CBOE’sVIX, which is a measure of the volatility level ofthe S&P 500 Index (SPX). But, given that theVIX itself is an instrument that fluctuates as themarket changes, it makes sense that the VIXalso has a volatility level. As such, the CBOEhas introduced the “VIX of the VIX” Index(VVIX). It represents the market’s best guess asto the expected volatility of the 30-day forwardprice of the VIX. For more detail, seewww.cboe.com/VVIX.

AUGUST

17Equity & OEXIndex OptionsStop Trading

AUGUST

16SPX, RUT, DJX

Index Options

Stop Trading

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19SPX, RUT, DJXIndex OptionsStop Trading

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20Equity & OEXIndex OptionsStop Trading

JULY

26Schaeffer’s Option Advisor Released

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Is there after-hours trading for options?BERNIE: Options trade on nine differentexchanges today with most contracts tradingMonday through Friday, 9:30 a.m. to 4:00p.m. Eastern Time. The timeframe coincideswith the hours of operation for the New YorkStock Exchange and NASDAQ Stock Mar-ket. Unlike some of the more popular stocksand exchange-traded funds (ETF), there isno extended-hours trading for options.

It was the rise of private trading systems,known as electronic communication networks, or ECNs, in the 1990s that allowedindividual investors to participate in after-hours trading. Prior to that, only high-net-worth investors and institutions like mutualfunds traded outside of regular market hours.Today, extended-hours trading for stocks andETFs is from 4:00 to 8:00 p.m. Eastern Time.There is also a pre-market session between7:00 and 9:30 a.m. Eastern Time.

Options do not trade after normal markethours, but some index and ETF contractscontinue trading until 4:15 p.m. EasternTime. The additional 15 minutes coincidewith the hours of trading for some popular-contracts like the S&P 500 Index. But after

4:15 p.m., all options cease trading until thenext business day.

Q: Why trade options if 80 or 90% ofthem expire worthless?BERNIE: Puts and calls are considered “wast-ing assets.” All options lose value over time,and contracts that are out-of-the-money(OTM) or at-the-money (ATM) at expira-tion will expire worthless. A put or call witha strike price equal to the stock price isATM. A call option with a strike price higherthan the current stock price is OTM. A putoption with a strike below the market priceof the underlying stock is also OTM, whichwill indeed expire worthless.

But it’s a common misconception that 80to 90% of options expire worthless. In fact,the majority of contracts are offset before theexpiration because, once a position isopened, it can be closed out any timethrough a closing or offsetting trade. In addi-tion, not all options are OTM at expiration.A large percentage of options contracts arein-the-money (ITM), and are therefore exer-cised by options owners. So, while the exactpercentages will vary by expiration month,not all options expire worthless. Some areITM and are exercised. The largest percent-age, however, is offset or closed out beforethe expiration.

At the same time, even if a large percent-age of options expire worthless, there are stillmany reasons to trade puts and calls. In fact,some strategies, like credit spreads, covered

calls, and calendar spreads, take advantageof the fact that options lose value over time,and many do indeed expire worthless.

Q: I heard an analyst say that now is agood time for put writing. What does thatmean?BERNIE: In options parlance, “writing” putsand calls is equivalent to selling options.Therefore, if I write a put to open a newposition, I am selling the contract. By doingso, I am also making the statement that I ama willing buyer of the underlying stock (orETF, future, index, etc.) at the strike price ofthe put option through the options expira-tion. I agree to buy 100 shares for every put.Once I am assigned on the contract, it is toolate to close the position. I’m on the hook tobuy shares at the strike price of the putoption. The contract ends when it is eitherexercised or expires.

What's the Deal?

THE TRUTH ABOUT OPTIONS AFTER HOURSAND THE MYTH OF EXPIRATION>> 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.

Only have a limitedtime to learn how totrade options?Go to sentiment.com/HSP12

Q:

The Man withthe Answers:Bernie Schaeffer

www.schaeffersresearch.com SPRING 2012 Ask Bernie 13Ph

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>> Got a question for Bernie? Send it toAskBernie@sir-inc.com./ / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / /

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Strategy14 S E N T I M E N TSPRING 2012

It’s often said that two opinions are better thanone.And three? Even better. At least in trading,that is—particularly when it comes to your style ofdiscipline. Combining fundamental, technical, andsentiment analysis will go a long way in helping youfind winning trades. But surprisingly, investorsgenerally stick to just oneapproach. Here’s why that’sa bad idea.

YOUR DISCIPLINEBy KEVIN LUNDPHOTOGRAPHS BY FREDRIK BRODÉN

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Strategy16

raders can be a funnybunch, especially dur-ing the early stages oftheir career. Through-out their learningcurve, they often tendto stay married to aparticular options

strategy—say, only buying call options, orselling put options. It works well in the begin-ning…until it doesn’t. And when it doesn’t,they start cherry-picking other strategies,without realizing that the problem may notbe the strategy, but rather, the trader.

It starts with big-picture analysis. A goodoptions strategy is only as good as the marketconditions allow it to be. And there are somany variables that can impact those condi-tions. Like strategy codependence, if you’remarried to just technical, fundamental, orsentiment analysis, you’re only seeing part ofthe picture. For example, if you’ve ever beenleft scratching your head after seeing a stockdecline, despite a great earnings report, youmay not have considered what the chartswere saying. Or when stocks rally, despitenegative headlines and a poor economicoutlook, you’re probably not paying atten-tion to investor sentiment.

Sure, you may find a great level of successwith any one of the three styles of analysis.Two is even better. But over time, taking aholistic approach that combines all threedisciplines makes the most sense for findingwinning trades consistently, and is the foun-dation for Schaeffer’s methodology calledExpectational Analysis®.(See Figure 1)

ELEMENTS OF STYLEWe’ve covered each of the three styles ofanalysis extensively in these pages before. Asa refresher, let’s break them down briefly:

1. Technical analysis = Charting the mar-ket’s historical performance. This approachtakes a look at price action and technical

indicators depicting momentum of the pre-vailing trend.

2. Fundamental analysis = Analyzing what’shappening now. For traders, this means look-ing at things like breaking market news andcompany earnings reports, versus corporatebalance sheets and long-term revenue growththat a buy-and-hold investor might consider.

3. Sentiment analysis = Assessing howinvestors collectively “feel” about what’s goingto happen—the mood of the market, if youwill. Ironically, since the market “discounts”the future, it prices itself based on the percep-tion of what it will do tomorrow, rather thanwhat it did today or yesterday.

Simply put, tech-nical analysis exam-ines the past;fundamental analysisinforms the present;and sentiment analy-sis attempts to projectthe future. Using allthree together helpsto get you into trades

before the crowd, out of trades before thecrowd leaves, or guide your plan for an immi-nent move when the crowd isn’t looking.

SENTIMENT: A CONTRARIAN’SFIRST LOVESpotting opportunities before other traders,and acting on them timely, is the essence ofsuccessful contrarian investing. But this isnot to be confused with blindly buying“unloved” stocks just because nobody else is,or reflexively trading against the trend—which tends to be the prevailing wisdom. Forthe most part, low-priced stocks are low for areason. And you don’t “fight the tape”unless there’s a compelling reason to do so,which more than likely is due to investorsentiment.

As a contrarian, your strongest signalswill come from investor sentiment that runscounter to the trend. Think about it. Gen-eral pessimism is a given in a falling market,so it doesn’t really serve you well as an indi-cator. However, pessimism (skepticism,really) during a rally can be quite bullish, ashas been the case since the March lows of2009. Despite persistent negative sentiment

FIGURE 1: MORE IS BETTER By itself, technical, fundamental, or sentiment analy-sis will provide the average trader moderate success. But put them all together,and you have a stronger edge when you look for winning trades over time.

DISCIPLINE LEVEL OF SUCCESS

Technicals Moderate

Technicals + Fundamentals Better

Technicals + Fundamentals + Sentiment (Expectational Analysis) Best

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surrounding global economic uncertainty,political unrest, high unemployment andlow housing prices in the U.S., we’vewatched the market rally over 100% sincethat time.

PULLING IT TOGETHEROnce you understand the premise of Expecta-tional Analysis, you simply pull it all togetherand follow a few simple rules of engagement:

1. Assess the technical picture on momen-tum. Price is everything. Yet it’s nothingwithout proper context. To get that, listen towhat the charts and their momentum indi-cators are telling you about price action.Don’t go crazy and pile on 10 different indi-cators. That would cause analysis paralysis,and you’d never make a decision. Movingaverages and Relative Strength Index (RSI) are a good start (see Figure 2), andthere is a mountain of information at SchaeffersResearch.com to help you under-stand how to use these and other indicators.

In addition to using technical indicators,there are a number of technical levels of sup-port and resistance to be aware of, like roundnumbers, “half highs” and “double lows,”which serve as springboards for the nextphase of a trend. (Bernie Schaeffer coversthese levels extensively in his 2-part article“Trading on the Level,” and “BreakingDown the Level” in the Summer and Fall2011 issues of SENTIMENT.)

2. Look for supportive fundamentals. Tra-ditionally, fundamental analysis is the pre-ferred method for long-term investors. Astraders, we’re not as concerned about the

long-term promise of a company. However,we do care about the fundamental backdropin the short term—i.e. company or sectornews, as well as earnings reports. Why? Byfocusing on a company’s “report card” versusthe longer view, we capture the fundamen-tals most relevant to the prevailing technicaltrend, and further, to the most critical pieceof the puzzle—investor sentiment.

3. Understand broad-market sentiment.When sentiment indicators run counter tothe prevailing trend and strong fundamen-tals, what you’re left with is room for thetrend to continue. Prevailing skepticism dur-ing a bull market means that not everyonehas bought into the rally, and thus there ismoney on the sidelines to continue stokingthe fire. The point at which sentimentreaches extreme levels of optimism (e.g.euphoria) is when you start to consider trad-ing against the trend.

To break things down a little further,there are two different types of sentimentindicators—qualitative and quantitative.

Qualitative—When major news outletsand magazines publicize extreme marketoptimism or pessimism, you can get a senseof frothy tops and rocky bottoms. Where doyou look? Scan websites like forbes.com andMSN Money (money.msn.com), etc. togauge the mood of the markets. While you’reat it, check out the magazine covers in thegrocery store. What are they saying aboutthe markets and the economy? Ask yourself,If the public at large now knows this infor-mation, and has already acted on it, who’sleft to buy or sell? Time could be running outon the prevailing trend by the time the retailinvestors are piling in.

Quantitative—If qualitative indicatorssupport your hunch, quantitative indicatorslike options open interest, volatility indexes,and put/call ratios will confirm them—par-ticularly when it comes to finding potential“speed bumps,” or areas of support and resist-ance, that might not show up in the charts(See Figure 3). There are more than justoptions-related indicators, but these are theeasiest place to start, and something every-

one has access to at SchaeffersResearch.comor with your broker.

THE NEW NORMALA successful Expectational Analysis per-formed in early 2009 would have put you atthe forefront of one of the most powerfulrecovery rallies in decades. If you hadjumped out of the market in February 2009while the news was bad (fundamental), youwould have missed the warning signs fromthe charts (technical), as well as extremepessimism in magazine covers and theoptions data (investor sentiment), that wewere very near a bottom. We all know whathappened next.

Now, no one is saying you can’t succeedon technical analysis alone—or just funda-mentals, or investor sentiment, for that mat-ter. Each has strengths that could providemoderate success to your overall profit andloss for a time. However, we live in differenttimes now. The markets have becomeincreasingly volatile and obsessed with theshort term. This has paved the way for a newparadigm of analysis to emerge, withinvestor sentiment at its core. The threecomponents of Expectational Analysis worktogether to give you the critical edge neededfor the greatest chance of success over thelong haul. At least, if you were to adopt sucha discipline, and your options strategy stopsworking, perhaps you can truly blame thestrategy, and not the trader.

17Strategy

FIGURE 2: KEEP IT SIMPLE Sticking with just a couple of indicators to confirm price action prevents analysis paralysis at the technical level. The chart here of INTC shows the 50- and 80-daymoving averages in the upper chart, as well as Relative Strength Index (RSI) at the bottom.

www.schaeffersresearch.com SPRING 2012

FIGURE 3: OPEN-INTEREST RESISTANCEOpen interest (OI) will let you see congestion atcertain option strikes that indicate potential support and resistance. In the case of INTC in this example, there is some potential overhead resistance at the 30-strike calls.

To earn your sentimentician wings, go to our websiteat sentiment.com/edu12. At the bottom of thepage, you’ll find links to articles on the most impor-tant Expectational Analysis indicators.

100000

80000

60000

40000

20000

CALL OI

18 20 22 24 26 28 30 32 34

PUT OI

INTC

50 DAY MOVING AVERAGE 80 DAY MOVING AVERAGE

2011 Year

RSI

29

27

25

23

21

19

70

50

30

INTC: MAY

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The Butterfly Spread18 S E N T I M E N TSPRING 2012

COME FLY

WITH ME

THE BUTTERFLY SPREAD HAS LONG BEEN

THOUGHT OF AS A RANGE TRADE. BUT FOR THE DISCERNING TRADER, IT CAN BE

AS USEFUL A TOOL AS A “TARGET”TRADE, BOTH INSTEAD OF

A LONG OPTION STRATEGY, OR AS A COMPLEMENT TO ONE.

By Alex MendozaILLUSTRATIONS BY

JOE MORSE

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WHAT’S A BUTTERFLY?A butterfly is defined as the purchase of onevertical spread, coupled with the sale ofanother vertical spread such that bothspreads:

• Have the same difference betweenstrikes

• Are made up of the same type ofoptions (either all calls or all puts)

• Have the same short strike in commonSo, for example, if XYZ is trading at $90,

you could buy the 90/95 call spread. This is abullish vertical spread, in which you buy the90-strike call and you sell the 95-strike call.

Then, to complete the butterfly, youcould sell the 95/100 call spread. This is abearish vertical spread, in which you sell the95-strike call (the same strike you bought inthe long 90/95 call spread) and you buy the100-strike call.

The rules have all been met here. Boththe long vertical spread and the short oneare composed of strikes that are five dollarsapart, both spreads are comprised solely ofcall options, and they share the same shortstrike in common.

The result is the 90/95/100 call butterfly.

WHY THE FLY?Once you understand the basic calculationsof a butterfly spread, you can see how butter-flies can provide extraordinary reward-to-risk ratios for a trader who can effectivelyforecast a stock range. Due in great part toits construction, a butterfly can potentially

offer a higher reward than what could beachieved with a long vertical spread, and at aconsiderably lower debit.

Calculating maximum risk. In a standardbutterfly, the spread that you buy is alwaysmore expensive than the one you sell. There-fore, the trade is always placed for a net debit.That being the case, the net debit is your costas well as your maximum risk. Hence, in theexample above, if the 90/95 call spread costs$3, and you can sell the 95/100 call spread for$2, then your butterfly would have a cost—and maximum risk—of $1.

Calculating maximum reward. Your max-imum reward would then be the differencebetween any two adjacent strikes and yournet debit. In this example, since the adjacentstrikes are five dollars apart, the maximumreward on your butterfly would be $5, lessyour $1 net debit, or $4. Your maximumreward can only be achieved if the stock set-tles exactly at the short strike—or $95 pershare in this case.

Calculating breakeven. Your twobreakeven levels would be the center strike,plus or minus your maximum reward. In thisexample, your breakeven levels would be$95 ± $4, which equals a stock price any-where between $91 and $99.

You can’t really avoid the numbers whendealing with complex spreads like the butter-fly, but you also don’t have to be a mathgenius. Going back to XYZ, if you thoughtthat a particular stock was going to settlenear $95 per share, and you were right, thenbuying the 90/95 call spread for $3 wouldlead to a possible maximum profit of $2,which is the difference between strikesminus the debit ($5 – $3 = $2). However,having bought the 90/95/100 call butterflyfor $1 would have led to a possible maximumprofit of $4 ($5 – [$3 – $2] = $4).

THE CASE FOR LEGGING INOne advantage of butterfly spreads is thatthey do not have to be placed all at once. Infact, in many cases, it is preferable to “leg”into a butterfly trade. Legging refers to trad-ing different components of a butterfly at dif-ferent times—waiting for the stock to moveto a different spot before adding another

The Butterfly Spread20 S E N T I M E N TSPRING 2012

T H E B U T T E R F LY C O U L D B Eone of the greatest strategies you’venever traded. And for good reason.There are multiple legs, multiplecommissions, and the idea of mak-ing money when a stock does noth-ing confuses even the mostseasoned traders at times. However,despite its outward appearance as a“complex” strategy, the butterfly isone of the more flexible and effi-cient option strategies available totraders. To dismiss it altogethercould possibly be to deny your evo-lution as a trader…or at least somedecent trading opportunities.

While traditionally, it has beenreferred to as a range trade—imply-ing the need for a sideways mar-ket—it’s better categorized as a“target” trade. And once you under-stand the basic construct of the but-terfly, you can expand your use ofthe strategy by taking a simple posi-tion, such as a call or a put, andadjusting it into a butterfly. By doingso, not only can you take risk off thetable and capture some profits in awinning trade, but also you canleave room for future gains.

Breakeven

( + )

( - )

LONG BUTTERFLY

Loss

S T O C K P R I C E

FIGURE 1: The Butterfly – Casting a Wide NetThoughtraditionally thought of as a “range” trade, the butter-fly can be thought of as a target trade that allows youto cast a wide, forgiving net.

Loss

Profit

LONG STRIKE SHORT STRIKE LONG STRIKE

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www.schaeffersresearch.com SPRING 2012 The Butterfly Spread 21

DESPITE ITS OUTWARD APPEARANCE,THE BUTTERFLY SPREAD IS ONE OF THE MORE FLEXIBLE AND EFFICIENT OPTION STRATEGIES AVAILABLE TO TRADERS. WHILE TRADITIONALLY, IT HAS BEENREFERRED TO AS A RANGE TRADE, IT CAN PROVIDE EXTRAORDINARYREWARD-TO-RISK RATIOS FOR ATRADER WHO CAN EFFECTIVELYFORECAST A STOCK RANGE.

component. Suppose that instead of buying the

90/95/100 call butterfly on XYZ outright,you first buy the 90/95 call spread, wait forthe stock to rise, and then sell the 95/100call spread later to complete the butterflytrade. Why later? Because the short verticalwill likely be worth more when the stockmoves higher, thereby allowing you to takein a bigger credit, and reduce the cost (andrisk) of the long call spread. Sometimes it’spossible to take in a credit on the shortspread that’s larger than the cost of the origi-nal call spread—at which point, you’d be inthe strategy for free, or even a profit.

In fact, as the following case study shows,you can start the legging process with some-thing as simple as a long call strategy, and

completing the butterfly by adding the rest ofthe pieces later. As you’ll see, there’s anadded benefit of receiving a larger credit byconverting even a simple long call positioninto a butterfly after the stock moves higher.

WALKING THROUGH A “TARGET” TRADEConsider the accompanying stock chart inFigure 2 of Google (GOOG).

Suppose on March 9, 2012, after lookingat the following chart on Google (GOOG),you note there is significant resistance ataround the $650 level. The stock has onlybroken through that level once before in thepast two years, and it quickly pulled backfrom those highs. In other words, you have aforecast in which you think the stock is goingto rise to previous highs, and then eitherremain there until option expiration, orretrace a bit from those highs. This is just thetype of setup that you could use to leg into abutterfly using a “target” strategy.

Here’s how it works. If you expect thestock to settle at a price of $650, you couldsimply buy the 630/650/670 call butterfly.However, that implies three commissions.And if the stock continues to rise above the$650 level, you could end up with a trade inwhich the stock moved your way and youstill lost money. However, by starting withjust a long call option, with the intention toadjust into a butterfly once the stock rises,you could effectively reduce the chance ofyour trade going out worthless if the stockcontinues to rise.

To begin the strategy, take a look at thefollowing call-option chain:

With the stock currently near the $600

FIGURE 2: Even at its IPO, shares of Google (GOOG)were mired in investor “disbelief” (red shade), only one step up from the “despair” that prevails atbottoms.When GOOG proved everyone wrong, investor “acceptance” (yellow shade) eventually led to“euphoria” (blue shade), at which point 100% of theanalysts covering the stock had “buy” ratings.

GOOG

640

600

560

520

480

2011 JUN JUL AUG SEP OCT NOW DEC 2012 FEB MAR

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level, you decide to buy the 630-strike calls,currently trading for $11, or $1,100 per con-tract plus any commissions (See Figure 3).You might plan to exit the trade if theoption’s price drops 50%, to $5.50. However,your upside profit stop is more technical. Forthat, you decide that the first day thatGOOG exceeds the $650 level, you’ll takeyour profits.

Fast forward a few days to March 28.GOOG starts to rise, climbing to $650 andcloses just over $655 per share. The 630-strike calls that you bought are now worthabout $33. If you sell your options now, youcan easily take down a profit of nearly $22per option, or $2,200 per contract.

The good news is the stock moved theway you wanted it to move. The better newsis the stock arrived at its destination early,thereby giving you time to take some addi-tional money off the table.

The great thing about a stock going yourway is that there are many ways to takemoney off the table. You could take yourprofit, or you could take your profit and giveyourself a chance to make even more profit.Either way, at the very least, taking yourprofits should also mean taking your originalrisk off the table.

FLY FOR MORE PROFITAt this point, instead of selling the 630-strike calls, you could convert the trade intoa long call vertical spread by selling an at-the-

money 655 call againstyour 630 call for $24.This would leave youlong a 25-point callspread at a net credit of$13($24 - original debitof $11). In other words,the worst you could do ismake $13 on your trade.The best you could do ifGOOG remained above$655 is to make $13 plus$25, or $38 on yourtrade. Normally, thismight be a good adjust-ment earlier in thestock’s run-up. How-ever, since there isn’t

much upside at this point, you can continue toexplore your options. What else can you do?Take in more premium. How? Turn the origi-nal call trade into a butterfly spread instead.(See Figure 4).

The idea is simpler than you may haveoriginally thought. Instead of selling one ofthe 655 calls, you sell two—giving youpotentially twice the credit. Of course, nowyou have an unhedged (or “naked”) shortoption. To eliminate this risk, you could buyone 680 call to hedge for about $12. You’venow turned your original long call into a long630/655/680 butterfly, and collected a crediton the second part of the trade of $36.

By adjusting the trade to a butterfly, andtaking in $36, the worst that can happen nowis a profit of $25. Let’s take a look at why thatis based on what the stock does next.

WHAT IF THE STOCK MOVES?What happens when the underlying stocktrades in all three directions?

1/ Stock moves sideways If the stock remains at its new level as you

forecasted, then your decision to convert thetrade into a butterfly will experience the bestof all worlds, since you will have taken in alarge credit and your trade will expire closeto its maximum value—thereby keepingmost, if not all, of the possible profit—in thiscase, $50.

2/Stock moves lower If the stock drops to previous levels, you’llkeep the total credit received, but start to loseon the initial long call position. Worst-casescenario is you lose all your initial debit (the$11), leaving you with $25 ($36 - $11 = $25).Life isn’t perfect, but still pretty good.

3/ Stock moves higherAs the stock continues to rise above $650per share, you’ll begin to give some moneyback. However, much like in the previousscenario in which the stock dropped, you arelocked into a minimum reward, due to thelarge credit you received upon adjusting yourlong call option. Worst-case scenario is thatGOOG closes at expiration above $680. Inthis case, you still net out $25 profit (the lossin short 655 calls is offset by the gains in thelong 630 and 680 calls, leaving you with the$36 credit, less the initial debit on the longcall of $11, for a net gain of $25).

OF COURSE, YOU DON’T HAVE TOwait to double or triple your profit on a longoption before you add a butterfly to adjustthe trade. You can place the butterfly any-time, including at the outset. Butterflies arevery flexible. However, be aware that thisstrategy can be commission-intensive, andthat it’s subject to slippage costs on threelegs. Many successful butterfly strategies areimplemented through adjusting a simplerposition, such as a long call, or a long callspread, via the use of legging techniques likethe one described above. That said, butter-flies allow savvy traders with decent fore-casting skills the potential opportunity tosecure fairly large credits after a stockreaches its target, by capturing profits andreducing your initial risk without leavingmoney on the table. Even a seasoned tradercan’t argue with the logic. How’s that forevolution?

S E N T I M E N TSPRING 2012The Butterfly Spread22

Spread Trading 101Do butterflies have you a little confused? Read our Spread Trading Primer in the Spring 2011issue of SENTIMENT by going tosentiment.com/spread12

FIGURE 3: Butterfly Part 1 Start with a long call trade by purchasing thelower-strike call (630 strike).

FIGURE 4: Final Butterfly An optimal time to put on the remainder of thebutterfly is after a run-up in the stock when the premiums are richer. Toturn the long GOOG call into a butterfly, you’d buy the higher-strike call(680) and sell two of the middle-strike calls (655).

GOOG CALLS MARCH 9, 2012 STOCK AT $600.25

GOOG CALLS MARCH 28, 2012 STOCK AT $655.76

BID

10.80

5.40

2.60

ASK

11.00

5.70

2.80

STRIKE

630

655

680

BID

37.00

24.00

11.80

ASK

37.20

24.20

12.00

STRIKE

630

655

680

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OPTIONS TRADING ONCE WORE Acloak of mystique to the averageinvestor. But since the millennium,through the introduction ofadvanced trading technologies,greater access to information, andincreased transparency in the mar-ketplace, retail options trading (i.e.you, the individual trader) hasgrown exponentially. And retailoptions trading volume continuesto top previous records.

While it’s true the derivativesmarkets contributed to the collapseof the global economy in 2008,these were unregulated, “over thecounter” markets—not the mar-kets in which retail traders partici-pate. All retail transactions have tooccur on highly regulatedexchanges, and be brokered andcleared by firms that are required tomeet strict financial, compliance,and supervisory mandates. In fact,we thought it might be worth it topull back the velvet curtain andexplain just how the process worksfrom start to finish—from the birthof an option through its expiration.

Back to Basics24 S E N T I M E N TSPRING 2012

The Life of an Option Trade

EVER WONDER HOW OPTIONS ARE BORN AND WHAT HAPPENS AFTER YOU PLACE ATRADE? WONDER NO MORE. O

1 ListedThe exchangelists an option.Market makerspost bid andask prices.

2 NoticedYou see the

option and itsprices on your

broker’s site.

3 QuotedOnce you express

interest in an option,your broker seeks a

quote on your behalf.You are not tradingyet. You are merelywindow-shopping.

6 RecordedThe time of sale,the bid, and theask at the time ofthe transactionare recorded bythe Option PriceReporting Agency(OPRA). Your bro-ker records all ofthe informationthat pertains toyour trade.

4 RepresentedYou decide to trade, so

you send an ORDERvia your broker to buy

or to sell the option.The Consolidated

Option Audit Trail Sys-tem (COATS) recordsthe National Best Bid

and Offer (NBBO) forthe option at the time

that the order came in.

7 Marked toMarketThe exchange keeps arecord of the dailychange in the option’sclosing value.

CLOSED You decide to close

out your optiontrade and the option

ceases to exist.

EXPIRES You take the optionthrough expiration

IN THE MONEYThe option is converted to stock andthe option ceases to exist. The stockposition must then be closed out.OUT OF THE MONEY

The option expires worthless and ceases to exist.

D O YO U W O N D E R ?

START HERE

5 TradedAn option is bornthe moment some-one takes the otherside of your trade.The broker setsaside the necessaryfunds from youraccount using guide-lines set by theOptions ClearingCorporation (OCC)to ensure the finan-cial transaction.

SIR12_BackToBasics_RD3.qxd:pages.layout 12-05-21 5:16 PM Page 24

SIR12_BackToBasics_RD3.qxd:pages.layout 12-05-21 5:16 PM Page 25

moving averages. Skep-tics often cited this indi-cator when 80% ofstocks were shown to betrading above thatmoving average. But weran the numbers, andfound this was hardly areliable sell signal.

Going back to 2000,we looked at previousoccasions when this sig-nal occurred (See Fig-ure 1). There were 23instances, and thereturns following wereactually quite impres-sive. Three monthsafter a signal, the SPXwas higher 77% of thetime, averaging a gainof more than 2%. Com-pare this to the typicalthree-month returnsince 2000 of just0.29%, with a 56%chance of being posi-tive. In other words,when you actually run

the numbers, you could more accurately usethis as an indicator for momentum, ratherthan an overbought market.

CITING THE FEAR GAUGE FUTURESAnother indicator naysayers favored was theCBOE Market Volatility Index (VIX) futuresterm structure. In the first quarter of 2012,VIX futures started trading at a hefty premiumto the cash VIX. Keep in mind that the VIXnormally moves in the opposite direction asthe market. Therefore, you could infer thatVIX futures traders were expecting stocks todrop. Since bears cited this data to make theircase, they must believe that VIX futurestraders are smart money.

WHENEVER A SIGNIFICANT

rally occurs, the marketgets slapped with theworn-out label of “over-bought.” The logic seemsto be that each leghigher increases the

chance of pullback overthe near term. But that’snot the case, judging bymonthly returns on theS&P 500 Index (SPX)over the last 30 years.After a negative month,

the market averages a0.82% gain the nextmonth, and is positive62% of the time. Thechance that the nextmonth will be positivedoesn’t go down for

IdeaLab26 S E N T I M E N TSPRING 2012

OVER THE PAST THREE YEARS, INVESTORShave seen the S&P 500 Index (SPX) morethan double. There have been only a couple ofsignificant pullbacks during this period, inmid-2010 and late 2011—and since we’re stillmore than 10% off the 2007 highs (as ofMarch 2012), you could argue there is stillroom to go higher. You might expect the bearsto be in hiding at this point, but that is surelynot the case. It’s very common to pick up thepaper or see on TV some bear calling a top inthe market. As contrarians, we believe thisskepticism of the rally is healthy, as it indicatesthere are still many investors holding cash onthe sidelines, which—when deployed—willextend the rally even further.

WHEN THE BEAR CRIES WOLFWhat we find peculiar are some common indi-cators that the bears use as evidence the mar-

ket has topped out. Their reasoning oftenappears sound, but when you actually quantifythe indicators being used, their arguments fallapart.

Take, for example, the common theory thatthe market was “overbought,” as evidenced bythe percentage of stocks above their 50-day

O

TURNING TRADITIONAL

MARKETR&D ON ITS

HEAD

DEBUNKING BEARMYTHS

BELIEVE WHAT YOU SEE, NOT WHATYOU HEAR

idea #1

each successive positivemonth. In fact, after fourstraight positive months,there’s a 76% chance ofa fifth—and after five,there is a 77% chance ofa sixth.

NEVER TOOHIGH TO BUY

F Y I

FIGURE 2: VIX FUTURES=SMART MONEY? When the VIX futures trades at apremium, bears view that as an indication that a market correction is imminent.We think otherwise.

FIGURE 1: DEBUNKING A BEAR’S MYTH If by a bear’s definition, “over-bought” means the majority of stocks are trading over their 50-day movingaverages, the bear would be wrong.

Returns 23 23 22 21

Average Return -0.21% 1.30% 2.10% 4.02%

Percent Positive 48% 70% 77% 67%

1-MonthReturn

2-MonthReturn

3-MonthReturn

6-MonthReturn

WHEN 80% OF STOCKS TRADE ABOVE THEIR 50-DAY MOVING AVERAGE

TYPICAL RETURNS SINCE 2000

Average Return 0.12% 0.24% 0.29% 0.45%

Percent Positive 59% 56% 56% 56%

Returns 30 29 29 28

Average Return 0.23% 1.09% 1.58% 1.91%

Percent Positive 63% 62% 62% 64%

1-MonthReturn

2-MonthReturn

3-MonthReturn

6-MonthReturn

2ND MONTH VIX FUTURES AT A 25% PREMIUM

TYPICAL RETURNS SINCE 2004

Average Return 0.38% 0.75% 1.03% 1.27%

Percent Positive 63% 62% 63% 62%

ConsecutivePositiveMonths

ReturnsAverage Return

PercentPositive

S&P 500 RETURNS (LAST 30 YEARS)

0 140 0.82% 62%

1 87 0.73% 62%

2 54 0.36% 54%

3 28 1.05% 61%

4 17 1.62% 76%

5 13 1.15% 77%

6 or more 22 0.49% 55%

SIR12_IdeaLab_RD3.qxd:pages.layout 12-05-21 5:36 PM Page 26

www.schaeffersresearch.com SPRING 2012 Idea Lab 27

Again, we put the bears’ claim to the test.Looking at the second-month VIX futurescontract, we gathered SPX returns when thefutures price was predicting a 25% rise or morein the VIX. We have VIX futures data sincethe middle of 2004, so that was the time framewe studied.

The returns after a signal are shown in theaccompanying table, and for comparison, wealso show typical returns since 2004. The per-centage of positive returns are about equal, butthe average returns after a signal outpace typi-cal market returns for time frames past onemonth. Bears have used VIX term structure asevidence that a correction is imminent, butthe numbers show it was never an accuratepredictor of this in the past. So, why would itbe now?

These are only a couple of examples of thenumerous omens that bears have touted dur-ing this rally to explain why a correction isabout to happen, or why stocks are about tostall. They have also mentioned indicatorssuch as the number of stocks making—or,actually, not making—new highs at certainpoints during the rally. Another one of thebears’ favorite claims is to point out each timethe VIX hits a lower level—for example, 20,and then 15—and flag that as a sign of compla-cency. But again, the market just keeps movinghigher.

While the quantified results are not sup-porting the bearish case, that’s not the mostimportant point. More notable for us is thefact that they keep pounding the table withjustifications for their pessimistic posture. Thefact that there are still a significant number ofskeptics out there, despite the fact that theSPX has doubled in the last three years, is tes-timony to us that this rally still has plenty ofsteam left in it.///////////////////////////////////////////////////////////////////////////////////////////////////////////////////////

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

VER THE PAST SEVERAL MONTHS, the IT group here at Schaeffer’s InvestmentResearch has worked tirelessly to update and redesign SchaeffersResearch.com. Launched in earlyFebruary, our newly remodeled website makes it easier to find all of the great options news, educa-tion, and market analysis that you have come to expect from the Schaeffer’s team. In our efforts tocontinue providing you with a leading, one-stop resource for options insight, we’ve made some keychanges to our award-winning website.

Breaking News & Options Insights— Each and every article, blog, and market video uploadedto SchaeffersResearch.com will first appear in this continuously updated area, located at the top of ourhomepage. Plus, new icons beneath each headline make it easier than ever to share your favorite arti-cles via Twitter, Facebook, Google+, and more. Don’t be left out. Get the latest contrarian content as itbreaks!

TraderTV—Be sure to start your day off on the right foot with a quick preview of what lies ahead forthe session to come—through the eyes of the Schaeffer’s trading squad, of course. See “SIR on theWeb,” page 11 of this issue, for more details on our daily market video series.

From Opening Bell to Closing Bell, and Beyond—Our timely and reliable market reports—spanning economic news, earnings reports, and other breaking events—are right at your fingertips. Onthe SchaeffersResearch.com homepage, you’ll always find prominently featured links to the latest edi-tions of our widely followed ezines: Opening View, Market Recap, and Monday Morning Outlook.

You’ve Got Options—As always, the engaging options content available onSchaeffersResearch.com is just a click away. Click on the Options Center link in the main navigationalbar on the top of the home page—or, if you prefer, scroll just below the fold to find the latest headlineson our Daily Option Blog. And, for a unique trader’s take on the market’s daily mood swings, stop byour Trading Floor Blog to hear spin-free analysis directly from our top researchers.

Meet the Team—You’re probably already familiar with their contrarian market analysis, but howwell do you know the Schaeffer’s Investment Research crew? Whether you’re interested in finding outwhere your favorite columnist went to college, or looking to follow some of our top analysts on Twit-ter, find out more about our contributors by visiting sentiment.com/contributors.

SITE FEATURE(NEW ANDIMPROVED)SCHAEFFERSRESEARCH.COM

idea #2

O

More of Rocky White’s market research studies can be found each week in the Monday MorningOutlook at www.sentiment.com/mmo.

SIR12_IdeaLab_RD3.qxd:pages.layout 12-05-21 5:36 PM Page 27

28

OUTSIDE THE BOXTHE OPTIONS TWEETERS YOUNEED TO FOLLOW NOWFOR ALL THE FINANCIALTWEETER “MUST-SEE” LISTS,OPTIONS TRADERS DON’T GETMUCH LOVE. ADAM WARNERINTENDS TO CHANGE THATWITH AT LEAST 40 OPTIONSTWEETERS YOU OUGHT TO BEFOLLOWING—STARTING WITHYOURS TRULY AT @SCHAEFFERS.

THE CONTRARIANLULULEMON ATHLETICA IS WORKING ON THE LONG HAUL YOGA IS TRENDING, AND SOHAS THE STOCK OF THIS MAKER OF YOGA WEAR ANDSUBURBAN MOM ATHLETICWEAR. IN USUAL CONTRARIANFASHION, WE PULL APART THEANALYSIS OF A RECENT BULLISHARTICLE ON LULU AND PROVIDEOUR TAKE ON THE STOCK'SFUTURE.

—To read these posts and moreof Schaeffer’s blogs, go to sentiment.com/blogs

Volatility Primer(SUMMER 2011 ISSUE)What you don’t knowabout volatility can cer-tainly hurt you. But all that’sreally needed is a good han-dle on the basics and a littlegumption.

Greeks Primer(WINTER 2011 ISSUE)Options greeks are essen-tial tools for understandinghow options behave—par-ticularly when you want tostress-test a new idea.

Prose from the Pros

.COM

SENTIMENT’SGREATESTHITS: PRIMEPRIMERSView any of the following articles at sentiment.com/archive12

commentary

INDICATOR OF THE WEEK: THE MAY EXPIRATION CYCLE

> Option traders like us don't often look at the calendar the same way othersdo. Rather than looking at calendar months, option traders tend to look fromone monthly expiration cycle to the next. Let’s take a look at the May expira-tion cycle.

Since 2006, April has been the most bullish expiration month for theS&P 500 Index (SPX), based on average return—and December is the onlymonth without a losing expiration cycle since 2006. May has been a ratherweak expiration cycle for the market, with the SPX averaging a loss of 0.75%.However, this has been skewed by a couple of very poor months—specifically,an 8.8% loss in 2010 and a 3.4% loss in 2006. Most of the time, in fact, theMay cycle has been positive (67% of the time).

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

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

Rocky WhiteMonday MorningOutlook

To read more of Rocky’s weekly commentary, sign up here: www.sentiment.com/mmo12

S E N T I M E N TSPRING 2012

Blog Exclusives

Online:WEB:www.schaeffersresearch.com

TWITTER:www.twitter.com/schaeffers

FACEBOOK:www.schaeffersresearch.com/fb

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

Market Commentary:MONDAY MORNING OUTLOOK(Weekly market analysis)sentiment.com/mmo12

SCHAEFFER’S OPENING VIEW(Daily, before the bell)sentiment.com/ov12

SCHAEFFER’S MARKET RECAP(Daily, after the bell)sentiment.com/mr12

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

SENTIMENT magazine:WEB: sentiment.com/archive12

IPAD:schaeffers.com/ipad

ANDROID:schaeffers.com/android

CONNECT TO SCHAEFFER’S

When combined withfundamental and techni-cal factors, sentimentbecomes a powerful toolfor analyzing stocks, sec-

tors, or the overall market. (We call this 3-tiered methodology Expectational Analysis®.)

There’s no such thing as an infallible indi-cator, and sentiment is no exception. Butwithout a feel for the expectational environ-ment surrounding a stock, analysis (be ittechnical, fundamental, or a combination) issimply not firing on all cylinders. Very oftenit's the expectational – or sentiment – back-drop that makes the difference between agood market call and a bad one.To access more articles on Expectational Analysis, as well as other options education, go to sentiment.com/edu12

SCHAEFFER’S U

AN INTRODUCTIONTO EXPECTATIONAL ANALYSIS

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

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

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

Spreads Primer(SPRING 2011 ISSUE)There’s an option spreadstrategy for any marketcondition. So if you’re onlytrading long calls and puts,you’re probably missingout. ///////////////////////////////

SIR12_Com_RD3.qxd:pages.layout 12-05-21 5:24 PM Page 28

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Pro Pearls30 S E N T I M E N TSPING 2012

1 / Place a cap on riskfor each trade. One ofthe biggest mistakesyou can make is com-mitting too muchmoney to an individualtrade. One rule ofthumb is investing nomore than 5% of yourportfolio on a singletrade, just in case thetrade doesn’t work outas planned. If you suf-fer a losing streak, eachsuccessive loss will beincrementally smallerthan the last, and keepyou in the game. Beforeinitiating any strategy,calculating your poten-tial risk as well as yourreward is essential.

2 / Understandimplied volatility. Calculated from anoption’s price, impliedvolatility is one of themost misunderstood

concepts in optionstrading. Exciting stockslike Apple and Googlehave higher impliedvolatility, while lessexciting stocks like GEhave lower impliedvolatility. Prior to newsannouncements, moststocks see their optionsinflate because manytraders are hedgingtheir bets or becauseeveryone just hopes forthe possibility of a bigprofit. Be forewarnedthough: You can losemoney on a call option,even when the under-lying stock rallies.Why? You likely over-paid for the volatilitypremium. Even thougha stock moves higher,that pumped-upimplied volatility goinginto the news eventincreased the optionpremiums. If the stockdoesn’t move farenough, the optionprice will fall. [Ed. note:You can compare thecurrent implied volatilityto past implied volatilityon most optionable stocksusing Schaeffer’s Volatil-ity Index (SVI) at scha-effersresearch.com.]

3 / Pay close attentionto earnings announce-ments. Events thataffect a stock’s pricesuch as earningsannouncements canhave a dramatic impacton implied volatilitiesof the options. Forexample, beforeApple’s recent earn-ings were announcedin April, the impliedvolatility of Apple’soptions zoomed as highas 90%. After the earn-ings were announced,although Apple shothigher by more than$50 a share, all put-andcall-options premiumsthat were still out ofthe money collapsed,and many investors lost

money. Anytime thereis an earningsannouncement, espe-cially with a volatilestock, expect an unex-pected reaction. Rec-ognize that optionprices do not behave asthey do under normalcircumstances.

4 / Be a disciplinedoptions trader. Nomatter how good yourtrading plan, if youaren’t disciplined anddon't follow it, you’relikely to lose money.What’s an “undisci-plined” trader? Some-one who often sellswinners too quickly,doubles down on losingtrades, and more often,

holds onto their optionspositions too long,because they refuse totake a loss. Anotherportfolio killer is greed,which is usually the fearof missing out on a hugeprofit. A disciplinedtrader is educated andunemotional. Losses arepart of a winning strat-egy. You can’t avoidthem. Just don’t letthem get out of control.Keep a trading journalto avoid repeating mis-takes. Be flexible, andlearn more than oneoptions strategy—afterall, there is more thanone market condition.

PreventativeMaintenance

AUTHOR AND TRADERMICHAEL SINCERE GIVESFOUR PREEMPTIVE STRIKESFOR OPTIONS TRADERS

/Michael Sincere(www.michaelsincere.com)is a freelance writer andauthor of UnderstandingStocks (McGraw-Hill, 2003),Understanding Options(McGraw-Hill, 2006), andAll About Market Indicators(McGraw-Hill, 2011).

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Schaeffer’s Investment ResearchMAIN OFFICE: 513.589.3800MAIN FAX: 513.589.3810CUSTOMER SERVICE:800.327.8833 prompt #2E-MAIL: service@sir-inc.comSALES: 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 our read-ers 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, the infor-mation 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 situations, before trading. Options involve risk and are not suitable forall investors. 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 andRisks of Standardized Options.” You can access and download a copy of the booklet on The Options Clearing Corporations (OCC) website at www.theocc.com/about/publications/character-risks.jsp. This link reference isprovided as a courtesy 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 1-800-327-8833 and 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 downloada copy of the booklet 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 NationalFutures Association 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 portfolio 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 partwithout explicit permission from a duly authorized officer of SIR, except by established news media that wish to quote brief passages for purpose of review. Copyright 2011, Schaeffer’s Investment Research, Inc.

SIR12_ProPearls_RD3.qxd:pages.layout 12-05-21 5:44 PM Page 30

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