Sunday, June 25, 2006

>Finding the Edge

IN THE EDUCATION OF an investor, information, arguably more than money, ultimately becomes the decisive factor to successfully navigating the financial markets. This realization often occurs after amassing a meaningful portfolio and an understanding that the market hurts most of the people, most of the time. At this point, investors usually find they're more concerned with not losing the money they've amassed, and they develop an insatiable appetite for insightful information upon which to base investment decisions.

Professional investors call this insight "edge," some special vision into the market's psychological and structural dynamics that gives investment decisions more insight than, say, dollar-averaging positions. This quest for an edge over other investors leads many folks to the options market. Other times, investors collide with the options markets when they experience the shock waves derivatives traders can cause when they are managing positions and buying securities with the intensity of whirling dervishes.

In the mystical world of puts and calls, things are rarely as they appear. Prices can move in opposition to underlying assets, and often do. Bearish activity can be bullish. Volatility ceases to be solely an adjective and morphs into a complicated mathematical model that divines future options prices. While investors can put a little money in options to control lots of stock, they shouldn't look for the astronomical returns hucksters insinuate can be made trading options. The options market is dominated by some of the world's most sophisticated trading firms. These firms rely on computer models to dissect stocks, and all related securities, weighing every nuance of a stock's price to determine what the asset is really worth. Rather than trying to out-trade the experts, most investors should try understanding the information embedded in options trading patterns, which can be more valuable than associated leverage.

The late Harry Roth, who in his time was considered the dean of the options strategists, had a simple rule for succeeding in the options market — the KISS principle, which he defined as Keep It Simple, Sweetheart. For professional traders, and maybe high-net-worth investors, there may be a legitimate need for exotic derivative strategies, like butterflies and volatility trades, but it's not abundantly clear that is true for anyone else. Consider this: Some years ago, a retired Bear Stearns derivatives salesman, who has a doctorate in mathematics, revealed that he often enjoyed spending the day formulating complicated volatility trades, but confessed he wasn't certain he made any more money than if he bought the stock or used a simple strategy like selling calls against a stock. Most investors who are interested in options will be well served remembering Roth's dictum.

What is clear — and this is true for investors of all experience levels — is that the options market is the heartbeat of the stock market. On any given day, the future of stock prices is debated in the options market. Traders buy and sell puts and calls to wager on upside and downside earnings reports. They use S&P 500 index options to protect equity portfolios from market fluctuations. When companies are rumored to be takeover targets, call options can reveal if the market believes the rumor, and, if so, the expected takeover premium. Sometimes options trading patterns are accurate; other times not. That's why many professional options traders consider themselves "contrarians." They express their fundamental view of the market by saying they buy fear and sell confidence. So, if everyone is selling a stock in reaction to news, contrarians buy the stock because they think investors have overreacted. Contrarians often do the opposite of other market participants because their fundamental market stance is to challenge the assumptions behind corporate actions and market events. This is another dictum investors interested in options should remember.

In any year, the stock market has about 225 trading days. Many of those days are scripted, and trading is in response to known events, such as the Federal Reserve's interest-rate meetings, corporate earnings or economic-indicator releases. This type of information is common knowledge among professional traders who try to anticipate events and remove as much uncertainty from investment decisions as possible. If you don't have access to a market calendar, you're at a disadvantage to everyone else who has the information, but that can be easily fixed. The International Securities Exchange distributes a five-day forward trade sheet, ISE Insights, that lists major market events, earnings reports and other critical information. Information about email delivery can be found at

Sentiment indicators are another important tool that reveals how options traders view stocks. Investors should learn about the Chicago Board Options Exchange's Volatility Index (VIX), known as the options market's fear gauge, at, and the ISE Sentiment Index (ISEE). The CBOE has made a number of refinements to the VIX, so spend time understanding those changes because volatility is synonymous with options prices. The VIX can be an early warning signal of market movements. (In the interest of full disclosure, I once worked at ISE and was involved in creating ISE Insights and the ISEE.)

For many investors, the markets are fascinating in their complexity, and majestic in their operation. Each day at 9:30 a.m. when trading starts, a staggering amount of intellectual firepower turns to the financial markets. The securities traded on stock exchanges represent the accomplishments of great scientists, industrialists, technologists — in short, people with the strength of will to turn concepts into companies, the growth of which Wall Street finances with stocks and bonds, which in turn have spawned myriad financial products like options. As a group, the people who work on Wall Street are heroic and villainous, elegant and vulgar, smart and dumb, honest and dishonest. Yet, all of them want the same thing, which is to make as much money as possible. Somewhere, not too far from the maddening crowd, are a handful of traders, in mastery of their emotions, disciplined, insightful, managing positions with precision. This mindset is another insight investors interested in options trading should remember.

For anyone who is curious about the forces percolating around stock prices, information embedded in puts and calls can be invaluable, and the options trading strategies can offer investors unprecedented flexibility coping with stock prices. These strategies may be increasingly important to the long-term health of a stock portfolio as global financial markets are becoming increasingly interdependent and asset-class performance becomes increasingly difficult to differentiate from one another.

"As the markets become more interconnected, many investors would be remiss or negligent if they didn't implement options strategies to navigate the stock market. If there is one lesson that we have all learned these past few years, the market fluctuates," says Michael Schwartz, Oppenheimer & Co.'s chief options strategist.

Schwartz counsels investors to remember that options should be used to reduce risk, not increase risk. "Options are part of your investment tool kit," he says. "

Options can be used to implement the four basic objectives of investing:

  1. buying below the market,

  2. selling above the market,

  3. increasing your return, and

  4. protecting your assets.

All of which can be implemented with conservative options strategies."

And that is exactly what The Contrarian is about.

To closely track Stock and Index {call puts and options traded volumes and oi} check this link.


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