My dad would often take me to visit the New York Stock Exchange and the American Stock Exchange, where I’d get caught up in the noise, excitement, and activity of the exchanges’ trading floors. I’d also accompany him at every opportunity on his visits to our local brokerage firm. At that time, all of the transactions on the stock exchanges were actually printed on a long, narrow roll of paper called ticker tape, and this tape was then projected onto a screen so that brokers and their customers could conveniently view the latest prices. I’d watch this stock ticker for hours, nearly hypnotized by the continuous ebb and flow of stock prices.
As I began studying the financial section of the newspaper, I noticed some fascinating little advertisements offering “put and call options” on big name stocks for as little as $112.50. While I had no idea what options actually were, the idea of being able to participate in the stock market for $112.50 was a very powerful attraction to a middle-class teenager, particularly when the rewards for successfully investing that $112.50 could be thousands of dollars!
My fascination with the profit potential of options trading combined with my degree in mathematics helped me to learn the principles of options at breakneck speed. I very quickly understood that call options gave me the right to buy a stock at a specified price for a specified period of time, and that put options gave me the right to sell rather than to buy a stock.
I also learned that if I were very bullish on a particular stock, I wanted to buy a call option, because if I was correct and the stock rose significantly in price, my call option would allow me to buy that stock well below the market price. I could thus buy low (by exercising the terms of my call option and buying the stock at the specified price) and then sell high (by selling the stock that had rallied). And relative to my small initial investment, my profits could be huge. Of course, all of this favorable stock movement needed to occur before the option expired, and if the necessary rally in the stock did not occur by the expiration date, I would lose the entire sum I paid for the option.
At the other end of the spectrum, if I were very bearish on a stock, I learned that I wanted to buy a put option, because if I was correct and the stock declined significantly in price, my put option would allow me to sell that stock well above the market price. Again, I would be buying low (by buying the stock that had declined) and selling high (by exercising the terms of my put option and selling the stock at the specified price).
My fascination with the ads offering various call and put options grew, but there was a significant stumbling block for me: While I had the $100 or $200 required to purchase many of these options, the process of actually exercising the options (should the stock move as I had expected) was far beyond my reach as a teenager. At that time, the only way to realize the value of a purchased call option was to buy the stock from the options dealer and then sell the shares on the exchange. While I had enough capital to buy the option, I was far short of the capital I would need to exercise it.
So, options remained an enticing but unrealized dream for me until 1973 when the Chicago Board Options Exchange (CBOE), the first exchange devoted exclusively to trading equity options, began operation. On the CBOE, options transactions occurred on a trading floor in a manner similar to how stocks traded on stock exchanges. Options investors enjoyed exchange and regulatory protections similar to that afforded stock investors. And most important for me, options could be purchased and sold on the exchange at any time (the technical term is full fungibility), so that I, as an options buyer, needed no additional capital beyond that required to purchase the option. I was in business.
Or so I thought. I spent most of the remaining part of the 1970s making every mistake possible by a beginning options trader. To add insult to injury, I repeated some mistakes with numbing regularity. Many of these mistakes involved ignoring sound money management principles. Too much of my total investment capital was tied up in my options trading, and too much of what I was investing in the options market was in just one or two situations. My other mistake was trading options in the exact same manner as I would trade stock, thereby ignoring the two most important words in options investing: “Options Expire.”
By the end of the 1970s, I had put together some extensive notes on what I had learned from my options trading experiences. I began to approach options trading in a much more serious, intelligent, and intense manner. At the time, I was vice-president and actuary for a major Midwestern insurance company and a career change appeared to be in order.
Like most investors of that era, I had subscribed to a number of market letters. These newsletters published the investment advice of entrepreneurs whose work was generally steeped in technical analysis (the analysis of stock price and volume patterns). While there were hundreds of these market letters, and many were very valuable sources of advice for stock traders, I was amazed to discover that there was little available in these publications for the options investor.
Though it was possible for the options investor to gain some value from these stock-oriented market letters, I was already well aware of the pitfalls of trying to adapt a stock trading approach to the options market. It became clear to me that the needs of the options investor were not being served by the investment-newsletter industry. I realized that I was at a juncture in life where I could fill that void for the options investor.
What were my qualifications for this role of market letter writer for the options trader? I had a thorough understanding of the stock market and the mathematics and practicalities of the options market. I had spent the better part of a decade learning from the mistakes most investors make in trading options. Plus, I had good communications skills. And finally, I was plain fascinated with options - their profit potential, their low capital requirement, and the excitement of trading them. I wanted to share my enthusiasm with other investors and show them how to benefit from my experiences so that they could trade options intelligently and, thus, profitably.
But I needed more than a solid foundation and enthusiasm about options. Trading options successfully is ultimately about successful timing - of the market, of industry sectors, and of individual stocks. To be successful at timing in the stock market, I learned that an investor needs an edge - a set of indicators or a methodology that is both unique and effective.
Many stock market indicators have proven effective over the years, but they share a common shortcoming - they lose their effectiveness as they gain in popularity. Too many market participants begin to use these indicators in their trading decisions. And then the “Heisenberg Uncertainty Principle” comes into play, which, simply put, tells us that any indicator that becomes too popular will, by definition, lose its effectiveness.
The difficulty is compounded by the fact that the unique indicators that avoid the consequences of the Heisenberg Uncertainty Principle are almost uniformly afflicted with the malady of ineffectiveness.
It also became obvious to me that following the “conventional wisdom” on Wall Street was a sure recipe for investment mediocrity. Time and again I would listen to the “experts” who were quoted in the pages of the leading financial publications, only to be led down the path to investment losses. But, like the fly that continually bumps into the windowpane in its logical attempt to get outdoors, I just couldn't seem to stop heeding all the expert advice, despite the losses I had sustained. How could the best minds on Wall Street be so consistently wrong when they were in agreement?
Fortunately, I took heed of the wisdom of those around me. I learned from reading the wry wit of Alan Abelson’s weekly column in Barron’s that research churned out by Wall Street firms was as often a subject for ridicule as it was an object of reverence. Joe Granville stimulated my skepticism even further with his simple yet profound trademark phrase: “The obvious is obviously wrong.”
But I still needed a logical explanation for why skepticism was the proper approach to the investment world. My breakthrough came when I read John Kamin’s pioneering iconoclastic newsletter, The Forecaster, which boldly stated on its masthead that “The Theory of Contrary Opinion Has Never Been Disproved.” John’s opinions tended to diverge significantly from the conventional wisdom that had so often disappointed me, and I became intrigued with what this contrary opinion theory, which Kamin attributed to one Humphrey Neill, was all about. I then read Neill’s masterpiece, The Art of Contrary Thinking, full of revelations that completely changed my approach to investing forever.
In this outstanding book, Neill revealed the reasons why the conventional wisdom on Wall Street was constantly letting me down. I began to understand that when market participants develop a strong consensus opinion, an atmosphere of vulnerability is created, rather than the atmosphere of safety that I first envisioned.
For example, a widespread bullish consensus on a stock indicates that most of the buying power to propel this stock higher has already been used to purchase the shares. The stock price then becomes vulnerable to selling based upon disappointing developments or from simple profit taking, as there are few buyers remaining to step up when sellers wish to get out. I began to refer to such stocks as "high-expectation stocks," which, by definition, are stocks to avoid or to consider for shorting or, better yet, for put buying.
Low-expectation stocks, on the other hand, are ripe for big gains on any positive developments, as there are very few buyers who have committed to these shares. Therefore, these stocks should form the core of my call buying list.
I was very excited about this expectational approach, but I still didn’t have my edge.
I recalled very vividly Neill’s warning, “We need accurate sentiment measures, otherwise we will conclude that the consensus is what we wish it to be.” In other words, if I wanted to know which stocks were truly high-expectation or low-expectation situations, I needed to have an objective way of measuring the sentiment on those stocks.
Once again, the options market provided my inspiration. I recalled that in the old days, prior to widespread options trading, it was the odd-lot traders (those who traded stocks in lots of less than 100 shares) who constituted the small speculators who were considered to be almost always incorrect when they agreed in large numbers. These were unsophisticated investors who tended to trade on rumors or on old news, and who thus were almost always buying late into trends or chasing ill-fated hot tips.
But once listed options trading became popular, the odd-lotters gave way to options speculators, who had the same propensity to be wrong. And the beauty of analyzing data from the options market was that it was available separately for puts and for calls, by expiration date and striking price. I could see at a glance which stocks the speculators were enthusiastic about through heavy call buying (my high-expectation stocks) and which stocks they were pessimistic about through heavy put buying (my low-expectation stocks).
I now had an effective methodology (Expectational Analysis) and unique and objective indicators (option trader activity) and I was prepared to begin publishing my options newsletter. The first issue of The Option Advisor newsletter was published in December 1981.
Over the course of the ensuing 30-plus years, equity options trading has continued to grow by leaps and bounds, with only a brief pause in the aftermath of the 1987 stock market crash. This growth accelerated during the 1990s, fueled by increasing participation of individual investors. And in 2012, equity options volume topped the 4-billion mark for the second consecutive year.
I believe that two major factors have helped drive this explosive growth in options trading. Today’s investor is increasingly aware of the benefits of adding an options trading component to their investment arsenal. Most investors are attracted to options because they can be used as a cheap, leveraged vehicle to profit handsomely from the movement in an equity. But options can also be used to protect a portfolio from a major decrease in value or to provide additional income, and these more conservative uses are attracting more and more attention in an increasingly nervous investment environment.
Second, the equity options industry has moved out of the back rooms and into the mainstream. It wasn’t too long ago that equity options transactions were performed for investors by a small group of obscure firms without the benefit of an options exchange. As a result, options tended to be very expensive. Compounding this problem was the fact that the options buyer could not take immediate advantage of changes in the value of their contract, as its terms could not be exercised until the day the option expired. It is not surprising that the tiny options industry sported something of an outlaw reputation.
Today options are traded on 12 exchanges in virtually the same manner that stocks are traded on stock exchanges. Plus, options investors have protections analogous to those traditionally enjoyed by stock investors. And options are now fully fungible, which simply means that an option buyer can turn around and sell his or her contract on the options exchange at any time up to and including the date that it expires.
When I look back over the past several decades of providing advice and analysis to investors, there are a number of accomplishments of which I am particularly proud.
I’m proud of the fact that The Option Advisor has grown to become the nation’s leading newsletter specializing in equity options recommendations. We’ve had the privilege of helping tens of thousands of investors understand the principles of an intelligent approach to options trading and avoid the common mistakes that have tripped up most options investors over the years.
I’m convinced that my market timing and stock-picking success has been the result of my ability to analyze investor sentiment and expectations and to combine this analysis with a sophisticated approach to technical and fundamental analysis.
Good luck with your trading!”