THE DAILY STRATEGIST NEW SUBSCRIBER INFO

Thank you for subscribing to The Daily Strategist. Our goal is to give you up-to-the-minute strategy information complete with trading recommendations and follow-up action. There will generally be two reports per day: one in the morning at the market open and one in the afternoon before the close of trading. In addition, your subscription to The Daily Strategist includes a subscription to The Option Strategist Newsletter and all its hotline updates by email. The Option Strategist is our semi-monthly publication, which includes educational and informational articles as well as specific trading recommendations. THE MARKET REPORT The first of the two daily newsletters included in your Daily Strategist subscription is The Market Report. Published and delivered each trading day at the market open, this report provides a detailed analysis of our market outlook along with speculative option trading recommendations based on various technical indicators. OSCILLATOR

The first thing you will find here, in the blue box at the top-left of the page, is a breakdown of market breadth (advances and declines), including our market breadth oscillators and our “ only” advance- decline figures. See the attached article on “The Oscillator” for background information on these indicators. You can also access that same article from a link in the blue box in each newsletter. SUMMARY INDICATOR OUTLOOK

Below the Oscillator box is a quick snapshot of the various broad market technical indictors we follow, including put-call ratios, breadth, and price action.

1 There is a risk of loss in all trading. Any time an option is sold uncovered; there is unlimited risk of loss. No representation is made that any strategies will produce profits. Data sources are believed to be reliable, but accuracy is not guaranteed. Please evaluate the markets before trading. Officers of - and/or Accounts managed by McMillan Analysis Corporation may hold positions in some of the securities recommended. http://www.optionstrategist.com

MARKET COMMENT

The first written section is a Market Comment. We use four criteria to analyze and predict the broad market – index price action (primarily $SPX), volatility ($VIX), equity-only put-call ratios (both standard and weighted) and market breadth. Generally, this section will recap the previous day’s market action, discuss any over-night market moves, and explain our current short-term (and sometimes longer-term) outlook. TRADING RECOMMENDATION

Page 2 of the Market Report will contain any new trading recommendations for the day if there are any. All new recommendations will be highlighted in yellow – in a rectangular box – such as this:

Position A1: Momentum Buy Signal in AAPL (AAPL)

Buy 2 AAPL Jan 500 calls at a limit of 5.00 or less

Set a mental closing stop at 495 for the position.

The recommendation will be given a Position Number (in this case Position A1) followed by a brief description of the type of trade. The actual trading recommendation (including quantity, options, price and trade type) is given, followed by a position stop. The two most widely used position stops for our recommendations are defined below:

Mental closing stop: if the underlying is going to be above or below (depending on the recommendation) the stated mental closing stop at the close of any trading session, close the open position at the end of the trading day. An easy way to do this would be to check five minutes before the close of each trading session to see if your positions are going to be stopped out. If they are going to be stopped out, close out the position.

Intra-day stop: if the underlying trades above or below the stated intra-day stop at anytime, close out the position immediately. The can be done automatically by setting a “stop order” at your brokerage.

Any follow-up action for the recommendations will be detailed in each subsequent Volatility Report.

2 There is a risk of loss in all trading. Any time an option is sold uncovered; there is unlimited risk of loss. No representation is made that any strategies will produce profits. Data sources are believed to be reliable, but accuracy is not guaranteed. Please evaluate the markets before trading. Officers of - and/or Accounts managed by McMillan Analysis Corporation may hold positions in some of the securities recommended. http://www.optionstrategist.com

MOMENTUM TRADING

Next is a listing of potential momentum buys or sells. We use a trend-following system for these speculative positions. In general, the system has two criteria for a “setup”: 1) the ADX must be 30 or greater – indicating that the underlying market is trending, and 2) it must have pulled back and touched its 10% exponential moving average line. Once these two items have occurred, then the underlying can be bought if it trades at a price higher than the high of the bar that touched the moving average (2nd criterion). Once bought, a mental closing stop is set at the low of that same bar – the one that touched the moving average. All such stops are spelled out in the newsletter.

Please see the accompanying article on “Momentum Trading” beginning on page 11 for further information on this topic.

Even if we are not making a specific recommendation, we list a table of potential momentum trading candidates – in stocks, indices, and futures – for those who might want some momentum ideas of their own.

There are actually two momentum trading tables – one for potential momentum buy signals and one for potential momentum sell signals. The /futures/index symbol is listed, along with the entry stop (buy stop for momentum buys or sell stop for momentum sells), the ADX as of yesterday’s close, and the stop loss point to be used if the position is actually taken. A sample is shown below:

MOMENTUM PURCHASE CANDIDATES

Symbol Entry Buy Point ADX Level Stop Loss

CBS 53.88 40 53.00

MOMENTUM SHORT-SALE CANDIDATES

Symbol Entry Sell Point ADX Level Stop Loss

/USU3 13378 33 13506

3 There is a risk of loss in all trading. Any time an option is sold uncovered; there is unlimited risk of loss. No representation is made that any strategies will produce profits. Data sources are believed to be reliable, but accuracy is not guaranteed. Please evaluate the markets before trading. Officers of - and/or Accounts managed by McMillan Analysis Corporation may hold positions in some of the securities recommended. http://www.optionstrategist.com

PUT-CALL RATIO SIGNALS

If there are significant new signals issued by the put-call ratio signals in indices, stocks, or futures, they will be summarized. The put-call ratios are contrary indicators. Essentially, when there is “too much” put buying – indicating that the public is bearish – the contrary trader should consider buying that market. Conversely, if there is “too much” call buying, we would look for a place to sell the stock short or buy puts. Our put-call signals are not generated from the ratio being at any particular level, but rather they are dynamically generated when the ratio rolls over and changes direction – especially when that rollover occurs at an extreme on the chart. A rollover of the ratio from rising to falling is a buy signal (there has been “too much” put buying and it has exhausted itself). A rollover from a falling ratio to a rising one is a sell signal (“too much” call buying has been taking place).

The Put-Call Ratio Signals section contains three tables for both buys and sells. The first table is a daily list of new computer generated buy and sell-signals. The second table contains the prior day’s signals whose charts have been visually confirmed today. These are the signals whose charts have “rolled over.” The third table contains the current signals that are still active. Click on each symbol to view its put-call ratio chart. For more information on put-call ratios, click here. OTHERS

From time to time, we may also recommend speculative broad-market plays, inter-market spreads, pairs trading or other strategic applications utilizing listed options. Again, these would be specific recommendations, with details including investment, risk, buy limits, and stops.

4 There is a risk of loss in all trading. Any time an option is sold uncovered; there is unlimited risk of loss. No representation is made that any strategies will produce profits. Data sources are believed to be reliable, but accuracy is not guaranteed. Please evaluate the markets before trading. Officers of - and/or Accounts managed by McMillan Analysis Corporation may hold positions in some of the securities recommended. http://www.optionstrategist.com

THE VOLATILITY REPORT The second daily newsletter included in your Daily Strategist subscription is The Volatility Report. Published and delivered a half hour before the market closes each trading day, this report provides insight into the day’s market action, recommends volatility trading option positions based on various statistical analysis scans, and provides a profit and loss statement (P&L) containing management information for all open and recently closed positions. VOLATILITY METRICS

Similar to the Market Report, there is a blue box spanning the left-hand column of the first page of the Volatility Report – this time containing the volatility metrics we follow. MARKET COMMENT

The Market Commentary in the Volatility Report recaps the day’s action, discusses changes in our indicators, and takes in-depth look at the volatility derivatives markets and their effects on the broad indices. TRADING RECOMMENDATION

As with the Market Report, page 2 will contain any new trading recommendations for the day if there are any. RECENT POSITIONS AND FOLLOW-UP ACTION

We follow each recommended position diligently. Any time we adjust a position, it is mentioned in this section. Also, if we are trying to establish a position at different price levels over a period of several days, the updates to that entry strategy will be included here as well.

In general, we set a stop for a position when it is established. Later, if profits should develop, we normally take a partial profit (perhaps on a third of the position), and then begin to use a trailing stop to let profits run. Commonly, this trailing stop will be the 20-day moving average, but we may at times use other – more sophisticated – stops, such as Chandelier stops.

5 There is a risk of loss in all trading. Any time an option is sold uncovered; there is unlimited risk of loss. No representation is made that any strategies will produce profits. Data sources are believed to be reliable, but accuracy is not guaranteed. Please evaluate the markets before trading. Officers of - and/or Accounts managed by McMillan Analysis Corporation may hold positions in some of the securities recommended. http://www.optionstrategist.com

SUMMARY OF CURRENT OPEN POSITIONS

Page 4 contains a table listing of all of our open positions, and a current mark to market. The stop prices are listed in this section along with any other notes. BUYS

One of primary volatility trading strategies is straddle-buying. This can be a complex topic, and we cannot go into all the facets of it here. However, suffice it to say that we do a number of statistical and probability analyses, and only the potential straddle purchases with the highest expected returns make this list. This table will normally contain several items.

Here is a sample of what the Straddle Buying table might look like:

% Prob. Of Und. Strd %-ile of 50 Stock/Index /Future Symbol Straddle Days Points % touching Price Price IV (%) B/E Chipotle CMG 403.92 Jan 405 55.50 112 2 6 97 100 87

Crocs Inc. CRUS 20.82 Mar 21 6.40 157 4 1 100 100 83

Deutsche Bank DB 45.10 Jan 45 7.00 112 9 18 98 98 82

Each column heading is explained below:

Symbol, Und Price: the underlying symbol and its closing price are shown. Index symbols begin with the character $ and futures symbols begin with @.

Straddle, Strd Price: the straddle being analyzed and its closing price.

Days: the number of trading days remaining in the life of the straddle being analyzed.

%ile of IV: the current percentile of the composite implied volatility of this underlying instrument. This volatility must generally be in the 10th percentile or lower in order for the straddle to make the list. Occasionally – during periods of expensive options – the threshold for %-ile might be raised to the 15th percentile. These terms are explained here, briefly:

Composite volatility: each day, all of the options implied volatilities on an underlying instrument are weighted by their trading volume and distance from the strike (at the money options get the most weight), to produce a single, weighted implied volatility for that entity. This is then the composite volatility, and it is stored in a database for each underlying entity daily.

Percentile: the percentile of implied volatility is determined from the database of stored composite implied volatilities. While the database may have hundreds, even thousands, of stored volatilities, we usually use only the last 600 data points in order to determine the percentile.

6 There is a risk of loss in all trading. Any time an option is sold uncovered; there is unlimited risk of loss. No representation is made that any strategies will produce profits. Data sources are believed to be reliable, but accuracy is not guaranteed. Please evaluate the markets before trading. Officers of - and/or Accounts managed by McMillan Analysis Corporation may hold positions in some of the securities recommended. http://www.optionstrategist.com

50: the amount by which the straddle price would change if the composite implied volatility of this underlying instrument returned to the 50th percentile in 30 days (while the stock price is unchanged). So, the implied volatility used in order to compute 50 is the one right in the middle of the implied volatility distribution over the last 600 trading days – where 50% of the volatilities stored in the database are higher and 50% are lower.

Historic Movement: there are two figures under the historic movement heading:

Points: the percent of the time in the past that the underlying instrument has been able to make of move equal in points to the straddle price, in the allotted time.

%: the percent of the time in the past that the underlying instrument has been able to make a percentage move equal to the current straddle price divided by the current underlying price, in the allotted time.

Prob: the probability of the underlying ever touching one of the other of the breakeven points at any time during the life of the straddle. This is an extremely important statistic. It is determined by use of our Monte Carlo simulation for probabilities. This same Monte Carlo Probability Calculator is a standalone product that can be purchased and is also available on the paid subscriber section of our web site, The Strategy Zone. This probability calculator is more sophisticated than the simple ones that merely give one the probability of the stock being at or beyond a target price at . In reality, a straddle owner will most likely make adjustments or take partial profits when the underlying reaches the breakeven point, whenever that may occur – not just at expiration. Thus, this Monte Carlo probability is the more appropriate one for most applications – certainly for straddle buying. (This probability must be at least 75% in order for the straddle to appear in this list.) IMPLIED VOLATILITY EXTREMES

We have often found that situations where volatility collapses or increases by a large amount in a short time are often viable straddle buying candidates as well. Hence two tables of these situations are included, similar to the following example:

High IV in Last 25 Percentile of Stock/Index /Future Symbol Stock Price Current IV Days IV Akamai Tech. AKAM 46.73 28.13 48.69 1 Amazon.com AMZN 292.61 22.02 43.61 0 AOL Inc. AOL 36.09 31.84 68.63 20 Chipotle Mexican Grill CMG 403.69 21.69 49.27 2

The stock name and symbol are listed, as well as the stock price. Then the current composite implied volatility is shown (Current IV), followed finally by the highest or lowest level of composite implied volatility in the last 25 trading days. If the current IV has dropped or increased more than 50% from the high or low IV levels in the 25 day period, then it is a candidate for this list.

7 There is a risk of loss in all trading. Any time an option is sold uncovered; there is unlimited risk of loss. No representation is made that any strategies will produce profits. Data sources are believed to be reliable, but accuracy is not guaranteed. Please evaluate the markets before trading. Officers of - and/or Accounts managed by McMillan Analysis Corporation may hold positions in some of the securities recommended. http://www.optionstrategist.com

VOLATILITY SKEWS

This section contains situations where there is a large volatility skew – potentially large enough to trade. “Volatility skew” means that the individual options on this particular stock, index, or are not the same. In fact, they are so disparate – and generally there is a pattern to these disparities – that a spread can be established to take advantage of them.

The table that lists these volatility skewing candidates looks like this:

Stock/Index /Future Symbol Underlying Price Volatility Skew %-ile of IV

Onyx Pharma ONXX~ 125.15 69.54 1 Emini S&P 500 /ESU3 1689.50 48.93 4 Nasdaq 100 /NDU3 3141 39.30 4 High Grade Copper /HGU3 3.3335 36.98 88 S&P 500 Index /SPU3 1689.20 34.29 13 Berkshire Hathaway Cl. B BRK.B 117.12 23.03 32

In this table the stock/index/or future name, symbol, and underlying price are shown. The next column is the most important piece of information – the Volatility Skew statistic. This really is the standard deviation of the individual implied volatilities of the various options on this underlying. Then that number is normalized, by dividing it by the daily composite implied volatility (which is listed in the next column).

The larger the number, the more skewed the options are. One would actually need to look at the options on the underlying with a real-time screen to see what options are skewed. The skew could be horizontal (near- term options are far more expensive than farther-term options), in which case a would be a good strategy. Or the skew could be linear (for example, out of the money puts trading with a much higher implied volatility that at the money puts, as is often the case with $SPX and other index options). In that case a or a put- would be appropriate. For more information on Volatility Skews, click here.

8 There is a risk of loss in all trading. Any time an option is sold uncovered; there is unlimited risk of loss. No representation is made that any strategies will produce profits. Data sources are believed to be reliable, but accuracy is not guaranteed. Please evaluate the markets before trading. Officers of - and/or Accounts managed by McMillan Analysis Corporation may hold positions in some of the securities recommended. http://www.optionstrategist.com

PUT-SALE ANALYSIS

Naked put selling and writing are equivalent strategies, however naked put selling is more efficient because it involves only one commission and one bid-asked spread when establishing (as opposed to two to establish a covered write). Moreover, if the maximum profit result occurs (i.e., if the stock is above the striking price of the written option at expiration), there is nothing to do as far as the naked put is concerned, whereas there is another stock sale commission if the stock is called away. Therefore, our preferred strategy for trading recommendations is almost always naked put writes. For a detailed explanation of why we prefer naked puts over covered writes, read the following article.

We publish a table of the most attractive naked put-sale candidates in the Daily Strategist each day. For a detailed explanation of the process we use to choose the trading recommendations, refer to the additional “Making Put Selling Decisions” article.

In short we looks for candidates that have less than 60 days until expiration, do not have an earnings announcement before expiration, have a 90% chance of expiring worthless, and have an annualized expected return of 20% or higher. We do occasionally sell puts on stocks that will be reporting earnings before expiration, but only if we feel, based on past statistics, that there is enough downside-protection to doing so. The table that lists naked put-sale candidates looks like this:

Stock Put Exp. Invt. Invt. Anlzd. Exp. Rtn. Stock/Index /Future Symbol Put Price Price () (Cash) (Mgn/ Cash) % Cliffs Natural Resources CLF 22.55 Sep 19 0.30 507 1870 22 / 6

Johnson & Johnson JNJ 90.15 Sep 87.5 0.85 1918 8665 22 / 5

Newmont Mining NEM 32.25 Sep 26 0.25 680 2575 25 / 7

In this table the stock/index/or future name, symbol, and underlying price are shown. The next column is the date and month, followed by the put premium. Next are the Expected Investment on margin and the Investment on cash. The last column offers the Annualized Expected Return on both cash and margin.

9 There is a risk of loss in all trading. Any time an option is sold uncovered; there is unlimited risk of loss. No representation is made that any strategies will produce profits. Data sources are believed to be reliable, but accuracy is not guaranteed. Please evaluate the markets before trading. Officers of - and/or Accounts managed by McMillan Analysis Corporation may hold positions in some of the securities recommended. http://www.optionstrategist.com

ADDITIONAL ARTICLES THE OSCILLATOR We occasionally make OEX recommendations, based upon our short-term overbought/oversold oscillator. If the oscillator rises to +200 or higher, the market is overbought. We then look to short the market (i.e., buy OEX puts) when it subsequently falls back below +180. Conversely, if the oscillator is below -200, then the market is oversold, and we will buy calls when it eventually rises back above -180.

The oscillator is calculated with the following formula:

Today's Oscillator = 90% of Yesterday's Oscillator + 10% of (Today's Advances - Today's Declines)

For example, if the oscillator stood at 100 yesterday, and today there were 1200 advances and 900 declines, then the today's oscillator number would be calculated as 120:

Today's Oscillator = 0.9 * 100 + 0.1 * (1200 – 900) = 90 + 30 = 120

The “Stocks Only” Oscillator

In the fall of 2001, several analysts were touting the fact that the NYSE advance-decline was making new all-time highs. At the time, we had a bearish opinion on the market, and I could scarcely believe that was true. But it was! Sure enough, even though the stock market had been struggling since the end of the tech boom rally in early 2000, the NYSE advance-decline line was indeed making new highs.

We have access to another good set of stocks, though – all stocks with listed options. That is, all optionable stocks. There is a large set of such stocks, so we created our own advances and declines (and our own advance-decline line), using that set of stocks. It was remarkably different. Figure 1 shows how much the “Stocks only” cumulative advance-decline line had differed from the NYSE cumulative advance-decline line.

This was mostly due to decimalization, for reasons that are too detailed to explain in this short piece.

However, because of this, we also compute a “stocks only” oscillator each day. Furthermore, we monitor both the “stocks only” and the NYSE-based oscillators as potential market indicators and as measures of market breadth.

Buy and Sell Signals

A Buy Signal is generated when the oscillator drops into oversold territory and them emerges from it. A Sell Signal is generated when the oscillator climbs into overbought territory and then falls from it.

For the NYSE oscillator: a Buy Signal is generated when it falls below –200 and then later rises above –180. A Sell Signal is generated when it rises above +200 and then later falls below +180.

For the “Socks Only” oscillator: a Buy Signal is generated when it falls below –400 and then later rises above –180. A Sell Signal is generated when it rises above +140 and then later falls below +120. #

10 There is a risk of loss in all trading. Any time an option is sold uncovered; there is unlimited risk of loss. No representation is made that any strategies will produce profits. Data sources are believed to be reliable, but accuracy is not guaranteed. Please evaluate the markets before trading. Officers of - and/or Accounts managed by McMillan Analysis Corporation may hold positions in some of the securities recommended. http://www.optionstrategist.com

MOMENTUM TRADING

The concept of momentum trading has been a powerful force in the markets over the past few years. The traditional concept is that a momentum trader identifies a stock that has already begun to move strongly and trades with the momentum. That is, if the stock is roaring up, momentum traders jump in and buy the stock – attempting to quickly ride it to even higher prices, and perhaps adding to the momentum with their own buying. Similar things can happen on the downside. Some momentum traders will only try to capture a small profit – perhaps just a fraction of a point for some day traders – while others will try to stay in the “hot” stocks until they lose their momentum completely. Those decisions are personal ones that each trader must make for himself – deciding whether he wants to trade for fractions or assume greater risk and try for greater rewards.

The key to this sort of trading is to be able to identify the momentum stocks with some degree of confidence. The trend following method described below has a good track record of success. Since we tend to hold onto our intermediate-term recommendations, preferring to try to let profits run until we are stopped out, we are going to take the viewpoint of buying and holding these momentum trades until they show some signs of weakness.

Trend-Following: Raschke’s “Holy Grail” System

A proven way of trading momentum is to get on a trend and stay with it. This system, described in full in the book, Street Smarts, by Linda Raschke and Larry O’Connor, is called the “holy grail” (tongue-in-cheek, of course, since there is no real holy grail). It’s quite simple, really – as many good systems are. Philosophically, the system is this:

1) find a market (stock, index, futures) that is trending 2) wait for it to pull back to support 3) buy it when the trend resumes.

Specifically, one must use the following items of technical analysis to implement the system. This implementation is very similar to Linda’s, but I have introduced a couple of small changes which reflect the way that I personally use this system:

1) to determine if a market is trending, it is necessary to know the ADX of that market. ADX is a term and indicator invented by Welles Wilder some years ago, and it is a conventional term in technical analysis. Most charting software has ADX built into it, so that you can readily find it if you want. When ADX is greater than 30 for a particular market, that market is considered to be trending. ADX is always a positive number, so you need to actually look at the chart to see if the trend is upward or downward.

2) if a market is trending, and prices pull back to touch the 10% exponential moving average of prices, that is considered support. Again, most charting software should be able to draw a 10% exponential moving average. Failing that, one could use the 20-period simple moving average, since the two are quite similar.

3) fulfillment of conditions 1 and 2 constitutes a set-up for the trade. One actually establishes a position when the market begins resuming the trend, and trades one tick past the bar that touched the moving average in step 2. This is an intraday entry – do not wait for closing prices to confirm the resumption of the trend.

4) stops are, of course, necessary. Initially, one places a stop at the opposite site of the bar that touched the trend line in step 2. If profits accrue, then begin using the 10% exponential moving average as a stop. I recommend using mental closing stops in both cases here in step 4.

11 There is a risk of loss in all trading. Any time an option is sold uncovered; there is unlimited risk of loss. No representation is made that any strategies will produce profits. Data sources are believed to be reliable, but accuracy is not guaranteed. Please evaluate the markets before trading. Officers of - and/or Accounts managed by McMillan Analysis Corporation may hold positions in some of the securities recommended. http://www.optionstrategist.com

In order to explain this concept, we’ll use a “classic” example.

The chart on the right shows November Crude Oil (symbol: @CLX) in the summer of 1999, when it was trending strongly. First, look near the top of the chart, where ADX is drawn. The straight line indicates an ADX of 30 (there is no scale for ADX on the chart, so this “30 line” is one’s only point of reference). You can see that ADX rose above the 30 line at the point marked “1" on the chart, and stayed there for the rest of the summer. So, by definition, Crude Oil was in a trending mode all summer. By inspection, the trend was up. This satisfies the first criterion: ADX >= 30.

On the rest of the chart, the price chart of @CLX is drawn, along with its 10% exponential moving average. The first point of interest is directly above the point marked as “2". That is where @CLX – which was trending upward at the time because ADX was greater than 30 – fell back and touched the 10% exponential moving average line. This satisfied criterion 2, and a setup was established.

The actual buy (Buy #1) took place the next day when @CLX traded above the high of the day marked as “2". This buy #1 took place at a price of about 19.85. At this time, one would buy the @CLX futures (or options, if you prefer). The initial stop would be set below the low of the day marked as “2" – at 19.20. That particular stop never came into play because prices rose.

Eventually, the buy was stopped out when @CLX closed below its 10% exponential MA about a month later (at the point marked as “#1 Stopped”). The sale came at a price of 20.67 – a profit of 82 cents on this trade.

Interestingly, even though the position was stopped out, ADX was still above 30, so another setup was simultaneously created (ADX was still above 30, and @CLX had pulled back and touched the exponential MA). So, three days later when @CLX traded above the high of the day it was stopped out, Buy #2 occurred – at a price of about 21.40. The stop for this new trade was initially set at 20.50 – just below the low of the bar that touched the moving average. It never came into play, however.

This second buy was even better than the first, with the trend resuming in earnest – carrying prices above the $25 level in Crude before pulling back suddenly and stopping out the position at 23.76 (at the point marked “#2 stopped”) – the last bar on the chart.

Summary

This system can be used for stocks and sector indices as well. It produces about 55% winning trades. That makes for excellent returns since the profits can be quite large if a long trend ensues, and risk is limited to a fairly small amount as designed in the stop criteria outlined above. Momentum trading recommendations are made most frequently in our daily publication, The Daily Strategist, but are sometimes included in The Option Strategist as well. #

12 There is a risk of loss in all trading. Any time an option is sold uncovered; there is unlimited risk of loss. No representation is made that any strategies will produce profits. Data sources are believed to be reliable, but accuracy is not guaranteed. Please evaluate the markets before trading. Officers of - and/or Accounts managed by McMillan Analysis Corporation may hold positions in some of the securities recommended. http://www.optionstrategist.com

MAKING PUT SELLING DECISIONS Reprinted from The Option Strategist Newsletter Volume 21, No. 1.3.

This article will describe some of the methodology number. Expected return encompasses the volatility of that we use to select recommendations for this the underlying instrument as a major factor. newsletter. Several subscribers have asked questions However, it is only a theoretical number and is not regarding how we go about this, so we’ll attempt to really a projection of how this individual trade will answer them by describing the processes that we use do. Rather, expected return is the return one could to recommend naked puts. expect to make on a particular trade over a large number of trials. This is not to imply that our way is the only way. In fact, in some cases, other methods will be discussed For example, consider a fair die (i.e., one that is not as well. However, our methodology is at least logical “loaded”). There is an equal, one-sixth chance that and based on sound statistical/option theory. That any number will come up on a particular roll of the means it usually doesn’t involve “stock-picking,” die. But does that mean if I roll the die six times, I which is often a vague and nebulous activity. will get one once, two once, three once, etc.? No, of course not. But if I roll the fair die 6 million times; I For the most part, we choose our positions based on will likely have rolled very nearly 1 million ones, 1 data that is available on The Strategy Zone – the million twos, etc. subscriber area of our web site. One could do the same sort of analysis yourself, as a subscriber to “the We are applying this same sort of theory to position Zone.” On top of that, the Option Workbench analysis in the option market. There are some caveats, provides additional analytical capability for that data. though. One is that we assume a lognormal distribution of stock prices. Therefore, any event- Our computers do a lot of option theoretical analysis driven scenarios that might involve a large move by each night – from computer to analyzing the underlying stock are not lognormal in nature and which to buy to graphs of put-call ratios. their expected return should therefore be viewed The Zone was started about 10 years ago, when I cautiously or even ignored. Second, we must estimate decided to make the outputs of our nightly programs volatility during the life of the option position, and available to anyone who was interested in paying a that can be difficult to do as well. Third, if the modest amount of money to view them. These position involves options expiring at different times, analyses are still the basis for almost all of our we must make the assumption that we can estimate recommendations. the implied volatilities of unexpired options when the Expected Return near-term options expire. That is another difficult assumption. For those readers who are interested in Expected return is the crux of most of these analyses. the various effects that these variables have on the For those of you not familiar with the concept, I will potential analyses, I would suggest that you purchase explain it here. This is in line with our general theory the Expected Return Calculator software and that we want these articles to be self-contained, by experiment with the variable values. laying out definitions and background information; this is especially useful for new subscribers. A couple of examples should explain the concept. The first example is that of a simple call . Expected return is a logical way of analyzing diverse strategies, breaking them down to a single useful

13 There is a risk of loss in all trading. Any time an option is sold uncovered; there is unlimited risk of loss. No representation is made that any strategies will produce profits. Data sources are believed to be reliable, but accuracy is not guaranteed. Please evaluate the markets before trading. Officers of - and/or Accounts managed by McMillan Analysis Corporation may hold positions in some of the securities recommended. http://www.optionstrategist.com

Example 1: Bull Spread Assume that the investment for selling the naked put is the customer margin: 20% of the underlying price, Assume the following: plus the put price, less any out-of-the-money amount. XYZ: 52 Furthermore, I usually don’t use minimum margin in Oct 50 call: 7 these estimates, because that is too aggressive. So I Oct 60 call: 4 use 20% of the underlying, plus an in-the-money- amount, which is slightly higher than exchange In a full expected return analysis, the computer minimum. calculates the potential outcomes at each 0.01 move by the underlying stock, from a low of minus 3 But whatever method of calculating margin that you standard deviations to a high of plus 3 standard use, you must first calculate the margin requirement deviations. However, for the purposes of this at the stock price in question, and then multiply that example, let’s assume that XYZ stock must be at one calculation by the probability of being at the stock of these six points at expiration of the options. The price. Then sum those to obtain the expected following table shows the probability of being at that investment: price at expiration, in the second column. This is Stock Expected roughly a lognormal distribution. The third column Probability Invt Price Invt shows the option profits of the simple bull spread at 40 1% 1800 $18.00 October expiration. The fourth column, “Expected 42 2% 1640 32.4 Profit,” is the multiple of Probability and Profit. 44 4% 1480 59.2 46 5% 1320 66.0 Stock Expected Probability Profit 48 8% 1160 92.8 Price Profit >50 80% 1000 800.0 <50 45% -300 -$135 Total: 100% +$1068.4 52 8% -100 –8 54 7% +100 +7 So, the expected investment is $1068.40, even though 56 6% +300 +18 58 4% +500 +20 the initial margin requirement is only $600 (10% of >60 30% +700 +210 the underlying, which is the minimum that the exchange will allow under naked customer margin). Total: 100% +$112 The higher figure reflects the probabilities that the So, the expected profit is $112. The investment is stock could fall below 50 and thus cause large $300 for the bull spread, so the non-annualized problems for the option trader in terms of capital expected return is $112/$300 = +37.3%. If these required to hold the position. In reality, one would options had six months until expiration, then the probably stop himself out of the position before the annualized expected return would be +74.6%. stock fell to 40, but that is another matter and not part of this theoretical part of the analysis. Example 2: Naked Put Write Now we calculate the expected profit in a manner When naked options are involved, the investment is similar to that of the bull spread in Example 1 (see variable (because of the way naked option margin is next page). calculated), as well as the profit.

Assume: XYZ = 60 Sell the August 50 put naked for 1.50

14 There is a risk of loss in all trading. Any time an option is sold uncovered; there is unlimited risk of loss. No representation is made that any strategies will produce profits. Data sources are believed to be reliable, but accuracy is not guaranteed. Please evaluate the markets before trading. Officers of - and/or Accounts managed by McMillan Analysis Corporation may hold positions in some of the securities recommended. http://www.optionstrategist.com

Stock Expected be able to do better than mere random stock selection Probability Profit Price Profit or other such dull-minded activity. 40 1% -$850 -$8.50 42 2% -650 -13.00 As noted earlier, there are the problems of the 44 4% -450 -18.00 assumptions of volatility and distribution. There is 46 5% -250 -12.50 also the element of bad luck, or the “casino analogy,” 48 8% -50 -4.00 as it is sometimes called. That is, the casino has a >50 80% +150 120.00 huge overall edge in the gambling games that it offers Total: 100% 64.00 (larger in some games than others). However, even casinos lose money at gambling sometimes – even So the expected profit is $64, and the expected over a period as long as a month or a quarter. Why? investment is $1068.40. So the raw expected return Bad luck. It just proves once more that when is: probabilities are involved, there is no guarantee of profit, but it is certainly optimal to put the Expected return = Expected profit = 5.99% probabilities in your favor as often as possible. Expected investment Naked Put Selling If there are two months remaining until August expiration, then the annualized expected return is: Naked put selling and covered call writing are equivalent. But naked put selling is more efficient 5.99% * (12/2) = 35.9% because it involves only one commission and one bid- asked spread when establishing (as opposed to two to We could also compute a cash-based expected return. establish a covered write). Moreover, if the On a cash-based put sale, one’s investment is the maximum profit result occurs (i.e., if the stock is strike minus the initial put price, or $4,850 in this above the striking price of the written option at case. So the annualized expected return for cash expiration), there is nothing to do as far as the naked would be: put is concerned, whereas there is another stock sale $64 x (12.2) / $4850 = 7.9% commission if the stock is called away. Therefore our recommendations are almost always naked put One must understand that expected return is merely a writes.1 logical way of ranking potential investments and strategies. It can be used for any strategy, so it could Again, remember that this is the way that I approach help one decide, for example if a naked put write is these strategies. An individual investor may find that superior to a diagonal call calendar spread – or other some of the concepts I use are not in accordance with such exotic strategy. his own philosophy of trading (too risky, for example, or maybe not risky enough), so another approach Expected return is not a black box, predictor of the might be more apropos for a certain individual. return on this one trade. It is not a guarantee of profits. Rather it is merely the return that one could From here forward, when I say “expected return,” I expect to make on this position if he were able to mean expected return on margin. Unless I specifically invest in it many times over many years. The same investment won’t be available many times over many years, of course, but by consistently trading in 1 In this context, I am speaking of a covered write position positions with positive expected returns, one should established from scratch. There are different considerations when writing calls against stock that is already owned (“over- writing”).

15 There is a risk of loss in all trading. Any time an option is sold uncovered; there is unlimited risk of loss. No representation is made that any strategies will produce profits. Data sources are believed to be reliable, but accuracy is not guaranteed. Please evaluate the markets before trading. Officers of - and/or Accounts managed by McMillan Analysis Corporation may hold positions in some of the securities recommended. http://www.optionstrategist.com say “cash,” assume that I am talking about margin be on the list perennially – Sears (SHLD), for sales. example. We had a couple of losing trades in SHLD last year, and I am thus not eager to write puts there. For naked put selling, the first thing I look at is the file of the highest potential returns. These are Another useful piece of information is the Percentile determined strictly mathematically, using expected of Implied Volatility. That is listed in the data, and if return analysis. This list is going to necessarily have a it is low (below the 50th percentile), then I will likely lot of “dangerous” stocks listed as the best covered not write that particular put. Recall that expected writes. Typically, these would be biotech stocks or return needs a volatility estimate – and for these other event-driven small-cap stocks. naked put writes we use the current composite implied volatility. However, if there is the possibility Next, I reduce the size of the list. I have a program that volatility could increase a lot (i.e., if the current that screens out a subset of these, limiting the list to composite implied volatility is in a fairly low stocks in the S&P 500 Index only. Individual percentile), then there is a danger that actual stock investors might have other ways of screening the list. movements could be much more volatile than we If returns at the top of the list are “too good to be have projected. Hence that is not a naked put that I true,” then one can assume that either 1) there is a would want to write. volatile event on the horizon (meaning the lognormal I also look at the absolute price of the option. I distribution assumption is wrong), or 2) the volatility realize that is taken into account in the expected assumption used in the expected return analysis is return analysis, but I personally do not like writing wrong. Throw out any such items. These would naked options selling for only 20 cents or so, unless likely have annualized expected returns in excess of it’s on a very low-priced stock. 100% – an unrealistic number for a naked put write. However, weekly put sales might sometimes be in that The expiration date of the option is important to me range. Those would have to be looked at separately. as well. I would prefer to write one- or two-month In general, if the underlying stock is going to report options, because there is less time for something to go earnings during the week in question, the put sale wrong. Occasionally, if there is a special situation should probably be avoided. that I feel is overblown on the downside – perhaps something like Chesapeake Energy (CHK) today – I At this point, I select all the writes with annualized will look into writing longer-term options, but that is expected returns higher than 24% (my minimum fairly rare. return for writing puts on margin), and re-rank them by probability of profit. Once that is done, I select These further restrictions reduce the number of those with a probability of profit of 90% or higher, writing candidates down to a fairly manageable level. and re-rank them by annualized expected return. In At this point, it is necessary to look at the individual other words, I am still interested in high returns, but I charts of the stocks themselves. It’s not that I am want ones with plenty of downside protection. This trying to predict the stock price; I really don’t care screening process knocks out most of the list, usually what it does as long as it doesn’t plunge. as much as 90% of the initial put writing candidates. Consequently, I would not be interested in writing a put on a stock, if that stock is in a steep downtrend. From there the analysis becomes more tedious, for at More likely, the chart can show where any previous this point it is necessary to look at the individual declines have bottomed. I would prefer to see a stocks and options to see if there is something unusual support level on the chart, at a price higher than the or especially risky taking place. Some stocks seem to

16 There is a risk of loss in all trading. Any time an option is sold uncovered; there is unlimited risk of loss. No representation is made that any strategies will produce profits. Data sources are believed to be reliable, but accuracy is not guaranteed. Please evaluate the markets before trading. Officers of - and/or Accounts managed by McMillan Analysis Corporation may hold positions in some of the securities recommended. http://www.optionstrategist.com striking price that I am considering writing. This last want to write a put with a strike within that range. criterion knocks out a lot of the remaining candidates. However, very often one can write a put well below that range and still get a very acceptable expected Some may say that the stock chart is irrelevant, if the return. Frankly, I can only remember two of our statistical and other criteria are met. That’s probably naked put writes being stopped out because of post- true, but if I have my choice of one that has chart earnings stock movement (APOL in Oct, 2010, and support above the strike and one that doesn’t, I am HPQ in March, 2011). There certainly haven’t been going with the one that does every time. many.

The potential put selling candidates that remain at this Invariably, if our put writes lose money, it’s because point are generally few, and are the best writing the entire stock market has become more volatile, and candidates. But I will always check the news the stock gets caught in a general decline (Oct 2008, regarding any potential write, just to see if there is May 2010, August 2011). something that I should know. By “news,” I mean earnings dates, any potential FDA hearing dates, I realize that many put sellers (or covered call writers) ongoing lawsuits, etc. use a different method: they pick a stock they “like” first, and then try to find an option to write. By this The reason that this news check is necessary is that “fundamental” approach, one is probably writing an these puts are statistically expensive for some reason. option that has a very low expected return – a la the I’d like to know what that reason is, if possible. The calls on almost every “dividend stock” in the current previous screens will probably have weeded out any market. They compensate for this by writing the call FDA hearing candidates, for their puts are so out of the money, so that they will have some profit if dramatically expensive that they would have alarm- the stock rises and gets called away. raising, overly high expected returns. To me, that is completely the wrong way to go about But what about earnings? Studies show that the it. If you like the stock, why not buy it and buy a put, options on most stocks increase in implied volatility so you have upside profit potential? What is the right before the earnings. In general this increase is obsession with writing a covered call? modest – a 10% rise in implieds, or so. But sometimes the rise is much more dramatic. Those Rather than that “fundamental” or “gut” approach, the more dramatic situations often show up on volatility use of expected return as a guide to the position skew lists and are used as dual calendar spreads in makes this a “total return” proposition – where we are earnings-driven strategies. But as far as naked put not overly concerned with (upward) stock movement, writing goes, if the expected return on the put is but rather more concerned with the combination of extraordinary, then that is a warning flag. option premium, stock volatility, rate of return, and probability of winning. To me, that is the correct Just because earnings are going to be announced approach. # during the life of the put you are considering writing, doesn’t mean you shouldn’t write the put. As you know, the straddle price of the options expiring just after the earnings, is the option market’s best guess at how far the stock is going to move. One could also check to see how far the stock has moved on earnings in the past, for a second opinion on how far the stock might move on the earnings. One certainly wouldn’t

17 There is a risk of loss in all trading. Any time an option is sold uncovered; there is unlimited risk of loss. No representation is made that any strategies will produce profits. Data sources are believed to be reliable, but accuracy is not guaranteed. Please evaluate the markets before trading. Officers of - and/or Accounts managed by McMillan Analysis Corporation may hold positions in some of the securities recommended. http://www.optionstrategist.com