 then  trade  in  theopposite direction because the major turning points generally turn out tobe the most proﬁtable trading opportunities.
Table  17.1  lists  key  contrary  indicators  and  other  technical  tradingtools.  The  rightmost  column  shows  how  each  indicator  can  be  used  bymarket technicians to keep up with changing market trends.
The market is always going to bounce around, and this constant ﬂuctua-tion may indicate that there’s never an exactly right time to enter a trade, butthere will always be a time that’s better than another. Professional traders
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TABLE 17.1 Key Contrary Indicators
Indicator
Type
Trend
Usage
Conﬁdence index
Sentiment
Parallel
Sentiment Contrary
Index rises as investors shift from high-grade to lower-grade bonds with bullish expectations.
Excessive adviser bearishness (60 percent) signals bottoms; optimism (10 percent bearish) signals tops.
Advisersentiment
Put/callratio
Odd-lottrading
Specialisttrading
Money-fundbalances
Mutual-fundliquid assetsratio
Sentiment Contrary
Excessive puts (70/100) or calls (40/100) signal bottoms or tops early.
Sentiment
Parallel
Odd-lot investors step up their buying at bottoms and sell into market tops.
Sentiment
Parallel
Cash ﬂow Contrary
Cash ﬂow Contrary
Specialists buy and sell ahead of the trend, using nonpublic information.
Rising balances draw money from shares; declining balances are bullish.
Cash balances rise as the trend nears abottom, when increased buying power exerts a bullish effect.
Customer credit Cash ﬂow Contrarybalances
Cash balances rise or fall as the marketbottoms or peaks.
Customer margin debt
Shortinterest
Short interestratio
Odd-lotshort sales
Specialist short-sale ratio
Up/down volume
Cash ﬂow Parallel
Margin buyers are half as much in debt at tops as at bottoms.
Short sale Contrary
Increased short selling fuels rallies, and at extremes signals trend turning points.
Short sale Contrary
Ratios of short interest to average dailytrading volume above 1.75 are bullish; ratios under 1.0 are bearish for the market.
Short sale Contrary Odd-lot short sellers are wildly 
Short sale
Parallel
speculative in the wrong direction.
Ratios of specialist short sales to public short sales above 3.5 percent are bearish; ratios below 1.8 percent are bullish.
Breadth
Parallel
Daily volume change of 90 percent or more signal trend reversal.
(continues)
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TABLE 17.1 (Continued)
Indicator
Type
Trend
Usage
OTC relativevolume
Advance/decline line
TRIN (short-term trading or ARMS index)
Market P/Eratio
Breadth
Contrary
Breadth
Parallel
Breadth
Parallel
Breadth
Contrary
DJIA dividendyield
Breadth
Contrary
OTC volume breakouts above 80 percent provide bearish signals of excessive speculation.
The broad market peaks and bottoms ahead of the indexes; divergence signals turning points.
Measures average volume of advancersrelative to decliners; readings above 1.5 are bullish, below 0.7 are bearish.
Price-earnings ratios of 5 and 25 are approximate lower and upper trend boundaries.
DJIA yield gets as low as 3 percent at  market tops and as high as 18 percent at bottoms.
use timing and technical indicators to secure the best moment of entry andexit. They take advantage of the market’s swings rather than letting volatil-ity take advantage of them. That’s why it is so important to learn how touse  timing  indicators—to  put  the  odds  in  your  favor  and  dollars  in  yourtrading account.
OPTIONS AND THEIR BUILT-IN SENTIMENT INDICATORS
The utilization of sentiment indicators has been common in the stock, fu-tures, and options market for a long time. However, the difference for theoptions market is that it inherently possesses its own sentiment indicatorsand does not have to look outside to gauge or measure investor feelings.The inherent sentiment indicators I am referring to come in the form ofimplied  volatility,  option  trading  volume,  option  open  interest,  andput/call  ratios.  All  of  these  reveal  important  sentiment  type  informationabout the markets.
First,  implied  volatility  is  a  calibration  of  a  stock’s  volatility  as  im-plied by the current price of the option. Many times it is referred to asthe fear factor as it gauges the level of concern investors might have inthe markets at a particular time. An option’s implied volatility is an ap-proximation of the underlying equity’s volatility in the future. Estimating
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the level required to arrive at the option’s current value gives us impliedvolatility.
To determine whether implied volatility is exhibiting investor fear orcomplacency, we compare it against its historical volatility levels. Histori-cal volatility, also known as statistical volatility, gauges a stock’s volatilitybased on the equity’s past price action. Historical volatility is constructedusing the standard deviation of a stock’s price changes from close-to-closeof trading for a speciﬁed time period.
If an option’s implied volatility is greater than the statistical volatility,the option is considered expensive or overvalued. The type of sentimentreading would indicate to the option strategist that they should considerselling  options.  If  an  option’s  implied  volatility  is  less  than  historicalvolatility then the option is considered cheap or undervalued. In this sce-nario, the options trader would pursue a strategy where he or she wouldbuy options. This comparison is necessary because just relying on impliedvolatility alone doesn’t really provide you with enough information.
Additionally, there are two other perplexing ways to use options forascertaining investor sentiment: option trading volume and open interest.Option  trading  volume  is  the  amount  of  option  contracts  traded  in  oneday recorded at the market close. The interpretation is based on the ideathat put purchasing is bearish and buying calls is bullish. Put volume di-vided by call volume determines if a speciﬁc market has a bullish or bear-ish sentiment.
Option  open  interest  is  the  number  of  outstanding  contracts  thatare  available  on  a  speciﬁc  option  series.  Monitoring  the  open  intereststatistics of an option allows an investor to judge the relative demandof an option. An increase in an option’s open interest means there areadditional purchasers for that option. On the other hand, a reduction inthe open interest of an option indicates fewer buyers and more sellersthan previously. Just as with option volume comparing the put option’sopen interest with the call option’s open interest generally indicates theunderlying equity’s bullish or bearish bias.
Finally, you can look at how bearish or bullish a particular market isby monitoring the ratio between put premiums and call premiums. This isby  far  the  most  popular  option  sentiment  tool  of  the  mix.  In  general,  ifthere is a lot of put buying compared to call buying the premium on putswill  be  higher,  which  signals  a  bearish  environment.  Conversely,  if  callbuying  exceeds  put  buying,  this  increased  demand  pushes  call  priceshigher signaling a bullish sentiment.
These inherent sentiment indicators are yet another illustration ofthe  amazing  ﬂexibility  of  an  option.  One  thing  to  note  though  beforeemploying the indicators as deﬁnite buy and sell signals: Sometimes anupsurge in open interest can be attributed to a large institution hedging
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a  position.  As  with  any  technical  tool,  look  to  get  conﬁrmation  from one  or  two  additional  indicators  before  locking  yourself  into  a  direc-tional bias.
VIX AND VXN
The Chicago Board Options Exchange created the CBOE Volatility Index,or VIX, in 1986. VIX has become the number one gauge of market volatilityavailable today. Computed throughout the trading day, it is unique in thatit  offers  up-to-the-minute  or  real-time  information  regarding  marketvolatility. Therefore, there are no cumbersome calculations and the infor-mation is available at the click of the mouse. (For example, go to the Op-tionetics.com home page and enter $VIX in the quote box.)
VIX  gives  up-to-the-minute  readings  of  market  volatility.  At  thesame time, it is not a gauge of actual volatility, but a measure of impliedvolatility. Implied volatility is derived using an option valuation model.In the case of VIX, the options are on the S&P 500, or SPX index, whichis  an  index  of  500  large  companies  with  stocks  trading  on  the  U.S. exchanges.  Therefore,  VIX  represents  the  market  consensus  view  re-garding  the  future  volatility  of  500  of  the  largest  and  most  activelytraded stocks.
So, as VIX measures the implied volatility of SPX options, it will beginto rise when traders expect volatility to increase. During times of uncer-tainty and market turmoil, VIX will move higher to reﬂect expectations re-garding future volatility going forward. For that reason, it is often referredto as the “fear gauge.” However, during times of relative tranquility in theU.S.  stock  market,  VIX  will  move  lower  to  reﬂect  investor  expectationsthat market volatility will remain low.
The chart shown in Figure 17.1 details the performance of VIX from1999 to early 2004. During the ﬁfth year, beginning in March 2003, the mar-ket  performed  well  and  stocks  moved  broadly  higher.  During  that  time,the CBOE Volatility Index edged lower. In fact, VIX fell to seven-year lowsof 14.3 percent in early 2004. There was no fear reﬂected in the market’s“fear gauge.”
Another  interesting  aspect  of  the  chart  is  the  periodic  spikes  in  thevolatility index. This happens during periods of panic in the market. Forinstance,  shortly  after  its  inception,  during  the  market  crash  in  October1987,  VIX  hit  a  record  high  of  173  percent,  which  has  never  been  sur-passed. In the mini-crash of 1989 after the problems associated with UALand its restructuring, VIX spiked again. In 1990, when Iraq invaded Kuwaitand the United States became embroiled in a war in the Middle East, the
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CBOE Market Volatilty Index
Weekly 2.17.2004
52
48
44
40
35
32
28
24
20
18
12
©2004 Pinnacor Inc.
1999 
2000 
2001 
2002 
2003
FIGURE 17.1 CBOE Market Volatility Index or VIX (Source: Optionetics © 2004)
volatility index spiked twice: once when Iraq moved into Kuwait in 1990and again in 1991 after the United Nations attacked Iraq.
More  recently,  in  October  1997,  investors  were  spooked  when  theDow Jones Industrial Average tumbled 555 points. VIX jumped to 55.5 per-cent. In the fall of 1998, as the impact of the global ﬁnancial crisis was be-ginning to shake U.S. markets, market anxiety once again picked up. Thevolatility index soared above 65 percent in October 1998. On the chart, wecan  see  VIX  spiking  again  in  September  2001  when  the  terrorist  attacksrocked the ﬁnancial center on Wall Street. Since that time, VIX has tradedbelow 50 percent.
In  response  to  the  growing  interest  in  Nasdaq  100  options,  theChicago Board Options Exchange launched an implied volatility indicatoron  the  Nasdaq  100  Index  in  January  2001.  Known  by  its  ticker  symbol,VXN, the new implied volatility indicator was created to track the impliedvolatility of the popular NDX options contract. Like VIX, it is updated con-tinually throughout the trading day.
In addition, traders can also plot the index’s long-term movement inorder to identify the extremes. As we can see from Figure 17.2, VXN has
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CBOE NasdaqMkt Volatilty Idx
Weekly 2.17.2004
80
70
60
50
40
30
2001 Feb Apr            Jul            Oct 
2002 Jan 
Apr 
Jul 
Oct 
2003 Jan 
Apr 
Jul 
Oct 
2004Jan
20
©2004 Pinnacor Inc.
FIGURE 17.2 CBOE Nasdaq Volatility Index or VXN (Source:Optionetics © 2004)
been in a long-term decline since its inception. However, there are timeswhen  it  spikes  higher,  like  in  September  2001  and  July  2002.  A  movehigher in the Nasdaq volatility index tells us that the implied volatility ofNasdaq 100 Index options is on the rise. Therefore, traders are expectingmarket volatility to increase going forward, which generally occurs wheninvestor anxiety levels and fear are on the rise.
Using VIX and VXN as sentiment indicators requires a bit of contrarythinking.  An  adage  among  options  traders  says,  “When  VIX  is  high,  it’stime to buy. When VIX is low, it’s time to go.” This tells us that when VIX ishigh, it is time to buy into the stock market with long strategies such asbull  call  spreads  or  other  bullish  strategies.  During  these  times,  marketanxiety  levels  and  pessimism  are  high.  In  that  case,  investors,  or  thecrowd,  have  probably  overreacted  and  driven  stock  prices  to  bargainbasement levels. When VIX is low, it is time to go, or get out of the market.During those times, investors are probably complacent or too bullish onthe  stock  market.  So  the  contrarian  thinker  will  get  out  of  bullish  posi-tions, or even set up some bearish trades.
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A NOTE ON BEING A CONTRARIAN
Taking  action  contrary  to  the  crowd  will  always  feel  uncomfortable.  Atthe actual time you must decide and act, you will never have all the infor-mation you’ll want because gauging market psychology is more of an artthan  a  precise  science.  Furthermore,  your  countertrend  decision  willmake you feel lonely, and we humans are social animals who seek com-fort and approval from others. Always remain tight-lipped about your in-vestment  moves.  If  you’re  a  talking  contrarian,  people  hearing  of  yourviews and behavior will exert immense pressure and may convince you toabandon your thinking at precisely the wrong times.
Successful  trading,  contrarian-style,  requires  observation,  under-standing, and, ﬁnally, action. First, you must see facts: events, trends, andrates of growth or decline. It is imperative that the contrarian trader de-velops a sense of history, an ability to put things together in context, and agood feel for when a trend is moving to an extreme. But even all that willdo you no good if you don’t take  action. Acting is usually the most difﬁ-cult skill to master.
Being  a  contrarian  requires  that  you  identify  the  market’s  situation,whether that be broad averages or the market of opinion. The factual andemotional  states  of  the  economy  and  the  market  can  be  observed  at  anytime.  Successful  investment  behavior  requires  patience  so  that  you  don’tpull the trigger at the very ﬁrst observation of important elements; you needto wait for an accumulation of evidence that an extreme is developing.
Trying to play contrarian on a short-term basis creates what is knownon the street as whipsawed traders. Given that the public is usually rightduring the trends but wrong at both ends, we should not get impatient atthe ﬁrst sign of extreme behavior in others. Let a trend run for a while andwatch the evidence accumulate.
This approach can be proﬁtable due to the bipolar nature of marketdynamics. The trick is to recognize a market’s turning points by monitor-ing  psychological  market  indicators  to  assess  your  next  move  and  thentrade  with  or  against  the  majority’s  view  of  the  market.  One  indicatoralone, like VIX, will not necessarily help you time the turning points. To in-vest contrary to the crowd, you need to consider a broad range of indica-tors, the big picture, and sometimes exercise a great deal of patience.
NONANALYTICAL METHODS
There are many other ways to ﬁnd a good investment. However, the twomost common are probably the most unreliable. It is important that youuse discretion as you make investment decisions.
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Reliance on Others
The biggest mistake most people make in the ﬁeld of investing is relying onothers. This includes consulting brokers, listening to friends, receiving tips,or  even  calling  psychic  hotlines.  Professional  money  managers  (mutualfund managers) also must be selected with care. Be careful whom you lis-ten to. You are the only person who is ultimately responsible for your ownproﬁtability. Make a strong commitment to relying on your own initiative.
Religious Experience
From  long  observation,  it  seems  to  me  that  prayer  is  truly  the  methodmost often used by traders and investors. Most traders and investors dovery little analysis and have no idea as to what is going on; still they goahead and trade. Then, they just pray that they will be right. Even whentheir  initial  position  goes  against  them,  they  just  stay  in  the  bad  tradepraying the market will come back. They continue to pray until they can’ttake the loss anymore or they lose all their money.
Nick  Leeson,  the  trader  who  allegedly  lost  $1  billion  for  BaringsBank—a loss that brought down the 200-year-old institution—got himselfinto a bad position and kept adding to that bad position praying that themarket would indeed turn around and make him right. It never happened.Seize the day!
CREATING A TRADING FILTER
After years of investing and trading, I came to the realization that to be-come good at this business I had to keep my eyes and ears open. I then setmyself up to be able to accept both visual and audio information and to ﬁl-ter out useless information. Peter Lynch, former manager of the FidelityMagellan mutual fund, is one of the best money managers of our time. Inhis books, he clearly states this principle of accepting all available infor-mation.  Although  the  Magellan  Fund,  like  many  other  funds,  focuses  onlonger-term investments, the principles stated in Peter Lynch’s books—aswell  as  books  by  other  great  investors—can  also  be  applied  on  a  short-term trading basis. I focus my attention on these principles of “intelligentinvesting” to get both the long-term and short-term perspectives.
Many  investors  may  be  satisﬁed  with  a  10  percent  return  on  theirmoney compared to 4 percent interest for a certiﬁcate of deposit. I preferto work a little harder in order to get a much higher percentage return. Af-ter all, this is the business I choose to be in. I want my trades and invest-ments to make me a very good living no matter how much money I started
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with. Remember, the only way to build your account up quickly is to spotthe consistently proﬁtable opportunities and to use your money efﬁciently.Most investors and traders have very little idea how to ﬁnd explosiveopportunities.  It’s  not  that  they’re  not  smart  enough.  It’s  just  that  theyhaven’t been made aware of the effectiveness of these techniques. Duringeach trading day, I can work as little as ﬁve minutes and still make moremoney (with a much higher return) than investors who work all day. Thisis not to say that I spend only ﬁve minutes a day trading. I enjoy this busi-ness way too much. In fact, I don’t even see what I do as work. I am some-times even a little disappointed when the trading day is over. Believe it ornot, weekends can be my most difﬁcult periods.
However,  explosive  opportunities  can  be  found  every  day.  To  gaintrue  opportunity  insight,  open  yourself  up  to  receive  information  fromthe perspective of a trader. Don’t let important information slip throughyour  ﬁngers  as  many  people  do.  Filtering  information  correctly  can  bethe  key  to  making  money.  Years  of  experience  have  shown  me  that  themega-successful  investors  are  unique  individuals  who  have  developedapproaches to ﬁnding opportunities others may be missing. Let’s take acloser look at where these chances to make a very high return on yourmoney in the short term—minutes, hours, or days—can be found.
Remember That Stocks Follow Bonds
If  you  keep  your  eyes  on  how  interest  rates  are  moving,  you  can  deter-mine where shares are likely to go. When interest rates are going up, bondprices are going down and shares will likely go down also. Conversely, ifinterest  rates  are  decreasing,  then  bond  prices  are  rising  and  sharesshould  also  be  rising.  If  interest  rates  are  stable,  shares  will  have  a  ten-dency to go up. You can use these insights to create consistent proﬁts inyour  account.  However,  there  are  points  in  time  when  this  relationshipdoes  not  hold.  When  this  occurs,  take  the  time  to  discern  what  has  af-fected  this  relationship.  For  example,  in  1998  turmoil  broke  out  in  theAsian markets which changed this relationship. Foreign investors boughtbonds, which increased the price of bonds and lowered yields while thestock market moved downward.
Stay Informed on Seasonal and Event-Driven Markets
Event-driven  markets  are  exactly  that:  markets  that  are  driven  byevents—seasonal,  political,  or  otherwise.  For  instance,  the  energy  mar-kets  are  seriously  affected  not  only  by  war  in  the  Middle  East,  but  byscheduled meetings of the Organization of Petroleum Exporting Countries
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(OPEC).  The  agriculturals  are  directly  impacted  by  seasonal  weatherchanges. Bonds are tied to changes in interest rates and the monthly re-lease of the government’s unemployment report. In essence, look for mar-kets that have an event that triggers a speciﬁc trade strategy once or twicea month, or maybe once every three months.
To  keep  up  with  these  important  market  factors,  you  must  keepabreast of daily news by watching television and reading mainstream andalternative newspapers and magazines in hard copy and on the Internet. Itcan  also  be  important  to  listen  to  what  key  people  in  speciﬁc  marketshave to say. Typically, you need to come home from work and study whatthe markets are doing from many angles. In the beginning, it can be em-powering to keep a journal of daily events and their effect on various mar-kets you are actively watching. If a market’s going to move, then it’s morelikely that you can make money from it. By studying the daily reactions ofspeciﬁc markets to events, you can begin to forecast which strategy canbe used to make the largest potential proﬁt.
Always  keep  an  eye  on  markets  that  are  dependent  on  the  weather(oil, soybeans, wheat, etc.). See how they are reacting to seasonal factors.The tougher the winter, the higher the price of heating oil. The longer thedrought, the higher the price of soybeans. All of this information can beused to ﬁnd highly proﬁtable trades.
Walk around Retail Stores
You  can  even  make  money  while  you  are  spending  it.  Just  open  youreyes and ears when you are shopping and see if you can spot an inter-esting investment.
• Find out what products are hot.• Notice which products have the most store shelf exposure.• Ask a clerk which products are literally ﬂying off the shelf.
On a shopping trip to a local toy store at Christmastime, I noticed thatnot only was the store ﬁlled to capacity, but people were ﬁghting over thelast items of one obviously hot product. Instead of jumping into the battleto ﬁght for a toy, I picked up a box to ﬁnd out the manufacturer. In addi-tion, I asked a clerk at the store about the frenzy over this one product.She stated that this was almost a daily occurrence and then told me abouta number of other items that were also ﬂying off the shelf.
This is not to say that everyone will be this helpful, but I was able tospot  some  particular  potential  investment  opportunities  by  just  askingquestions  of  a  store  clerk.  I  then  called  my  broker  and  investigated
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whether these particular companies were doing well. The next time youare shopping, take a look around and see if you can spot hot products orhot companies.
Look for Opportunities When Driving
Even  when  you’re  driving  your  car,  you  can  spot  opportunities.  Onceagain, all you have to do is keep your eyes and ears open. For example, afew years ago I found a new restaurant—at least it was new when I foundit—by the name of Boston Chicken. I ﬁrst visited the place because I washungry. However, when I saw the food and tasted the meals, I realized thatthis was a different kind of fast-food restaurant. I was given large portionsof  delicious  food  at  a  good  price.  I  was  not  only  satisﬁed  with  the  foodquality, but I felt that I got a good deal as to price and quantity as well. I re-turned on several occasions with others and everyone had the same im-pression.  In  addition,  the  counters  displayed  information  on  franchiseopportunities. Although I was not interested in becoming a franchisee, itwas  clear  this  concept  had  to  take  off.  Sure  enough,  these  restaurantsstarted popping up all over Boston, and the list of franchises exploded na-tionwide. When the company went public, I knew I had to get in on this.The company’s public offering was a smash success. Now the company isknown as Boston Market with stores all over the country and entrées insupermarkets as well.
When driving, always look for trends. Years ago I spotted a number ofcars  and  trucks  that  had  some  interesting  designs.  It  surprised  me  thatthey were Dodge products—I had never been a big fan of Dodge or anyU.S. manufacturer’s automobiles. However, I kept seeing television com-mercials about the “new Dodge.” Well, I knew the old Dodge was not veryexciting; but as a car fan—I love sports cars—I kept reading about theirnewest “super car,” the Dodge Viper.
Luckily for me, a friend ended up buying one and I had the privilegeof  driving  the  Viper  in