are a number of web sites, includ-ing EDGAR Online, that will give you access to a ﬁrm’s 10-K statement andother ﬁnancial information. Libraries also carry many other sources ofﬁnancial data on a ﬁrm.
One ﬁnal bit of housekeeping: Which is better, a 10-K or an annual re-port?  A  10-K  is  a  ﬁnancial  statement  required  by  the  Securities  and  Ex-change  Commission  to  be  ﬁled  with  the  SEC  by  every  publicly  tradedcompany on an annual basis. The report is a comprehensive look at the ﬁ-nancial dealings of the ﬁrm throughout the year. The difference betweenthe 10-K and the annual report is that the 10-K requires all ﬁrms to ﬁle cer-tain detailed information and to list it in a speciﬁc order. The annual re-port will often include the 10-K, but even if it doesn’t, it has basically allthe information required in the 10-K, and sometimes with even more de-tail. Personally, I prefer an annual report because I like to look at all thephotos of smiling employees and happy customers, as well as the manage-ment discussions that usually accompany the dry numbers.
Okay, say you have an annual report in front of you. Where do you start?The ﬁrst thing you should realize is that there are no absolutes in ﬁnancial
ccc_fontanills_ch17_415-452.qxd    12/17/04    4:43  PM    Page  418
418
THE OPTIONS COURSE
statements. Unlike the basic laws of physics, what you see is not necessarilywhat you get; and everything is always open to interpretation. What we willbe concerned with is not necessarily in coming to a conclusion on a particu-lar annual report, but rather to point out the pitfalls and areas to be aware ofwhen you start to analyze a statement.
Remember: First, foremost, and always, an annual report is often asales  pitch—management  pays  for  the  annual  report,  and  they  will  beputting their best foot forward in the presentation. Therefore, don’t letsubjective  statements  sway  your  opinion  of  the  company  too  much.Most  fundamental  analysts  dig  deeper  inside  the  report  and  study  theactual numbers.
Some  traders  overlook  fundamental  analysis.  However,  as  mosttrades  are  not  totally  neutral  (in  other  words  you  have  a  bias  as  towhether you would prefer the shares to go up or down), studying the fun-damentals of a ﬁrm should at least help you to be in front of the trend. Ifyou are looking at a strong company in a strong industry, you should thinktwice before putting a bearish trade on that stock and vice versa. This isespecially true for longer-term trades.
There  are  three  important  factors  to  consider  when  studying  the  in-come  statement  and  also  three  from  the  balance  sheet.  On  the  incomestatement, you want to look at sales, gross proﬁt (or operating income),and net income. From the balance sheet, you need current assets, currentliabilities, and total assets. In addition to these six numbers, the curiousinvestor will have to do a couple of divisions to glean about 80 percent ofthe information available.
Sales  are  good.  They  are  necessary  to  generate  income,  so  more  isgenerally better than less. In addition to the raw number, most investorsdivide this year’s sales by last year’s sales to look at the rate of growth. In-creasing  growth  is  generally  better  than  decreasing  growth,  providingeach sale is generating more revenue than it costs to produce it.
To determine if a ﬁrm is generating proﬁtable sales, we use the secondnumber from the income statement, the gross proﬁt. Dividing gross proﬁtby sales gives the gross proﬁt margin, a number that describes what per-cent of each sales dollar is available (after the direct costs of producingthat sale) to pay for overhead, debt repayment, taxes, and, of course, divi-dends.  Larger  is  better.  A  gross  proﬁt  margin  that  is  deteriorating  fromprior years is generally not so good. It may not be a problem, but a deteri-orating  number  should  raise  a  red  ﬂag  so  that  your  antennae  are  tunedinto looking for the reasons when you read articles about that company.The reasons for a deteriorating gross proﬁt margin can come from manythings. Raw material and employee costs can escalate faster than the ﬁrmis  able  to  raise  prices;  this  is  typically  not  a  very  good  situation.  On  theother  hand,  the  ﬁrm  could  simply  be  changing  its  sales  mix  (selling  a
ccc_fontanills_ch17_415-452.qxd    12/17/04    4:43  PM    Page  419
How to Spot Explosive Opportunities
419
larger percentage of low-margin products) or be going after sales that areless  proﬁtable  (possibly  large  orders  with  associated  discounts,  etc.),which could be a good strategy. The idea, here, is for the investor to sim-ply be aware that there is something happening.
Finally, the net proﬁt line on the income statement is important. As abullish  investor,  you  want  to  see  this  number  positive  and  increasing.  Ifyou  are  looking  for  a  bearish  position,  negative  and  decreasing  is  yourideal.  However,  remember  that  net  proﬁt  is  a  result  of  many  things,  notjust  the  operations  of  the  company.  From  your  perusal  of  the  footnotesand the auditor’s letter, you should be able to judge just how much conﬁ-dence you can place on this particular number.
While  the  income  statement  gives  us  a  picture  of  just  how  well  theﬁrm prospered over the past year, the balance sheet gives us a glimpse asto how conservative the ﬁrm is with its assets and how efﬁciently it is us-ing them. Current assets and current liabilities are deﬁned as those assetsand liabilities that either are or will, in the normal course of business, beturned into cash over the next 12 months. Thus, receivables will be col-lected, inventory will be sold, prepaid expenses will be utilized (et cetera)in the upcoming year. Similarly, all accounts will be paid, notes and loanswill  be  paid,  and  unpaid  taxes  will,  by  deﬁnition,  be  paid  during  the  up-coming  year.  Thus,  if  current  assets  are  greater  than  current  liabilities,there should be no trouble (barring some unforeseen circumstance) meet-ing all obligations with cash collected from various accounts, even if thereare temporary glitches in sales, collections, or production. Obviously, thelarger the difference in those two numbers (current assets and current lia-bilities), the better.
The ﬁnal number that we are concerned with on the balance sheet istotal assets. By dividing “net income” by “total assets,” we get return onassets (ROA). This is a measure of just how efﬁcient management is in uti-lizing the assets at its disposal. This is a more accurate measure of man-agement efﬁciency than is the return on equity (ROE) that many investorsutilize.  ROE  is  a  direct  result  of  ROA,  adjusted  for  the  amount  of  debtmanagement  has  assumed.  By  simply  borrowing  more  money,  manage-ment can usually increase the ROE without doing anything better opera-tionally. In fact, the total proﬁt will decrease, as additional funds will beneeded to pay the interest costs of the new debt. If carried to the extreme,or if the ﬁrm hits a patch of trouble, the increased leverage of the addi-tional debt will become critical.
The  standard  income  statement  is  generally  constructed  utilizingwhat  is  called  “accrual  basis  accounting.”  In  layman’s  terms,  this  meansthat management chooses when a sale is ﬁnal and then records it, regard-less of when the ﬁrm actually receives cash for that good or service. Thisgives  rise  to  the  balance  sheet  account  called  “accounts  receivable,”  or
ccc_fontanills_ch17_415-452.qxd    12/17/04    4:43  PM    Page  420
420
THE OPTIONS COURSE
the amount of money owed the ﬁrm by its customers for goods and ser-vices delivered but not yet paid for. To fairly represent the true proﬁtabil-ity  of  the  ﬁrm,  the  costs  of  those  raw  materials  used  in  the  productsdelivered are then listed on the income statement as a cost, regardless ofwhen they are paid for. Similarly, assets such as buildings and equipmentare  depreciated,  or  expensed  a  little  bit  each  year  as  management  feelsthey are used up, again regardless of when they are actually paid for.
The statement of cash ﬂows, then, is the vehicle that converts accrualaccounting back to a cash basis, and hence is far more critical than mostinvestors give it credit for being. If the ﬁrm cannot generate enough cashfrom its operations to pay for those operations, it will never be able to payfor new investments needed for continuing operations nor be able to re-pay  debt  previously  borrowed  nor  pay  dividends  to  shareholders.  Thus,the “net cash provided by operating activities” should always be positive(if the company is going to prosper), and the second major category (in-vesting  activities)  should  not  always  be  negative.  A  negative  number  inthis category is ﬁne if the ﬁrm is doing major expansions, but it should, af-ter a few years, turn positive. Finally, a glance at the ﬁnancing activitiessection should clue you in on how the ﬁrm is paying for all the cash needsit has. Is it raising cash through debt (adding risk) or through the sale ofmore equity (diluting the shareholder’s position)? Or, as one would hopein a mature company, is it repaying past borrowings?
The ﬁnal section of numbers that the trader should look at is the “Rec-onciliation of Retained Earnings.” This statement is a detailed look at thedepreciation and other noncash adjustments that resulted in the ﬁnal bal-ance  of  the  shareholders’  equity  account  on  the  balance  sheet.  This  ac-count  lists  extraordinary  items  that  have  taken  place  during  theaccounting period as well as adjustments to prior years’ statements thatdo not directly ﬂow through the income statement or any of the other bal-ance sheet accounts. This statement should tie in with your investigationof the footnotes. While you are not looking for anything speciﬁc, strangeentries should raise questions.
Again, there is no right or wrong answer to any of these particular cat-egories. You are just trying to get a feel for the general health of the ﬁrm. Iftoo many of the numbers turn up negative, then you should recognize thatthis ﬁrm is not a slam-dunk gold-plated investment, and appropriate pre-cautions must be taken in your trading efforts.
Entire industries are built around fundamental analysis. Every majorbrokerage  ﬁrm  has  armies  of  analysts  to  review  industries,  companies,and commodities markets. The majority of what you see and hear on tele-vision or read in the newspapers is fundamental analysis.
Fundamental analysis comes in many shapes and forms. For example,you may hear that a company’s product is selling like hotcakes, or perhaps
ccc_fontanills_ch17_415-452.qxd    12/17/04    4:43  PM    Page  421
How to Spot Explosive Opportunities
421
there has been a management change. Maybe the weather is killing the or-ange  juice  crop.  It’s  up  to  you  to  learn  how  to  apply  this  information  tomaking money in the markets. Typically, I don’t listen to others, becausetoo often they are wrong. On the other hand, I love to ﬁnd opportunities todo  the  opposite  of  everyone  else.  This  is  known  as  the  contrarian  ap-proach—when all the information is too positive, look for an opportunityto sell, and when it is too negative, look for an opportunity to buy. Moral ofthe story: Listen to the market. It will tell you a great deal. Use a discerningear when listening to anyone else.
TECHNICAL ANALYSIS
Technical analysis evaluates securities by analyzing statistics generatedfrom  market  activity,  such  as  past  prices  and  volume,  to  gauge  theforces of supply and demand. Furthermore, technical analysis is built inpart  on  the  theory  that  prices  display  repetitive  patterns.  These  pat-terns  can  be  utilized  to  forecast  future  price  movement  and  potentialproﬁt opportunities.
Technical analysts study the markets using graphs and charts to deter-mine  price  trends  and  gauge  the  strength  or  weakness  of  an  investment(stock, futures, index, etc.). The technical analyst is trying to understandthe past price trends of the stock or commodity in order to try to deter-mine price patterns that will forecast future price movements. The type ofanalysts  that  use  this  method  of  predicting  stock  movements  are  some-times called technicians or chartists.
Do I believe in technical analysis? Absolutely. I believe a good techni-cian  can  look  at  many  factors  and  determine  future  price  action  with  acertain degree of accuracy. In fact, since many option strategies are rela-tively short-term in nature, it’s important to use technical trading tools tohelp improve the timing of certain trades. Many options traders use tech-nical analysis more than fundamental analysis for that reason.
However, no person or computer can predict the future 100 percent ofthe time. We need to use all the information available about the markets inthe past and present to attempt to forecast the future. Although many aproﬁt has been made from complex technical charts, there are no crystalballs. Therefore, we recommend studying technical analysis and using itwhen  implementing  trading  strategies,  but  don’t  rely  exclusively  oncharts, patterns, or other technical trading tools.
The simplest and most widely used technical analysis tool is a movingaverage. A moving average is the analysis of price action over a speciﬁedperiod of time on an average basis. This typically includes two variables
ccc_fontanills_ch17_415-452.qxd    12/17/04    4:43  PM    Page  422
422
THE OPTIONS COURSE
(more can be used). For example, we may look at the price of gold tradingright  now  and  how  that  price  compares  to  the  average  over  the  past  10days and the average price over the past 30 days. When the 10-day averagegoes below the 30-day average, you sell; and, conversely, when the 10-dayaverage goes above the 30-day average, you buy. Technicians go to greatlengths to ﬁne-tune which time spans and averages to use. When you ﬁndthe  right  time  frames,  the  moving  average  is  probably  the  simplest  andmost effective technical tool.
Moving  averages  and  crossovers  can  be  very  useful  tools.  To  keeptheir  strengths  and  beneﬁts  in  perspective  follow  these  ﬁve  suggestionsregarding their use:
1. If you get a buy or sell signal and you take on a position, keep thatposition until the 18-day line goes ﬂat or changes direction. Do nottake  on  a  new  position  until  there  is  a  proper  realignment  of  allthree averages.
2. To protect accumulated proﬁts along the way use the 50-day moving
average as an exit point.
3. Think of the 50-day moving average as a support or resistance line.4. Moving averages work very well in uptrends and downtrends and notas well in sideways markets. That’s because in sideways markets, youcan get buy signals near tops and sell signals near the bottom. If youtrade on those signals, you will more than likely incur losses.
5. Finally, because moving averages do not work that well in sidewaysmarkets, which can occur a fair amount of time, use caution. Try toﬁnd stocks that trend a great deal if you plan to rely on this tool.
Moving  averages  are  a  time-tested  tool,  and  I  would  urge  any  new
market technician to understand their proper use and application.
Another  technique  is  to  use  a  momentum  indicator.  This  technicalmarket  indicator  utilizes  price  and  volume  statistics  for  predicting  thestrength  or  weakness  of  a  current  market  and  any  overbought  or  over-sold conditions, and can also note turning points within the market. Thiscan  be  used  to  initiate  momentum  investing,  a  strategy  in  which  youtrade with (or against) the momentum of the market in hopes of proﬁtingfrom it. It’s one of my favorite ways to trade because I can spot stocks, fu-tures,  and  options  with  the  potential  to  make  money  on  an  acceleratedbasis.  Finding  these  explosive  proﬁt  opportunities  is  the  key  to  highlyproﬁtable trading.
Brieﬂy, a momentum investor looks for a market that is making a fastmove up or down at a speciﬁc point in time, or there is an indication of an
ccc_fontanills_ch17_415-452.qxd    12/17/04    4:43  PM    Page  423
How to Spot Explosive Opportunities
423
impending movement. Like a volcano about to erupt, a great deal of pres-sure starts to build, followed by an explosion for some time, with a calmthereafter. A momentum investor might miss the eruption but be able tocatch the market move right after the eruption. Different techniques areused in each case. To catch the ﬁrst move (another example is that of asurfer trying to ride a wave), you have to see the signs, place the appropri-ate strategy, and then get ready to get off when the momentum (or erup-tion, or wave) ﬁzzles. This can be hours, days, or weeks. If you miss theﬁrst  move,  it’s  best  to  wait  until  the  movement  ﬁzzles  and  then  look  toplace  a  contrarian  trade.  If  you  wait  until  there  is  a  slowdown,  you  canthen anticipate a reversal. If you employ a contrarian approach, you willbe  trading  against  the  majority  view  of  the  marketplace.  A  contrarian  issaid to fade the trend (which suits me just ﬁne). Very fast moves up lead tovery fast moves down, and vice versa.
Trading,  investing,  and  price  action  are  driven  by  two  elements—fear  and  greed.  If  you  can  learn  to  identify  both,  you  can  proﬁt  hand-somely.  Momentum  investing  plays  off  of  these  two  human  emotionsperfectly:  greed  not  to  miss  a  proﬁt  opportunity  and  fear  that  proﬁtsmade will be lost if the market reverses course, thus intensifying the re-versal in many cases.
There  are  hundreds  of  technical  analysis  tools  out  in  the  market-place.  Be  very  cautious  with  those  that  you  decide  to  use.  Make  sureyou  thoroughly  test  these  systems  over  a  long  period  of  time  (i.e.,  10years or more).
Both  fundamental  and  technical  analyses  have  their  proponents.Some traders swear by one and hold great disdain for the other method.Other traders integrate both methods successfully. For example, funda-mental analysis can be used to forecast market direction while techni-cal  analysis  prompts  proﬁtable  trading  entrances  and  exits.  Mostinvestors  have  had  to  use  trial  and  error  to  determine  which  methodswork best for them. Ultimately, it depends on what kind of trading youare more inclined to use, and which methods you are most comfortableemploying.
When  you  begin  to  select  investment  methods,  try  to  determinewhy they work, when they work best, and when they are not effective.Test each method over a sufﬁcient period of time and keep an accurateaccount  of  your  experiences.  If  possible,  you  should  always  back-testsystems as well. You can use trading software to back-test almost anytechnical  analysis  technique  available.  Inevitably,  as  the  marketschange,  suitable  methods  of  analysis  will  change  also.  The  key  is  to remain  open-minded  and  ﬂexible  so  that  you  can  take  advantage  ofwhat works.
ccc_fontanills_ch17_415-452.qxd    12/17/04    4:43  PM    Page  424
424
THE OPTIONS COURSE
SENTIMENTAL ANALYSIS
The stock market is a fascinating place. It is particularly interesting in thatthe day-to-day ﬂuctuations reﬂect the views, expectations, and forecastsof investors around the world. Indeed, it is an arena in which the ﬁnal out-come depends not on one individual decision maker, but on the activity ofmillions of investors.
Given  that  market  moves  are  due  to  decisions  of  a  mass  of  marketparticipants, or the crowd and not one individual decision maker, historyis replete with episodes of crowd or mob behavior. Basically, under cer-tain  decision-making  situations,  the  individual  may  act  quite  rationally,but  as  part  of  a  crowd,  will  act  based  on  feelings  and  emotion.  In  thewords of Humphrey B. Neill:
Because a crowd does not think, but acts on impulses, public opin-ions  are  frequently  wrong.  By  the  same  token,  because  a  crowd  iscarried away by feeling, or sentiment, you will ﬁnd the public par-ticipating enthusiastically in various manias after the mania hasgot well under momentum. This is illustrated in the stock market.The  crowd—the  public—will  remain  indifferent  when  prices  arelow and ﬂuctuating but little. The public is attracted by activity andby the movement of prices. It is especially attracted to rising prices.(The Art of Contrary Thinking, 1963).
As  an  example,  take  the  contagion  that  spread  throughout  global  ﬁ-nancial markets in the fall of 1998. The fact that the sell-off of one stockmarket  in  one  country  eventually  led  to  a  drop  in  another,  and  then  an-other, was an example of extreme crowd behavior. It was labeled conta-gion: deﬁned as the ready transmission of an idea, response, emotion, andso on. However, given that global ﬁnancial markets recovered toward theend of 1998 and early 1999, obviously the panic selling and drop in globalfinancial  markets  was  overdone.  In  that  case,  it  was  the  opposite  of  amania, but still an example of crowd psychology in its worst form—fear,panic, and disengagement.
Given the nature and impact of crowd psychology on ﬁnancial mar-kets, many traders use sentiment analysis to gauge the overall attitude ofthe mass of investors, or the crowd. Studying market sentiment, in turn,is an endeavor in contrary thinking. In other words, one of the premisesunderlying the study of sentiment data is that, during certain periods oftime,  it  pays  to  go  against  the  masses.  Speciﬁcally,  when  market  senti-ment becomes extreme in one direction or another, the contrary thinkerwill act in a manner opposite to the crowd. For example, at the apex ofpanic  selling  during  the  global  ﬁnancial  crisis  of  1998,  the  contrary
ccc_fontanills_ch17_415-452.qxd    12/17/04    4:43  PM    Page  425
How to Spot Explosive Opportunities
425
thinker  armed  with  an  understanding  of  sentiment  data  may  well  haveturned into a buyer: just as the crowd was getting rid of shares. Indeed,when the market is gripped with fear and panic, it usually turns out to bethe best buying opportunity.
An often-heard saying in the stock market is that investors are “righton the trend, but wrong at both ends.” In a rising or bull market, investorsare better served buying shares. In a declining or bear market, the trend isdownward and it is a better time to sell. In short, during signiﬁcant markettrends, it is more proﬁtable to go in the direction of the market rather thancontrary to it. So the crowd is not always wrong. The turning points, how-ever, often catch investors unaware. Sentiment analysis offers a variety oftools for identifying the extreme crowd behavior or “the ends.” Let’s startby taking a closer look at put/call ratios.
Put/call ratios are widely used and easy to obtain. All of the necessarydata  is  available  on  the  Chicago  Board  Options  Exchange  web  site(www.cboe.com). As the name implies, the put/call ratio is computed bydividing puts by calls. It can be done for shares or index options. I focuson two put/call ratios: the CBOE total put-to-call and index put-to-call ra-tios. While the CBOE put/call ratio uses the total of all option trades onthe Chicago Board Options Exchange, the index ratio considers only in-dex  trading.  For  example,  February  12,  2004,  508,743  put  options  and916,360  calls  traded  on  the  CBOE.  So  the  put-to-call  ratio  was  .56  (or508,743/916,360). The same analysis is repeated for the CBOE index put-to-call ratio, but the equation considers only index options. The ratios areavailable daily at the CBOE web site.
Put/call  ratios  are  used  as  a  contrary  indicator.  Since  calls  makemoney when shares or indexes rise, they often represent bullish bets onthe part of investors. Conversely, puts increase in value when a stock orindex  moves  lower  and,  therefore,  reﬂect  bearish  bets.  So  when  theput/call ratio increases, it suggests that there are a greater number of putstraded relative to calls, and market sentiment is turning bearish. When itfalls, call buying is increasing in comparison to put buying. Again, study-ing put/call ratios is an exercise in contrary thinking. Speciﬁcally, if mostmarket participants, or the crowd, are buying puts, it is a sign of negativesentiment and reason to turn bullish. Conversely, a low put/call ratio is in-terpreted as a market negative since the crowd is excessively bullish, butprobably wrong.
In practice, readings of .50 or less from the total put-to-call ratio are asign  of  heavy  call  activity  and  extremely  bullish  sentiment.  In  that  case,the  contrarian  would  turn  more  cautious  or  bearish.  On  the  other  hand,readings of 1.00 or more are a sign of excessive bearishness and reason tobe bullish. The index put-to-call ratio will rise above 2.00 when investorsare too bearish and drop below 1.00 when bullish sentiment is extreme.
ccc_fontanills_ch17_415-452.qxd    12/17/04    4:43  PM    Page  426
426
THE OPTIONS COURSE
Adviser  sentiment,  which  is  used  to  measure  excessive  bearish  andbullish positions, is one of the more popular contrarian indicators and iscertainly one I employ. If adviser bearish sentiment is greater than 60 per-cent, this is a signal that a possible bottom is forming. If adviser optimismis greater than 70 percent, this signals a market top.
The mutual fund liquid assets ratio is based on the premise that cashbalances rise as the trend nears a bottom when increased buying powerexerts a bullish effect. If buying power is greater than 10 percent of bal-ances, this is bullish. The Investment Company Institute (ICI) releases thenumber monthly. The ﬁrst cousin of this indicator is customer credit bal-ances  and  is  based  on  the  fact  that  the  cash  balances  rise  or  fall  as  themarket bottoms or peaks.
The short interest ratio indicator consists of ratios of short interest toaverage daily trading volume. Readings above 1.75 are bullish and ratiosunder 1.0 are bearish. A related indicator is odd-lot short sales, which typ-ically are wildly speculative in the wrong direction.
The ﬁnal three contrarian indicators I look at are the over-the-counter(OTC) relative volume, market P/E ratio, and the Dow Jones Industrial Av-erage dividend yield. OTC volume breakouts above 80 percent provide bear-ish  signals  of  excessive  speculation.  Price-earnings  ratios  of  5  and  25  areapproximate lower- and upper-trend boundaries. DJIA yields get as low as3 percent at market tops and as high as 18 percent at market bottoms.
The different numbers I have used for quantiﬁcation purposes are typ-ical rules of thumb used by most contrarian traders. I basically use themas a ballpark ﬁgure versus an absolute. They will change through time andshould be considered in light of their long-term trends. As far as ﬁndingthe latest readings for these indicators, information can be found in Bar-ron’s, Value Line, and Investor’s Business Daily, as well as on a multitudeof Internet sites.
In conclusion, there is a wide variety of sentiment tools that can beused to enhance your trading, especially if you are interested in becominga  contrarian  trader.  The  premise  holds  that  the  crowd  is  not  alwayswrong, but invariably on the wrong side of the market during major turn-ing points. The goal behind using sentiment analysis, therefore, is to iden-tify  extreme  cases  of  bullishness  or  bearishness  and