Profitable options trading requires traders to have an edge over everyone else in their trading. One quote that should stick with every serious options trader is from the very popular investor, Warren Buffet, who said, “In markets, be greedy when other are fearful and be fearful when others are greedy.”

The entire ideology of acting against the crowd is based upon the theory of contrary thinking. Application of contrarian principle in options trading can be described most simply as taking positions in the market by purposefully opposing the majority’s sentiment.

When implementing this unique ideology in options trading, traders predict, at times when the whole market is overly optimistic or pessimistic about a stock or the market in general, that a trend reversal is inevitable. A deep dive into sentiment analysis is key here.

In this article, the team at Schaeffer’s Investment Research will provide you a detailed understanding of contrarian thinking and how we recommend utilizing it in the pursuit of huge profits from options trading with minimal risk exposure.

Understanding the Contrarian Approach to Options Trading

As mentioned above, the contrarian principle in trading is when a trader takes positions on a stock by going against the current overriding investor sentiment. The idea here is that when a simple saturation point is reached in a stock, whether during an uptrend or a downtrend, the stock has no other option but to reverse its pricing path.

Therefore, if a stock has been receiving overly optimistic attention concurrent with that stock reaching an overbought position, then a contrarian would lean toward purchasing a put option on the stock to capitalize on the correction.

On the flipside, if a stock has been receiving overly pessimistic attention concurrent with that stock also reaching an oversold position, then the contrarian would know this is the ideal time to purchase a call option to capitalize on the stock price reversal that is looming.

A great example is the 2008 housing crisis when the market was at an all-time high and investor sentiment was over-the-top optimistic. It was the time when it was believed that the only direction market could go was up and up and up. At that moment, proficient traders who used the contrarian approach to identifying options trading opportunities began to purchase put options that bet on stock price crashing within the real estate sector. The traders who were able to capitalize on this over-the-top positivity were able to make a huge amount of profit when the housing bubble popped.

Contrarian thinking is part of the core principles that we employ at Schaeffer’s Investment Research when implementing our Expectational Analysis ® approach to identifying trading opportunities. Our expertise in sentiment analysis, or analyzing crowd behavior, is key to our ability to completely and proficiently utilizing contrarian thinking in our trading.

The Proper Application of Contrarian Thinking in Options Trading

Almost all traders have had the experience of buying calls on a stock after the company outperformed expectations on quarterly earnings, and despite that positive news, the stock price continued to sink. Similarly, almost all traders have experienced buying puts on a stock that just released mediocre earnings that missed expectations and the stock price brushed off the news and continued to soar. These frustrating experiences reinforce the necessity of alternative thinking when trading, especially in the options trading space.

We understand it is highly frustrating and confusing when something that seems like an obvious reaction goes the opposite direction. These situations can cause traders to doubt their gut instincts. But that is not the right path to go down. Think about it like this: everyone knew that the stock underperformed or outperformed on earnings, that fact alone is not going to give you an edge in your trading. A proficient option trader must understand what the majority of traders expected out of earnings and the crowd’s expectations immediately prior to the earnings release to get the full picture of the stock price’s potential future movement.

A hidden aspect which very few consider is the Wall Street sentiment. Trading the stock market is not only about crunching numbers and correctly predicting how events will play out, but also understanding the inclination of market participants. The answer to the above examples can be easily understood by looking into the differing expectations surrounding the stocks prior to the event.

In the case of the stock that outperformed earnings expectations, the sentiment may have been excessively bullish heading into the report, making the shares ultimately vulnerable to a drawdown correction. There may have been a build-up of call options being purchased, or a lot of anticipatory buying of the stock, which then becomes exhausted by the time earnings are reported. Such a high-expectation environment creates a heavy burden on the stock to issue a blow-out earnings report and, even if it does, the pricing for betting against the stock will be far more compelling than that of betting along with everyone else.

For the stock that underperformed earnings expectations, there may have been a prevalent concern about a company's fundamental health and an excessive amount of put options being purchased on the underlying stock. Evaluating the sentiment associated with the underlying stock being considered for an options play is critical to trading around earnings.

With nearly 40 years of options trading experience and proven historical trading results, Bernie Schaeffer and his team of traders at Schaeffer's Investment Research have developed a 3-tier proprietary methodology called Expectational Analysis®  which combines fundamental, technical, and sentiment analysis, providing a bulletproof approach for identifying  and timing options trading opportunities.

The true pioneers of Expectational Analysis®, Bernie Schaeffer and the Schaeffer’ Investment Research team of analysts have tested and developed many different proprietary methods to measure investor sentiment. The distinguishing difference is that indicators used at Schaeffer's Investment Research do not reflect only the overall market, but individual sectors and stocks, specifically.

As an investor, there are two strategies made by companies that you should be aware of: 1) buybacks and 2) stock splits. A stock buyback, at its essence, is when a company repurchases its own stock. This typically boosts the immediate value of the stock, since there are less shares available to trade in the market. A stock split, on the other hand, increases the number of outstanding shares by splitting them (most commonly in the way of 2-for-1 or 3-for-1), which investors often see as long-term strength. 

Buybacks

One reason companies may buy back their stock is if they think it is significantly undervalued, reminiscent of currency inflation, which is certainly a bullish signal for shareholders. Two other reasons are 1) to utilize excess cash, as a way of way of returning extra cash flow back to investors and 2) for tax purposes, giving shareholders a way to defer capital gains. However, it's also important to be wary, as there are companies that will artificially boost their stock price this way, sometimes in order to raise it in the short-term. 

Stock Splits

A stock split, which again, divides one share into multiple, is usually the result of strong price action, pointing to overall health. Giving the shares more attractive prices appeals to a wider range of investors, and the move also improves the stock's liquidity, which refers to the speed at which a stock can be bought or sold without affecting its price. Though stock splits have no effect on the fundamental value of the stock, many still note positive sentiment surrounding them. 

Drilling down, here is how it works: 

For example, if stock XYZ is trading at $90 per share with 1,000,000 available common shares of stock, its market capitalization would be $90 million. Splitting its stock 2 for 1, there would now be 2,000,000 shares of stock, each shareholder holds twice as many shares, the price of each of which is adjusted to $45. The market capitalization remains the same at $90 million.

Reverse stock splits, on the other hand, are the direct opposite. As you could have guessed at this point, this is often done to raise the stock's price. In many cases following a reverse stock split, however, the stock price will actually decline, and there has been some academic research proving as much.  

The price one pays to buy options is called options premium, which is fairly straightforward. Contrastingly, the process that determines the value of this option premium is both multifaceted and complex. There are several factors that influence the value that one will pay to buy options contracts. Understanding these factors becomes pivotal in determining the most suitable time to buy or sell options. If, after completing this article, you still find yourself hesitant to trade options on your own, consider checking out one of Schaeffer's beginner's options trading newsletters. Our options trading newsletters rely on Schaeffer's experts' understanding of options and let you sit back and benefit from our 40+ years of experience. 

Extrinsic and Intrinsic Value

The ultimate goal of options trading is to make a profit, clearly. The value of this profit revolves around the strike price of the options, the price you pay as premium, and the current underlying stock price. In application, intrinsic value becomes the difference between the stock price and the strike price that helps you make a profit. The options will have the highest intrinsic value when the difference between these two variables is the greatest. If you earn no profit when exercising your options at the expiration date, that means your options had zero intrinsic value. When an option holds significant intrinsic value, it's referred to as an in-the-money option.

If a put option has high intrinsic value, you would sell the stock at a strike price higher than the current price of that stock in the market. Alternatively, for a call option, the strike price has to be lesser than the current price of the stock in order for you to gain a profit. Subscribe to the best options newsletter to understand how you can maximize your profits while keeping in mind the intrinsic value of options.

The easiest way to understand what the extrinsic value of options is to subtract the options' intrinsic value from its total value (the value you paid for its premium). An out-of-the-money option is one that possesses a high extrinsic value. If it's an out-of-the-money call option, its strike price will be greater than the underlying asset's market price. Whereas, if it's an out-of-the-money put option, its strike price will be lower than the underlying asset's market price. All of this may seem like a lot of complex information to take in, but the more you commit to understanding options, the easier all of this will come for you.

Options Volatility: Historical Volatility and Implied Volatility

The volatility of an option is the fluctuations that the market price of the stock is susceptible to. Thus, volatility becomes a very crucial factor in deciding the premium that you are going to pay for options. In a nutshell, highly volatile options have higher premiums. This is because they accentuate the probability of profits through the upward and downward potential of the options. If you own a call option, the upward volatility will increase the chances of earning a higher profit. But if you own a put option, the downward volatility will help you sell the underlying asset at a higher price.

There are two kinds of options volatility that you should know about before trading options. The first of these is historical volatility. This kind helps you understand the magnitude of the fluctuations in the value of the underlying stock statistically. The most common method employed to do this is through using standard deviations, however, there are several others too. If the stock has undergone severe fluctuations in its value in the past, it is classified as highly risky. Along with this high risk, comes the probability of earning a significant profit, and thus, valuable options.

Implied volatility is the second common type of volatility. As the name already suggests, implied volatility revolves around the predicted changes in the stock price. This type of volatility becomes extremely important because it helps you understand the market expectations through the eyes of market experts. You can then use this information to estimate the probability of the stock prices fluctuating in the future. Remember, the greater the fluctuation, the more room for you to exercise your profitable options.

Options trading may not be everyone's cup of tea. However, if you are eager to step into options trading, Schaeffer's publishes the best options newsletters that will provide the guidance required to get started.

Eaton Corporation (NYSE:ETN) has been on a steady tear higher, doubling from its March coronavirus-induced lows. Now, after a pullback to support at the 40-day moving average, it looks like ETN is poised to add to its 19% year-over-year gains.

Analysts are mostly hesitant on Eaton Corporation stock, even after the company's Feb. 2 earnings and revenue beat. More specifically, seven of the 13 in coverage carry a "hold" rating on ETN, leaving plenty of room for increased optimism that could push the stock higher.
 
There is some pessimism in the options pits as well, per ETN's 10-day put/call volume ratio of 1.23 at the International Securities Exchange (ISE), Cboe Options Exchange (CBOE), and NASDAQ OMX PHLX (PHLX). This ratio stands higher than 60% of readings in its annual range, suggesting puts have been picked up a slightly quicker-than-usual clip during the last two weeks.

That said, speculating on ETN's next move with options could be a prudent play. The stock's Schaeffer's Volatility Index (SVI) of 25% stands higher than just 7% of all other readings in its annual range, implying that options players are pricing in relatively low volatility expectations at the moment. Lastly, Our recommended call has a leverage ratio of 7.6, and will double in value on a 12.1% rise in the underlying security.

Subscribers to Schaeffer's Weekend Trader options recommendation service received this ETN commentary on Sunday night, along with a detailed options trade recommendation -- including complete entry and exit parameters. Learn more about why Weekend Trader is one of our most popular options trading services.

“Small caps may be the biggest area of opportunity, as measured by the iShares Russell 2000 ETF (IWM -- 190.30) and Russell 2000 Index (RUT -- 1,911,69).  With the IWM and SPY experiencing about the same performance in 2020, there is much more short-covering potential in the small-cap area relative to large-cap stocks.”

-Monday Morning Outlook, December 14, 2020

After year-end 2020 short interest data was released by the exchanges last week, I could not help but think about the comments that I made in the middle of December, as excerpted above. My sense, given the trajectory of moves we have seen in many individual stocks during the past few weeks, is that we have seen major short-covering rallies in the small-cap space since I made those mid-December comments.

Per the table below, this has translated into significant outperformance in small-cap equity-based exchange-traded funds (ETFs), relative to larger-cap ETFs such as the technology-focused Invesco QQQ Trust Series (QQQ – 311.86) or the broader large-cap SPDR S&P 500 ETF Trust (SPY – 375.70). 

“So how do you play this environment?  First, options can be used in lieu of stocks to reduce dollars at risk but allow leverage to work for you in the event you are playing stocks to the upside that might rally…”

          -Monday Morning Outlook, December 21, 2020

In fact, one of a few strategies that I have recommended during this past month is the use of call options as a substitute for stock plays in recognition of the bullish price action amid the sentiment-based risk, emerging Covid-19 vaccine headlines, and new strain uncertainties. Call options allow you to reduce your dollars invested, define your risk, and the leverage gives you attractive profit opportunities. 

With the above in mind, many of our subscribers benefitted directly from the small-cap, short-covering advance, taking huge profits on GameStop (GME), Bed Bath & Beyond (BBBY), SunPower (SPWR), Under Armour (UA), Shake Shack (SHAK) and Axon Enterprises (AAXN) call options. 

If the short covering continues, the best opportunities are likely to continue to be found in small-cap equities in the weeks ahead. 

While there has been short covering among S&P 500 Index (SPX – 3,768.25) components, which is likely supporting the index on pullbacks, total short interest is at a multi-year low. Plus, if you are looking at large-cap technology names, as measured by short interest in QQQ components, you may be fighting a headwind as short interest is building from a multi-year low.  

Meanwhile, short interest on Russell 2000 Index (RUT – 2,123.20) components is decreasing. From a broader perspective, total short interest on its components is nearer to multi-year highs, which leaves significant room for covering activity. Whether you are utilizing call options to speculate on individual stocks or allocating equity investments between small caps or large caps, ensure that you give the small-cap space focus.

“…despite the headlines, some of which could have given the bulls pause, the SPX never breached the rising 20-day moving average, which sits below the first level of potential support on a pullback, which is the 2020 close of 3,756.07.”

          -Monday Morning Outlook, January 11, 2021

Ahead of the long weekend, Friday’s action saw everything pull back, whether large cap, technology, or small cap. Even though high-profile banks reported much stronger-than-expected earnings and President-elect Joe Biden released his stimulus plan on Thursday evening, buyers were nowhere to be found. 

That said, last week’s pullback in the SPX can hardly be defined as one that would stir panic among traders, who have been extremely bullish during the past several weeks. Friday’s SPX low, in fact, was around its 20-day moving average, which is now sitting around its 2020 close of 3,756, which I identified last week as the index’s first level of potential support.

The CBOE Market Volatility Index (VIX – 24.34) rose slightly last week, but Wall Street’s “fear gauge” still isn’t hinting at major volatility ahead, as it remains well below its 252-day moving average. Moreover, per the first pane in the chart below, the round year-over-year 100% gain in this index acted as a “resistance” point, which has been the case since mid-December. 

Looking ahead to the end of the month, if this 100% year-over-year gain in the VIX comes into play, it will be on the heels of a surge into the 36 area in November, as it was around this time last year that it began rising from the 12 area into the 18 area, just weeks after China disclosed a novel virus had emerged in the country.

One thing we are not seeing now relative to this time last year is the emergence of a significant number of VIX call buyers relative to put buyers, per the chart immediately below. These call buyers proved prescient with respect to their timing last year, when VIX calls were being purchased at a rate of four-to-one relative to puts in the previous 20 days. At present, this ratio stands at only 1.35.

To conclude, one (or all) of the following strategies continue to be recommended:

1. Use calls in lieu of stocks to manage sentiment-based risk but also play the current trend higher.
2. Use straddles -- the simultaneous purchase of a call and put -- for the same reason as the first bullet (and to manage earnings risk).
3. If not using call options as a stock replacement, consider index puts to hedge long stock positions.
4. Emphasize small-cap stocks over large-cap equities.

Todd Salamone is Schaeffer's Senior V.P. of Research

Continue reading:

• The Week Ahead: Blue Chip Earnings Headline Holiday Shortened Week
• Indicator of the Week: How Much Is the Dow Worth in Alternative Assets

The first full week of April certainly came in like a lion, with the major benchmarks roaring to life and picking up several record highs on the way. The week began on a strong note, as traders pored over an upbeat round of jobs data, and bond yields eased, sending both the Dow and the S&P 500 to fresh closing highs. President Joe Biden's $2 trillion infrastructure plan was also a major point of focus this week, and while this proposal has been mostly well-received by investors, stocks took a breather on Tuesday, brushing off more strong jobs data. 

By Wednesday, the S&P 500 inched back toward another all-time peak, though the Dow and the Nasdaq saw another muted day of trading, while Wall Street eyed the Federal Open Market Committee's (FOMC) latest comments on the state of the economy. This muted trading was temporary, and markets charged back by Thursday's close. The S&P 500 extended its gains, and the Nasdaq notched a triple-digit win, brushing off disappointing employment numbers. Meanwhile, mortgage rates dropped for the first time in over a month, pressured by steadily retreating bond yields. By midday today, stocks are taking a breather, though all three indexes are on track for weekly wins. 

Stocks Seeing Analyst Love This Week 

Plenty of big names were being noticed by analysts this week, giving many a boost, including Honeywell (HON) which jumped to fresh highs following a deluge of bull notes. U.S. Bancorp (USB), on the other hand, was unable to capitalize on an upgrade from J.P. Morgan Securities, as it struggled with technical trouble on the charts. 

Meanwhile, Illumina (ILMN) shared upbeat current-quarter and full-year guidance, prompting a price-target hike from Canaccord Genuity. JetBlue Airways (JBLU) also got a lift from Raymond James, which bet on recovery for international travel, while Wolfe Research suggested traders look into CBS Corporation (VIAC) while the stock is still on sale, following last week's dramatic plummet. 

Checking In With Big Tech

Tech stocks enjoyed a rebound this week and bond yields retreated and investors rotated back into the sector. Several sector members, in particular, were in the spotlight, including Tesla (TSLA), which surged after hitting a record number of deliveries for its first quarter. Amazon (AMZN) made its way into the headlines too, as employees awaited the results of a historic union drive. Separately, a look at the stock's past suggests AMZN might continue to climb in the second quarter, while we break down the best way to play this potential pop, considering the stock's lofty price point. On the social media front, meanwhile, photo sharing app Snap (SNAP) was getting some attention, winning praise Atlantic Equities over its strong as business an pipeline products. 

Big-Name Earnings Take a Seat Next to Fed Update

Next week, investors will be looking at the Federal budget balance, the Fed's "Beige Book," the latest round of jobless claims, as well as the Empire State Manufacturing Index. Plus, business inventories, retail sales and industrial production data will be coming out. Several major names set to step into the confessional, too, including Aphria (APHA), Bed Bath & Beyond (BBBY), Citigroup (C), Delta Airlines (DAL), Goldman Sachs (GS) and UnitedHealth (UNH). In the meantime, traders can delve deeper into buying opportunities within tech, or check out Schaeffer's Senior Quantitative Analyst Rocky White's explanation of what happens when the 10-year Treasury note yields more than S&P 500 stocks. 

Last week, Cleveland.com reported Ohio could legalize sports betting as soon as this summer. We last discussed the gambling landscape in October and since then, Tennessee, Michigan, and Virginia launched their first online sports book. Meanwhile, Louisiana, Maryland, and South Dakota all legalized sports betting. To understand the potential of stocks like DraftKings Inc (NASDAQ:DKNG) is to read the writing is on the wall and realize it's a matter of when and not if in the rest of the states. Amid these legislative tailwinds, is DraftKing's potential as a growth play baked in already? Developments in the last week, plus a closer look at some technical and historical data say not so fast.

As Ohio prepares its bill, DraftKings was making two under-the-radar moves. First, they inked a deal with Worldwide Wrestling Entertainment (WWE), becoming an official partner subject to regulatory jurisdictions. DraftKings' immensely popular free-to-play pools product will integrate with WrestleMania, on April 10 and 11. A day later, they acquired Vegas Sports Information Network, Inc. (VSiN), a multi-platform content company that offers betting news and analysis.

Does wrestling and a niche news network really move the needle? Absolutely not. But consider DraftKings also has broadcasting partnerships with Walt Disney's (DIS) ESPN and Dish Network (DISH). It is also an official partner to the NBA, MLB, NFL, NASCAR, UFC, and PGA Tour. They are slowly but surely nudging and positioning themselves into every sporting landscape out there where money changes hands. And regarding VSiN, DraftKings can now tap into the Vegas gambling infrastructure, a critical element in any sports betting landscape.

A month ago this article may not have been written, because DKNG was nabbing record highs left and right, and its 14-day Relative Strength Index (RSI) crept up into 70 and firmly in overbought territory. But since a March 22 peak of $74.38, the stock has taken a roughly 18% haircut and offered up an attractive entry point for speculators, with its RSI last seen at a much more palatable 48. What's more, that pullback has sent DKNG within one standard deviation of its 80-day moving average after a lengthy stretch above the trendline. For the purpose of this study, Schaeffer's Senior Quantitative Analyst Rocky White defines that as the equity trading above the moving average for 60% of the time over the past two months and closing north of the trendline in eight of the last 10 sessions.

According to White's data, five similar signals have occurred during the past three years. DKNG was higher one month later after all five of these signals, averaging a one-month return of 13.6%. A similar move from the security's current perch would put the stock back above the $70 mark. And there's still more pessimism to be unwound to make a run at that record high; short sellers have increased their positions by 37.5% in the two most recent reporting periods and account for a healthy 7% of DKNG's total available float.

Meanwhile, option traders' sentiment has shifted. The equity's 10-day put/call volume ratio at the International Securities Exchange (ISE), Chicago Board Options Exchange (CBOE), and NASDAQ OMX PHLX (PHLX) has moved up to 0.37. While this shows call buying has remained more popular on an absolute basis, the reading ranks in the 88th annual percentile, revealing an unusual interest in long puts.

DraftKings options can be had at a premium right now too, per its Schaeffer’s Volatility Index (SVI) of 59% sits in the lowest percentile of its annual range. This means options players are pricing in relatively low volatility expectations at the moment. Plus, the equity’s Schaeffer's Volatility Scorecard (SVS) sits up at 87 out of 100, showing that DKNG has tended to exceed option traders' volatility expectations during the past year -- a boon for option buyers.

One final note to tie things up. DraftKings' market cap tagged 25 billion in the middle of September 2020, per the chart below. After inching higher to as high as $28 billion to begin March 2021, DKNG's market cap has now pulled back to that $25 billion level. This will be an area to watch in the short-term with April stock seasonality in focus

Subscribers to Bernie Schaeffer's Chart of the Week received this commentary on Sunday, April 4.