Home Study Course by Bernie Schaeffer

Teacher

Chairman

About Course

Bernie Schaeffer, president of the Investment Research Institute, is best known as the senior editor of The Option Advisor, the largest-circulation options newsletter in the US. He is also senior editor of Fund Profit Alert and Schaeffer’s Research Review newsletters. Schaeffer made the Dick Davis Hall of Fame for being bearish ahead of the stock market correction in 1987, and since then, he has been steadfastly and correctly bullish, in large part to his use of sentiment-based indicators, which helped him recently to garner the Market Technicians Association’s Best of the Best award in sentiment and psychological analysis; in addition, he has a book due out even as you read this from John Wiley & Sons entitled The Option Advisor: Wealth-Building Techniques Using Equity and Index Options. So how’s he view the market these days? To find out, STOCKS & COMMODITIES Editor Thom Hartle interviewed Schaeffer via telephone on August 19, 1997.

How did you start out in the business?

I had always been fascinated with the stock market, dating back to my years growing up in New York City. I remember my dad taking me to the visitors’ gallery at the New York Stock Exchange and watching the ticker tape go by. Those were the days when you could actually look at a ticker tape and run the paper through your fingers. I remember one particular scene on the floor of the NYSE. There was a problem in Central America that affected United Fruit Co. It was pandemonium at the trading post for United Fruit, and that scene always stuck with me because it was exciting seeing the kind of feverish pitch of activity that can occur in the stock market.

So did you start your career with a brokerage firm?

No, my business career began as a casualty actuary in the insurance field. I completed all of the examinations to become a Fellow in the Actuarial Society. Not long after I attained my full professional standing as an actuary, though. I left a large insurer to start Investment Research Institute. That was in 1981.

How did that come about?

As I mentioned earlier, I had this longstanding fascination with the stock market. Which led to my interest in the options market. I would pick up The New York Times on Sunday and track the over-the-counter options. Of course, the advent of the listed options in the early 1970s really piqued my interest.

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With your strong mathematical background, I would imagine that you found the options market intriguing.

Exactly. And I was always working on strategies and doing some recreational trading. Which became a little more serious over the years. I had an associate in the insurance company and we were always exchanging thoughts on the stock market and on the options market. We both decided that we had had enough of the corporate world. And we were looking for another business to get into. Just out of curiosity, we went to a seminar on how to start a newsletter.

An investment newsletter?

No, it wasn’t really an investment-related seminar, but the newsletter business made sense to us because we were both good communicators and the startup capital was not really that large.

So your plan was to write about the options market?

I subscribed to a number of investment newsletters and I never really noticed anything of real value regarding options. That didn’t surprise me. At the time, listed options had been in existence for less than a decade, and trading options really hadn’t captured the public’s interest. So I felt there was a good niche to be filled by an options-based newsletter, and that’s why we started one. The first issue of The Option Advisor was published in December 1981.

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And so The Option Advisor newsletter was your primary focus?

Yes. In the first several years of the newsletter’s existence, we were a single-product company. We gradually evolved in two additional directions.

What were they?

The first was more short-term oriented for the option trader; we delivered options recommendations by fax. The second was a body of research I developed at the same time. There was a lot of valuable information from analysis of the options volume, open interest and pricing that I was using as tools for my recommendations, and I began to realize that the information was valuable as sentiment-based indicators.

Can you walk us through how you interpret some of these key indicators?

Sure. The first thing that struck me was the importance of focusing more on analyzing options open interest than on options volume. Options volume is the most obvious statistic for people to use, but I began to see that it was really the open interest, which represents the number of real positions held overnight, that is a more informative statistic compared with volume.

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How so?

Volume is a very gross indicator, meaning it’s not that precise. First of all, a lot of volume, particularly in options that are near expiration, represents day trading activity where traders are in positions in the morning and out in the afternoon. If you’re looking to forecast out five-, 10-, 15-, 20-day movements in an underlying stock, based on an options-based indicator, the activity of day traders is pretty irrelevant to that whole process.

Mixing apples and oranges, say?

Right. In traditional technical analysis, if you have a 10-day time frame, you would look at things like 10-day moving averages. Your past data period for analysis is consistent with your future trading horizon. I found that volume, because of its distortions due to a lot of day trading, is not good for a position trader who’s looking forward for, say, 10 or 15 or 20 days. And there’s another aspect of volume that can be very deceptive.

And that is?

You can look at heavy volume and say, “If it’s heavy call volume and I am a contrarian, I need to be concerned because there is obviously a lot of optimism by traders in call options.” The problem with that is if we’re looking at the options for a company that is actively traded in the front-month? options — for example, IBM or Intel — that heavy volume could be the result of position liquidation, as opposed to new interest being created in those options. Same thing for analyzing the activity in options on futures contracts. Again, you don’t know whether the volume is being generated by those liquidating their positions or by those adding new positions.