From Cabot Wealth Advisory May-June 2010

What's your investing background?

Rick: I have had a number of positions in the investment industry. Investing first got into my blood back in high school when my economics teacher entered me and two other students into an investment competition. In my freshman year of college I had a part-time job as a cold caller for a local EF Hutton office. Then I got my Series 6 license to sell mutual funds in 1987. At this point, I had quit school and was attempting to build a business, but things were not going as well as I had hoped and then the crash happened and I left the business for a while.  I went to work in the banking industry for a few years and went back to school to finish my degree in economics.  

When I finished college I went to work at Schaeffer Investment Research. I had always been more of a technical analyst and understood fundamentals, but I felt like there was something missing.  It was at Schaeffer that I learned the value of sentiment analysis and why it worked. I was at Schaeffer for six years when an opportunity came up with a division of Agora Publishing in Florida. When I joined the company in the summer of 2006, the plan was to build an investment newsletter from scratch. We launched Investor's Daily Edge in August 2006 and within a few years we had built a subscriber base of over 250,000. I was eventually moved to the position of Managing Editor of the newsletter.

For the past year, I have been writing my own newsletters and have continued developing some strategies I had been working on for several years. These strategies gave me a more quantified approach to trading and they have lead to the development of the Cabot Options Trader.

What are options?

Rick: Options are contracts that give the owner the right to buy or sell a stock at a specific price by a certain time in the future. For instance, the owner of an XYZ June 50 call has the right to buy 100 shares of XYZ stock at $50 anywhere between the time of purchase and the third Friday in June. If the stock is trading below $50, the option will be worth nothing come expiration day and the owner will not choose to exercise the right.  If the stock is trading over $50, the option should be worth the amount that it is above $50. If the stock is trading at $60, the option will be priced at $10, which really means it is worth $1,000 since it gives the owner the right to buy 100 shares at $50.

You may notice that I keep using the word "right." This is a big difference between buying options and writing options. Buyers have rights, and on the other side is the writer of the option, who has an obligation to deliver the stock he wrote the call on should the owner choose to exercise his option.  

Looking at the other side of the equation, the buyer of a put option has the right to sell 100 shares of the underlying stock at the stated strike price before the expiration day. Looking at the same XYZ scenario from the call example, if you own a June 50 put contract on XYZ, you have the right to sell XYZ at $50. If XYZ is above $50 at expiration, the put option won't be worth anything because you can sell it on the open market for a higher price. If the stock drops down to $40 and you have the right to sell 100 shares at $50, your put is now worth $10, or $1,000 since it represents 100 shares.

Do you prefer options to other investment vehicles?

Rick: I can't say that I prefer options over any other kind of investment vehicle, I have just learned how to use them effectively over the years. Many people are scared of options because they don't really understand them.  I have spent over 20 years learning to trade options and as a result of this practice, I have come to understand them better than most people. I will say that I got hooked on options at an early age when I was holding calls on a company and they were bought out by another company. I saw my small investment turn into a rather large stake. Unfortunately I went looking for the next buyout and lost most of the money I made on that trade. Fortunately that trade allowed me to make many mistakes and that was the cost of my education in the market. The leverage that options provide is incredible and once you learn to use that leverage effectively, options can be an invaluable weapon in your investment arsenal.

I believe that options should not be your only investment vehicle, nor should they be used as your primary investment vehicle. The best way to use options is as an enhancement to your long term portfolio. When we have a volatile period like we have seen lately, you can use the leverage of options to capture nice gains with less money exposed to the market.

What did you learn from the Bear Market of 2008 and the historic recovery last year?

Rick: As an options guy, I tend to look at the short-term picture a little more closely than the long-term picture.  In late 2007, my economics education gave me a pretty good heads up that a recession was on the horizon and that the market was in for a rough period. Little did I know how rough it was going to be, but the lesson I learned was that you can't get too caught up in the short-term and you have to step back and look at the bigger picture as well. I started getting pretty bullish toward the end of 2008 and that was because I was looking at daily, weekly and monthly charts. The S&P was more oversold than at any point in history on the monthly charts. Had I just been looking at the short-term, I would not have been positioned right for the huge rally in 2009. I actually have friends in the business that missed the rally last year and I think it is because they were too focused on the short term.

What can readers expect in Cabot Options Trader?

Rick: With the test issues we have put together over the last few months, I have come to appreciate the idea of the Cabot Options Trader even more than I first anticipated. As we continued developing the concept, I realized it was more than just option recommendations. I think what we have put together is more comprehensive than any other options newsletter I am aware of.

Each week, readers will get a summary of the previous week and they will get my take on the overall condition of the market. I may make a recommendation that investors lower their equity allocation if I think the overall market is headed down or I may suggest they increase their equity exposure if the market looks like it is due for a rally.  We also include a proprietary market indicator that I developed over the last couple of years called the Cabot Options Trader Barometer. The readings will move back and forth into positive and negative territory, but what we are looking for is extreme levels in the readings. In 2009, there were three times that the indicator went over 75- March 4, July 10 and November 2. If you look at a chart of the S&P and look at what happened following these extreme readings, I think you will see the value of the Barometer.

Another item in the newsletter each week is an economic calendar. My personal opinion is that you have to be aware of when important economic reports are coming out and you also need to know what the market expects since that is what the reports will be to be measured against.  I will also give my opinion on certain reports if there is something that doesn't make sense.

Finally, readers will get one or two put or call option recommendations each week. These recommendations come from my proprietary systems that I mentioned earlier. I look for stocks that make my bullish or bearish list and then select ones that have performed the best after previous readings. Between the recommendations and the barometer, subscribers should get their money's worth.

Who is best suited for Cabot Options Trader?

Rick: With the way the newsletter is laid out and the instructions that we give, I think any investor can use the Cabot Options Trader. As I mentioned earlier, I have been trading options for over 20 years and I try to explain things in very easy to understand language. A very experienced trader will benefit most from the recommendations and the barometer. A beginning trader will benefit by getting an education on the economy and the market and of course the recommendations and the barometer as well.

One thing we have done for subscribers is develop a special report on options that will teach the basics to beginning option traders. We have also developed a report on how to make the most of your subscription. We want subscribers to understand what they are getting each week and how to use the information to protect and grow their portfolios.

What are your top investing rules?

Rick: You're giving me a layup here.  I've actually made a list of trading rules that I try to live by and I call them "10 Secrets of Trading."  Here they are:

1) Stick to your guns
2) Be Diligent, but Not Rigid
3) Trade Both Sides of the Market
4) Avoid Personal Attachments
5) Keep it Simple
6) Do Your Homework
7) Trade What You SEE
8) Breathe In, Breathe Out, Move On
9) View Each Trade Independently
10)  Don't Follow the Crowd

What is your favorite investment book?

Rick: This is a much tougher question than the previous one.  I have so many books that I like, but I would have to say my three favorites are "Reminiscences of a Stock Operator," the original "Market Wizards and Sun Tzu: The Art of War for Traders." I am sure you have heard those first two on numerous occasions, the "Art of War for Traders" is probably a little more unique. I have always been a fan of Eastern philosophies and have several versions of the original "Art of War," but when I saw Dean Lundell's version for traders I had to have it.

One book that I have to say that isn't about investing that I love is Bruce Lee's "The Tao of Jeet Kune Do."  While the book is about martial arts, I have found there are some very sound principles that can be applied to trading as well. I actually have approximately 30 pages of notes that I wrote about the book and how the lessons can be applied to trading. So who knows, one day you may ask a trader/investor for their favorite book and they may answer, "The Tao of Jeet Kune Do for Traders by Rick Pendergraft."