Must Read – Grantham Quarterly Letter

A must read for any serious investor is Jeremy Grantham’s GMO Quarterly Letter. The 3rd Quarter letter is available here. He doesn’t pull any punches on this letter and calls out those responsible for our current economic mess. He also says the S&P 500 is above fair value, which he estimates at 860 but still sees ‘high-quality’ US companies as attractive.

There seems to be a consensus among the economic thinkers I read – Grantham, Rosenberg, Hussman, Mauldin, etc. – that we are overvalued. This doesn’t mean a ‘crash’ is imminent, but it could mean we are, as Grantham puts it, in for ‘seven lean years’.

More To-Read Articles

Tom Lydon shows us Two New Ways to Hedge Against Inflation (hint: tickers CPI and GRES)

space:pre"> As an aside, I can’t wait to dig into his new book,The ETF Trend Following Playbook: Profiting from Trends space:pre"> in Bull or Bear Markets with Exchange Traded Fundsborder:none !important; margin:0px !important;" />

David Rosenberg has a special report on the Loonie (pdf)

More gloom (pdf) from Rosenberg:



The S&P 500 is riding a four-day losing streak. And while we have seen these corrections turn around before during this massive bear market rally that started last March, the difference this time is that the uptrend line from the lows has been violated across a fairly broad front, including the S&P 500, Nasdaq and the Russell 2000. When trend lines get violated, and when this happens on high volume, it usually, though not always, signals something big.

So many people are deluding themselves that we have some sort of durable recovery on our hands and yet consumer confidence, at 47.7 in October, is unbelievable — the lowest this every got in the 2001 recession, which included the 9-11 terrorist attacks, was 84.9. Think about that for a second. If the equity market is catching on to the view that we could be in for some slowing in the data, then a significant correction after a 60% surge is very likely. This is a time to be raising cash if you haven’t done so already — valuation, technicals, fund flows and fundamentals at this juncture are all near-term obstacles.

In terms of valuation, we said yesterday that the P/E ratio on the S&P 500 on a normalized 10-year basis is 20x and the long-turn norm is 16x. Just to go back to the norm, let alone compress to a level commensurate with an unusually high level of economic and financial uncertainty, would suggest that we would see the S&P correct down towards 875.


The man on the street sees it a little differently, perhaps less enthused by the fact that a lower rate of inventory destocking is arithmetically underpinning GDP growth at this time. Put simply, a Wall Street Journal/NBC News poll just found that 58% of the public believe the economic recession still has a ways to go — and that is up from 52% in September and means that the private investor, unlike the hedge fund manager, is not interested in adding risk to the portfolio even after a 60% surge in the equity market.

Only 29% of those polled believe the economy has hit bottom — imagine having that psychology with nearly zero interest rates, a bloated Fed balance sheet and unprecedented fiscal deficits (poll was taken from October 23-25). Nearly two in three (64%) said the rally in the stock market (still a bear market rally — not the onset of a new bull market) has not swayed their view (or ours for that matter). There is going to be some very tough slogging ahead as far as the economy is concerned.

Update on SPY

Even though I said I would be only posting links to articles this week, I couldn’t help myself. The SPY is either going through a healthy consolidation, or the end of the bull run is here. It is too early to tell, either way we have seen a significant pullback in the last week.

I previously wrote in July that the ‘Lehman Gap’ was an important resistance point to watch on SPY. We have filled the Lehman Gap and are now pulling back. I also previously detailed some daily and weekly charts with trend lines. We could be looking at the 100 range as a support level on SPY.

Below are the updated charts. The first is a weekly chart with fibonacci retracement levels:

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Now, a daily chart with some additional indicators showing a negative divergence – not good for bulls. In addition. as I have previously noted the volume on down days has generally been outpacing up days on SPY. In addtion, MarketClub’s Trend Analysis of SPY now has it in ‘Sideways mode’ with a score of +55 (-100 to +100 scale). It still is on a Monthly and Weekly Buy signal, but I would be watching it very closely to see if it turns to a sell shortly (for their Free Trend Analysis on any security, click here):

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Additional Readings for This Week

As stated yesterday I won’t be doing much this week besides passing on some readings:

John Mauldin posts commentary from David Einhorn of Greenlight Capital, Liquor before Beer – In the Clear
Jim Jubak: How to Buy the Next McDonalds (a couple of his ideas – CTRP, LFUGF, PNGAY). To get FREE trend analysis on CTRP, LFUGF, PNGAY or any other stock, click here

Here are some ‘Yellow Flags’ according to David Rosenberg’s (Gluskin Sheff) October 26th Market Commentary (pdf):


• U.K. real GDP, instead of edging up 0.2% QoQ in Q3 as everyone expected, contracted 0.4% instead.

• Global trade flows, as per the just-released Netherlands Bureau for Economic Policy Analysis, fell 2.0% in August from July — an indication the recovery that has everyone so excited may be a tad more fragile (didn’t Mark Carney use that word?) than generally expected.

• The Dow Transports are sending off a troubling signal — down 3.5% on Friday in the fourth decline in a row as well as the worst showing in two months. In fact, the index has not made a new high since September 15 and have put in a classic double-top.

• In another sign of a possible investor move to lighten up on risk, the Russell 2000 also closed the week down 2.5%.

• The market, last Friday, continued to post declines on higher volume; and, a majority of the up days in market were on lower volume. We realize that some will guffaw at the technicals, but in a technical as opposed to fundamental market rally, the technicals need watching. As the Investor’s Business Daily correctly points out, “six distribution days on the Nasdaq and eight on the S&P 500 would in most circumstances be enough to kill an uptrend.”

• Did you see the VIX index (a measure of volatility in the equity market) jump 7.0% last Friday, to 22.3 — a bit of the complacency (but not nearly all) may be coming out of the marketplace.

• The financials sagged 1.6% on Friday and have done squat now for 5½ weeks.

• Just as the economists are taking their housing numbers higher, in classic “sell the fact” mode, the S&P Homebuilding index just closed down 18% from the mid-September high. That almost classifies, dare we say, as a … bear market!

• Oh yes — this is surely a sign that the credit crunch is behind us. Regulators closed seven more regional banks last Friday, bringing the tally for the year to 106. There have been more bank failures this year than in the past 15 years combined, and the only reason why the big boys never followed suit was because the government guaranteed all their debt and then allowed them to hide their losses by switching to mark-to-model accounting from mark-to-market. Believe us when we tell you that even the most renowned experts could not tell you what is really sitting on the balance sheets of these large U.S. banks — but there is limited downside risk because Uncle Sam has deemed them all to be ‘too big to fail’. Those who were investors in American United Bank, well, we are sorry to have to tell you that you were involved in an institution that was small enough to close down.

• We realize that this did not make it anywhere in the weekend press (outside of a microscopic piece in the IBD) but the ECRI leading economic indicator actually fell (by 0.2 of a point) for the second week in a row (and the smoothed annualized growth rate declined 1.6% —- now what is that all about?).

Building a Long-Term Portfolio Strategy

size:small;">I wrote in my last article about diversifying your strategies in order to hedge your bets. I will be taking a few days off, so I thought it would be a good time to come full circle with some ideas I have been discussing the past several months.

size:small;">Several strategies and services have been detailed in-depth on size:small;">Scott’s Investmentssize:small;">. My desire to detail so many strategies is to help myself become a better investor and research what works (historically) and what has not worked. My goal, as size:small;">I wrote in early Julysize:small;">, is to diversify not only my securities but also my strategies. I encourage you to read that article if you have not already done so. Also, another good place to start is by looking under the ETF and Timing Portfolios on the right hand side of my blog. This is a list of strategies I have begun tracking on a monthly basis.
size:small;">What I have learned to date is that there are viable alternatives to buy and hold. Some of my favorite strategies include the following (Please keep in mind these ideas are size:small;">notsize:small;"> investment recommendations, they are simply for educational and entertainment purposes. In addition, historical returns are not a guarantee of future performance):
size:small;">1) A long-term moving average system, detailed in depth by Mebane Faber in size:small;">The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets is superior on a risk-adjusted basis to buy and holdsize:small;">border:none !important; margin:0px !important;" />. Historically, buying a diverse portfolio of securities when they are above a long-term moving average and selling when they are below the moving average has produced superior risk-adjusted returns. Nominal returns are very similar to buy and and hold, in some cases greater, but with much less risk.
size:small;">2) Options can help reduce risk and size:small;">potentiallysize:small;"> increase returns. has some excellent free material and studies showing the historical returns of a buy-write (covered call) strategy and selling cash-secured puts. For a summary size:small;">click heresize:small;">.
size:small;">3) The Fundamental Index appears to be a historically superior index to cap-weighted indexes. This strategy was detailed in size:small;">The Fundamental Index: A Better Way to Investsize:small;">border:none !important; margin:0px !important;" /> and I wrote a book review size:small;">heresize:small;">.
size:small;">4) Following the ‘smart money’, while still in its early stages of historical tracking, shows promise. Mebane Faber (yes, the same guy from point 1) stated the following on his site:

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size:small;">I started tracking a portfolio of 10 hedge funds way back in 2007. Long time readers of my blog will recall how I used to backtest these funds by hand – it took me a couple months with a co-worker to do only a few funds (which now takes seconds on AC).

size:small;">I started tracking a group I called World Beta. It simply invests in the 10 most popular stocks amongst these 10 managers: the Baupost Group, Berkshire Hathaway, Blue Ridge Capital, Eminence Capital, Greenlight Capital, Lone Pine Capital, Maverick Capital, Okumus Capital (we did a real time switch to Appaloosa in 2009), Private Capital Management, and Tiger Capital Management. When I backtested the returns we found outperformance of a stunning 15% a year.

size:small;">Real time, out of sample results are size:small;">annualized returns of 25% a year size:small;">vs. size:small;">-6.8% a year for the S&P500size:small;">. That equates to a difference of over 100% in total return in that time period. While the S&P500 lost almost 20%, the World Beta clone almost doubled.


size:small;">Investors interested in tracking ‘smart money’ can sign up for Faber’s new project, AlphaClone. The full service is not free (you can track one or two clones for free) but is worth heavy consideration if you have even a modest portfolio and have an interest in owning individual stocks.

5) In my opinion, momentum and trend-following can lead to superior long term returns. I have detailed several momentum strategies – for a high yield momentum system click here, a rotation system here or here. There are several other articles I have written on the topic so I would suggest just typing ‘momentum’ on the search engine on my blog. Much of it is inspired by Faber and research done by
There are also pay-services which do the trend following for you and issue buys or sells. One service, Marketclub (of which I am an affiliate) is a service that historically done well in trending markets. Choppy/sideways markets lead to undperformance but the system has done very well in volatile markets. For an article I wrote showing backtest results of their system click here.
I also did a backtest of my own on Marketclub‘s monthly trade signals (they also have shorter duration weekly signals). The first buy on SPY was issued on 11/18/05 at an unadjusted price of $124.74. Had you invested $10,000 using Marketclub’s signals on that date, excluding dividends and commissions, you would have $10,454.04 on 10/21/09. There were 11 trades in the roughly four year time period. Including dividends, buying and holding SPY on 11/18/05 would leave an investor with only $9341.25 on 10/21/09. My test assumed only round number of shares were purchased and any leftover cash was put in a cash account earning 0%. To be fair, their monthly system would have lagged buy and hold on SPY through the first part of 2008 – thus, their signals appear to be of most benefit when markets make significant, sustained up/down moves (see late 2008 and most of 2009).
I did the same backtest on DBC. The first buy signal was issued 5/2/06 at $26.21 unadjusted. Nine trades later, you would have $12093.13. If you had bought and held DBC on 5/2/06 at an adjusted price of $24.57 (thus, including dividends), you would have $10012.21 on 10/21/09.
If interested, you can try the Marketclub service risk-free for 30 days.
6) Value historically produces superior long-term returns. Dividends also significantly add to a portfolio’s long-term returns. I have yet to identify a service and/or method for screening and picking superior value stocks. The Fundamental Index (see point 3) is the closest I have come. I will try to place a greater emphasis on this going forward.
As always, please make sure to do your own due diligence and feel free to send comments my way.
size:x-small;">At the time of writing I do not own any of the securities mentioned.

The Bull and Bear Arguments

Jon Markman of MSN Money is a bullish contrarian – I call him a ‘contrarian’ because his stance seems so bullish that he is outside even the normal realm of bullishness. This is in stark contrast to David Rosenberg, another thinker I feature on Scott’s Investments, whom I would consider a bearish contrarian.

Consider the following – Jon Markman’s recent article, Why Savings is for Suckers, makes the following prediction after giving some investment recommendations (emphasis mine):

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family:verdana, sans-serif;">Keep it simple. Adding sectors and specific regions will increase the complexity of your portfolio but probably won’t add much more in returns, which could well exceed 15% per year after the recent crash in value.
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family:verdana, sans-serif;color:#333333;">These are not buy-and-hold-forever ideas, because cycles will change. And they won’t go straight up. There will be long periods of sideways motion or bumpiness. But the fiscal and monetary stimuli poured into the global financial system over the past year, as explained two weeks ago, will more than likely lead to a prolonged recovery of at least a year and more likely two or three or more.
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Markman seems almost giddy with bullishness. Contrast this to David Rosenberg whose primary concern is with deflation. In his October 22nd economic commentary (pdf) for Gluskin Sheff:

family:Arial;">In the past two days I have seen two articles that cement my view that deflation risks trump inflation risks — and I say this following two years in which the Fed has printed $2 trillion worth of greenbacks to reflate the credit system and economic activity. See Retailers Feed Holiday Demand for Free Shipping on page D1 of Wednesday’s Wall Street Journal (Target just launched its holiday free-shipping promotion, two weeks earlier than last year!) and Best Buy Free Offers Are Signs of the Times (free delivery and setup au gratis is the new normal) on page B7 of the same edition. And Wal-Mart, which started a price war on books last week, said that it is going to start cutting its prices on holiday items starting … today!
family:Arial;color:#333333;">The state by state U.S. employment data were just released and showed that the aggregate job loss in September was 451,600 (recall that the initial nonfarm payroll release revealed a 263,000 decline). New record highs for the unemployment rate were reached in three states — Florida, Nevada and Rhode Island. There are now 14 states that have double-digits unemployment rates. Moreover, the decline was so widespread that 43 of the states posted reductions in their employment base last month.

John Mauldin has stated on several occasions that being on the right side of the deflation/inflation argument is key for investors in this era. For now, despite the runup in equity markets, the data, in my opinion, still points to deflation. However, it would probably be wise to hedge your bets. The technicals, while weakening some this month, are still in the bull/Markman camp. However, valuations (also see here) and economic data–despite showing some signs of improvement–are more in the bear/Rosenberg camp. My preferred strategy is to diversify my strategies to guarantee myself at least a portion of the benefit of being either a bull or bear.

Jim Welsh’s Must Read Monthly Letter for October

Jim Welsh’s October Letter is available for
size:small;">freesize:small;"> on Barry Ritholtz’s blog size:small;">The Big Picturesize:small;">. size:small;">Do yourself a favorsize:small;"> and read the letter in its entirety. I look forward to Welsh’s monthly letter because I think he is one of the more insightful reads available on the web and this month’s letter puts historical lessons in perspective for investors in 2009. Below are some excerpts which I felt were particularly useful for readers of my blog (emphasis Welsh’s):


size:small;"> “family:Georgia, 'Times New Roman', Times, serif;">size:small;">History suggests that these extended periods of instability (1929-1949, 1966-1982), do not reward investors who buy and hold, or the institutions that disdain cash….The uncomfortable reality is that none of us, including the Federal Reserve and Congress, knows how all of this will play out. What we do know is that we are in a period of instability and higher unpredictability. During periods of instability, the surprises are generally negative. This will require that investors adopt a more flexible investment game plan than quarterly rebalancing a diversified portfolio of assets…

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size:small;">From a historical perspective, visualize a pendulum that oscillates between stability and instability, with each period reaching an extreme after 15 to 20 years. The period of stability that ended in 1966 was heralded with the political phrase “size:small;">The Great Societysize:small;">”…The period of stability, which began in 1981-1982, probably reached its extreme as investors embraced the ‘size:small;">New Paradigmsize:small;">’ in 1999, and bid technology stocks to absurd valuations. In response to the bursting of the tech bubble, the Federal Reserve aggressively lowered interest rates to keep the economy from deflating. Ironically, the extended period of economic stability between 1982 and 2000 encouraged market participants to take on highly leveraged risks, even as the pendulum was already swinging away from stability toward instability.size:small;">This new 15 to 20 year period of instability began in 2001 or 2007, but it did not end in March 2009…

size:small;">…size:small;">The fundamental challenges facing our financial system and all levels of government are structural in nature, and the result of excesses that have built up since 1982. There are no easy solutions. During the 1966-1982 period of instability, the DJIA made its price low in December 1974. (Chart below.) Even though the period of instability had another 7 years to run, the DJIA never fell below 730. My hope (and prayer) is that the March 2009 low marks the price low in the stock market, even as the economy struggles and social unrest increases in coming years. If the March 9 low is broken, it would suggest that all the efforts and money spent to prevent a deeper economic contraction had failed.



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size:small;">“As measured by the 21 day average of total volume, volume expanded 5.9% as the market declined between September 29 and October 2. (1.309B to 1.378B). This is the first time volume has expanded on a decline since the March low. Since October 2, the S&P has rallied from 1,019 to 1,092, but total volume has shrunk from 1.378B to 1.255B, or -8.9%. As noted last month, I thought the S&P could trade up to 1,095. Although 1,109 is possible, doing a little selling or hedging into strength is a good idea. A decline to 990-1,015 by the end of October, or early November is likely, given the technical back drop. The DJIA closing above 10,000 and Intel’s good news should help the market hold up a bit more, although trading is likely to be choppy. The market is likely to make higher highs after this correction, based on the overall technical health of the market, and statistical support for the V-shape recovery during coming months.”

Two Winning Options Strategies

I wrote a book review yesterday on Get Rich with Options: Four Winning Strategies Straight from the Exchange Floor (Agora Series)border:none !important; margin:0px !important;" />.

I thought a follow-up was in order for readers interested in learning more about options.
In my opinion the best, free site for options investors is the Chicago Board Options Exchange, There is an abundance of free material on the site – you could literally spend weeks on the site.
I want to highlight two strategies/studies on the CBOE site. The first is a buy-write strategy which CBOE tracks using the CBOE S&P 500 BuyWrite Index (BXM). According to CBOE the strategy involves:

(1) buying an S&P 500 stock index portfolio, and (2) “writing” (or selling) the near-term S&P 500 Index (SPXSM) “covered” call option, generally on the third Friday of each month. The SPX call written will have about one month remaining to expiration, with an exercise price just above the prevailing index level (i.e., slightly out of the money). The SPX call is held until expiration and cash settled, at which time a new one-month, near-the-money call is written.

A study on the strategy can be found here (pdf). In addition, a second study shows some of the benefits of buy-write strategy. A buy-write strategy essentially matched the performance of the S&P 500, however, it had significantly less volatility. Sound familiar? Moving average studies detailed on this site have had similar results. The buy-write study:

In 2006 Callan Associates, an investment services consulting firm, published a new study on the CBOE S&P 500 BuyWrite Index, with an analysis of performance from June 1988 through August 2006. Their study builds upon the earlier studies done by Professor Robert Whaley (now at Vanderbilt University) and by Ibbotson Associates. The new Callan Associates study had several key findings, including:

  • BXM generated superior risk-adjusted returns over the last 18 years, generating a return comparable to that of the S&P 500 with approximately two-thirds of the risk. (The compound annual return of the BXM was 11.77% compared to 11.67% for the S&P 500, and BXM returns were generated with a standard deviation of 9.29%, two-thirds of the 13.89% volatility of the S&P 500.)
  • The risk-adjusted performance, as measured by the monthly Stutzer Index over the 18-year period, was 0.20 for the BXM vs. 0.15 for the S&P 500. A comparison using the monthly Sharpe Ratio yielded similar results (0.22 vs. 0.16, respectively), confirming the relative efficiency of the BXM over the 219-month study period.
  • The BXM underperformed the S&P 500 during most rising equity markets and consistently outperformed the S&P 500 in all periods of declining equity markets, demonstrating the return cushion provided by income from writing the calls.
  • The BXM generates a return pattern different from that of the S&P 500, offering a source of potential diversification. The addition of the BXM to a diversified investor portfolio would have generated significant improvement in risk-adjusted performance over the past 18 years.
There are closed-end funds, mutual funds, and ETFs which employ a buy-write strategy. Two ETFs by PowerShares are PQBW (buy-write on the Nasdaq 100) and PBP (S&P 500 buy-write). Free INO Trend Analysis on PQBW and PBP can be found Here.
A second strategy, selling naked puts which was highlighted in Get Rich with Option is also featured on CBOE. The CBOE has an index which tracks a naked put selling strategy. An introduction:

In June 2007 the Chicago Board Options Exchange (CBOE) announced that it is beginning to publish daily data on the value of the CBOE S&P 500 PutWrite Index (ticker symbol PUT). PUT is an an award-winning benchmark index that measures the performance of a hypothetical portfolio that sells S&P 500 Index (SPX) put options against collateralized cash reserves held in a money market account. The daily historical data for the PUT Index now extends back to June 30, 1986.

The PUT strategy is designed to sell a sequence of one-month, at-the-money, S&P 500 Index puts and invest cash at one- and three-month Treasury Bill rates. The number of puts sold varies from month to month, but is limited so that the amount held in Treasury Bills can finance the maximum possible loss from final settlement of the SPX puts.

Sound risky? It can be – a collapse in the markets like the one seen in 2008 can put you on the hook for purchasing shares at a much higher price then the current market price. However, the historical data on PUT is impressive. Ennis Knupp did a study in December 2008 (pdf) on PUT. From June 30, 1986 to October 31st, 2008 employing the strategy yielded the following results:
The systematic sale of put options over the entire time period would have earned an annualized return of 10.32%, before fees, with an annualized standard deviation of returns of 9.91%. The risk and return of the PUT Index compare favorably to the S&P 500, which earned annualized returns of 8.77% with a volatility of 15.39% over the same time period. The CBOE S&P 500 PutWrite Index was announced in June 2007 and the track record of returns was generated using historical options prices, with the assumption that each put option was sold at the bid price.

Again, we see significantly less volatility when using this strategy versus the S&P 500. Selling naked puts can involve significant risk; however, that risk is mitigated if the seller has cash on hand to cover the amount of stock on which they are selling puts. This is the strategy with PUT – thus, your potential downside is actually less then holding the S&P 500 since you received the initial premium for selling the put. I would highly recommend reading the Ennis Knupp study in full to gain a further understanding of the strategy.

No disclosures

A Book Review: Get Rich With Options – Four Winning Strategies Straight From the Exchange Floor

Having a basic knowledge of options and option trade strategies I was excited to read Lee Lowell’s Get Rich with Options: Four Winning Strategies Straight from the Exchange Floor (Agora Series)border:none !important; margin:0px !important;" />. The primary appeal of the book was its promise to provide a four specific option strategies for making a profit in bull and bear markets (the second edition includes a fifth, ‘bonus’ strategy).

For a beginner option trader who may have never heard of a call or a put, this book will move you quickly from defining some basic option terms to trading specific strategies. The book is ideal for an investor with a basic understanding of options but who has never put together a game plan for trading specific strategies. Lee Lowell details five of his favorite strategies:
1) Purchasing Deep-In-The-Money Calls in lieu of purchasing the stock outright.
2) Out-of-the-Money Naked Put Selling (only on stocks you may want to own someday)
3) Credit Spreads, a strategy he refers to his as an ‘All-Star Strategy’
4) Selling Covered Calls
5) Ratio Option Spreads
The primary theme of his strategies, besides purchasing DITM calls, is that investors should seek to get paid when they trade options. Most beginning investors think of options as a lottery ticket, however, as Lowell details there are several strategies an investor can implement to get paid to sell options. The title of the book and its promise to ‘get rich’ may be apt if you are on a long enough timeframe (years). I would stress that there is no magic ticket in investing, option or otherwise. Thus, once you have read this book you will still need to a) familiarize yourself with an options software platform to analyze potential trades, and b) identify potential securities on which you are bullish/bearish/neutral on. The option strategies in the book can help you profit from your security analysis but this book is not going to help you actually pick the securities on which to trade options.
If you are an experienced option trader or have ever traded a ratio spread, then this book is too basic for you. However, I think it has substantial value for the beginning to intermediate options trader.