Don Fishback

The Three Proven Keys

To Beating The Market

www.oddsprovenincome.com

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 Table of Contents

Chapter 1 ......................................................................... 1
A Layman’s Introduction to the Efficient Market
Hypothesis and Financial Market Anomalies ............. 1
Profiting From the Abnormal ..................................... 2
The Efficient Market Hypothesis................................ 5
You Can’t Get Something For Nothing ...................... 6
The More Popular a Profit-Making Strategy Becomes,
the Worse It Performs ................................................. 7
Chapter 2 ....................................................................... 11
A Discovery By An Amateur Investor ..................... 11
The Academic Community Discovers the Momentum
Effect ........................................................................ 12
Application to Industry Groups ................................ 15
Putting The Momentum Effect To Work.................. 16
Chapter 3 ....................................................................... 17
The Irrational Investor .............................................. 17
Is Buying Insurance Rational? .................................. 18
Options As Insurance................................................ 19
Financial Consequences of Buying Protection ......... 20
Chapter 4 ....................................................................... 24
Putting Two Anomalies Together............................. 24
But What About The Risks? ..................................... 24
Chapter 5
Enhancing Momentum with “Market State”.....27

© Copyright 2014, Donald M. Fishback, Jr.

ALL RIGHTS RESERVED. No part of this publication may be
reproduced, stored in a retrieval system, or transmitted, in any form
or by any means, without the prior written permission of the
publisher and the author.
This publication is designed to provide authoritative, accurate
information in regard to the subject matter covered. It is sold with the
understanding that the author and publisher are not engaged in
rendering legal, accounting, or other professional advice.

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Options involve risk and are not suitable for all investors. Past
performance does not guarantee futures results.

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Chapter 1
A Layman’s Introduction to the Efficient Market
Hypothesis and Financial Market Anomalies

What is an anomaly? An anomaly is something that

is odd, uncommon, out of the ordinary. Pure and simple,
an anomaly is abnormal.
In this report, we’re going to investigate two
anomalies in the financial markets. More important,
we’re going to show you how we put these anomalies to
work. We have created an investment strategy based on
our own discoveries. What’s interesting is that what we
found has been confirmed by research from some of the
most distinguished members of the financial academic
community.
Before we get started, however, there is an important
question I’d like to ask you: Do you want your trading
strategy to be based on rock solid research that has been
proven over time? I’m sure most people will say yes.
Well, be careful how you answer that question.
Because if that’s what you want, you then have to ask
yourself a couple of follow-up questions: Do you want
to have a full understanding of the methodology? Will
you be able to get through the explanation of the
research?
The reason I ask is because this booklet provides a
massive amount of information on the anomalies that
allow us to do what we do. It does so in a very short
report that doesn’t contain any fluff. Some might say
it’s too much information. But I have to tell you that I’d
rather give you too much information than not enough.
When I evaluate a trading strategy, I want to know
everything.
The good news is, there is nothing in this report that
goes over the head of anyone who has an interest in
options. [As far as the cited articles? Well, that’s
another matter. You can get most of them off of the

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internet or from a library. They are not for the faint of
heart.]
Here’s the thing. If you find that this report is too
tedious or the subject matter too complicated, do not
worry. You do not need the information contained in
this report to use ODDS Proven Income. The service
does all the work for you. We’ve developed systems
that utilize the information in this booklet and automated
them so that all you need to do is access a web page that
provides a list of potential trades. All you have to do is
log in and read the daily updates. It could not be easier.
So enjoy the rest of the booklet, but don’t fret if it
gets too overwhelming the first time you read it. As
stated, this report covers a vast amount of information
that would be helpful if your goal is to understand what
we’re attempting to accomplish. But it’s not necessary
for the actual day-to-day operation and utilization of the
service.

Profiting From the Abnormal

In investing, the accepted norm over the past half

century has been based on the Efficient Market
Hypothesis, or EMH.
At its core, the Efficient Market Hypothesis assumes
that the current asset price--what ever it might be--is
based on all known information by all parties.
Everyone has an opinion as to where an asset’s price
is likely to be headed in the future. Their buying and
selling has caused the price to go to a certain level.
Where the price goes from that level is random. And it
follows a normal distribution. [Okay, it doesn’t perfectly
follow a normal distribution. But it’s close enough that
we can use the mathematics of a normal distribution to
make derivative valuation estimates with models.] At
the top of the next page is a graphic of the S&P 500 with
a modeled distribution that looks like a bell curve and
the actual distribution of daily returns.

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 Because an asset’s price is based on the expectations
of all parties, the only way for an asset’s price to change
is for a catalyst to come along and change those
expectations.
In the case of a stock, it may be company specific
news. In the case of the stock market, it may be political
or economic news.
The key is, while some might be able to predict the
news, no one can consistently predict how the news will
impact investor expectations. That’s why the direction a
stock takes is considered random.
One of the other precepts that supposedly proves
EMH is that very few investors have been able to
consistently beat a market benchmark without taking
undue risks. In other words, the only reason investors
beat the market on a regular basis is due to luck,
leverage or investing in riskier stuff.
Consistent profitability above and beyond a
benchmark that is achievable via traditional investments
like CDs, bonds or broad-based stock indexes—without
taking undue risks—would be considered an anomaly.

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 We’ve seen this “rule” get enforced over and over
again when you see a hot money manager or hot
investment idea suddenly blow up.
Fortunately for us, however, our Measure Don’t
Model® approach that’s based on data from our massive
and cutting edge database has given us the opportunity
to profit repeatedly and consistently. That’s because it
assumes that the normal distribution may be incorrect.
Here’s an example where a stock’s distribution deviates
wildly from the normal bell curve.

The actual “tail”

is taller than the
theoretical peak
of the bell curve

Because we take into account these deviations, our

Measure Don’t Model® approach may be an exception to
the rule … an anomaly.
This report is going to cover two other anomalies.
They’re two of the most widely researched anomalies in
all of academia. Countless research papers have been
published on these topics.

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 Although the report is only slightly more than 25
pages long, it is chock full of some of the most valuable
investing information found anywhere. It’s a summary
of decades of research done by me and by hundreds of
other research professionals in a succinct format.
Once you’ve completed this report, you’ll have a full
understanding as to why our ODDS Proven Income
approach works the way it does. You’ll understand why
the profits from this method truly are abnormal.

The Efficient Market Hypothesis

First, a little background.

Like I said, EMH requires that the general
investment community comes to a consensus about an
asset’s price. Let’s say that you have countless investors
trading a stock. Let’s say the stock is Apple (AAPL).
Let’s also say that AAPL shares are trading at $100.
That means, based on the information that traders
involved in AAPL currently possess, they have come to
the conclusion that $100 is the correct price for AAPL
shares.
It’s important to note that the $100 price is not
determined by earnings, sales or any fundamentals.
Those factors would give you value, not price. Price is
determined by an open, mostly online auction between
buyers and sellers.
EMH says that the only way for the price to fluctuate
from this level is for new information to come along.
When that new information arrives, the change in the
price is rapid and cannot be exploited.
We see this all the time when a stock gaps higher or
lower after a news event, such as earnings. While the
new information might be accurately predicted, one of
the problems is that, very often, the new information was
already expected and, therefore, was already reflected in
the price. The future movement of the stock from that
point cannot be exploited. So the direction the stock
takes once the news comes out is random.

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 This happens in the real world quite frequently when
a company provides an updated outlook when earnings
are announced. One of the key factors influencing a
stock’s price after earnings are announced is not
necessarily the earnings report itself. It’s how the
earnings compare to analysts’ expectations. In fact, it’s
gotten to the point that not even current earnings will
influence a stock’s price. Instead, what drives the stock
is the company’s outlook for the future. In other words,
how the stock behaves after earnings are announced
depends on how expectations are adjusted based on new
information from the company.
Another key fact about EMH is that it assumes
investors are rational. This is not hard to understand. If
investors find something that works, they flock to it.
What happens is that potentially winning trading
strategies get discovered by a few, then the strategy gets
known by many. Rational investors flock to the winning
strategy so that it becomes widespread. [As we’ll learn
later, rational investors should flee strategies that cost
them money unnecessarily.]
With all those rational investors doing the same
thing, their expectations become reflected in the stock
immediately. So if you were an early adopter of the
strategy who is now looking at the same information that
everyone else is, any edge you might have had
disappeared and the winning strategy stopped working.

You Can’t Get Something For Nothing

A classic example of this occurred during the real

estate bubble. During the buildup to the bubble, the
Federal Reserve was earnestly striving to keep interest
rates low so that the economy could recover from the
popping of the tech bubble. Savers and investors were
unhappy with the yields they could get on CDs and other
fixed income securities. So many of these supposedly
sophisticated professional institutional investors
“reached for yield”. Unhappy with 4.5% interest on

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their money, these investors looked for relatively safe
alternative investments that paid a slightly higher rate.
The investments many of these so-called pros
bought were mortgage-backed derivative securities. The
key is that many of these derivatives were AAA-rated by
the national ratings agencies. Through the alchemy of
financial engineering, risky junk was converted into
interest-bearing securities that were supposedly safe.
When the securitization process of creating highly
rated mortgage backed derivatives started, all was well
and good. The investors that got in at the beginning did
quite well. Other investors saw how well the early
adopters were doing and they jumped in. More
followed, and then more. Eventually, the trickle of
money into the mortgage market turned into a tidal
wave.
We all know how this turned out. The risky junk
turned out to be just that--risky junk. And the purported
safety was just an illusion.
Here’s the point: These investors basically fell
victim to the EMH. They did not get a return higher
than the benchmark with the same level of safety. They
got a higher return for a while, but the perceived safety
was a fantasy. When the true riskiness was realized, the
high returns turned into huge losses.
It’s like the old adage says, You can’t get something
for nothing.

The More Popular a Profit-Making Strategy

Becomes, the Worse It Performs

There are plenty of other examples where the EMH

has taken its toll on investors who think they have an
edge.
The fact that only a handful of investors can beat the
market consistently is another key piece of evidence
indicating that persistently finding situations that can be
profitably exploited is extraordinarily difficult.

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 Let’s look at another situation, this time by
answering a question. If you flip a coin 9 times and it
comes up heads all 9 times, what’s the likelihood of it
coming up heads on the next flip? The answer is 50/50.
The coin has no idea what the result of the prior flip was.
The result of the next flip is independent of the prior
flips.
Let’s say you’re going to flip a coin 10,000 times.
You know ahead of time that the number of heads and
the number of tails is going to be pretty close to 5,000
each. But that does not mean if you flip a coin 10 times
and they all come up heads that the next 10 flips will
come up tails. That’s because the probability of the
result being heads or tails for each flip is independent of
the result of the prior flip. So no matter what the streak,
the probability of flipping heads or tails on the next flip
is 50/50.
EMH says the same thing about a stock. If a stock
goes up 1% every day for 9 straight days, what’s the
probability it goes up the next day? EMH says 50/50.
If it was anything else besides 50/50, that would
have very powerful implications. For instance, let’s say
that we did some research and found that in past
instances where, after a stock goes up for 9 straight
trading days, there is a 90% chance that it will go down
on day 10. Imagine that we did some statistical analysis
and found that there have been 5,000 instances of a stock
going up 9 straight days. Imagine that we also found that
in 4,500 of those situations, the stock dropped on day 10.
That tells us that 90% of the time, the stock moves
lower. Also, imagine our study found that the size of the
down move it takes 90% of the time is 3 times greater
than the up move it takes 10% of the time.
So the stock goes down much more frequently than
it goes up. When it does go up, it doesn’t go up much.
When it goes down, it goes down a lot.
Armed with that information, what would you do?
Well, one very easy thing you could do is construct a
trading system that screens for stocks that have gone up

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9 consecutive days. Once you get the results of that
screening process, you could put on a huge short
position in the stock and make a very reliable, very large
profit!
Here’s the thing. If you started doing that, pretty
soon others would notice and start doing the same thing.
Believe it or not, despite the mixed results many
traders have, there is actually a lot of brain power on
Wall Street. Pretty soon someone else would figure it
out too. The effect would be that, as the stock’s streak
of gains started approaching 9 straight days, traders
would start to take notice. As the end of the 9th day
approached, people would start shorting the stock to take
advantage of the near-certain drop on day 10. That short
selling would push the price of the stock down so that
the stock may actually finish that 9th day lower, thus
breaking the streak before the 9th day is complete, which
ruins the system, which means the action on day 10 is
now uncertain … random.
The net effect of all of this leads to the Efficient
Market Hypothesis. As information becomes known,
stock prices react immediately to the information.
Therefore, future market movement is based purely on
the market’s reaction to fresh news. That reaction will
be random and cannot be predicted.
A consequence to this is that anytime an investor
does appear to beat a benchmark, it’s because they’re
taking on excessive risk or just lucky.
If an investor does appear to have an edge that leads
to consistently high performance and that high
performance comes without taking on excess risk, that
edge will disappear as rational investors start mimicking
his or her methodology.
If, in the unlikely event, you can find an exception to
those rules, it would be considered an anomaly …
abnormal.
The question then becomes, are there anomalies?
The answer is, YES!

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 Ironically, one well-known anomaly, the momentum
effect, has been thoroughly researched and supported by
the man who developed the EMH -- Nobel-Prize winner,
Professor Eugene Fama of the University of Chicago.

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Chapter 2
A Discovery By An Amateur Investor

So what is the momentum effect? Let me begin with

a true story about my dad, who was an inspiration to me.
He loved the stock market. He wasn’t a trader. He was
a long-term investor. And when I mean long-term, I
mean my mom still owns some stock they bought in the
1960s (Dad passed away many years ago).
Back in 1991, my dad noticed something. It had to
do with the relatively new Fidelity Select Funds. These
were sector-specific funds. It’s funny to think about
how revolutionary these mutual funds were back then
considering the proliferation of ETFs today. But they
were truly ground-breaking when they were introduced.
Anyway, my dad noticed that in late-1991 that the
Fidelity Select Biotechnology fund had been the best
performer that year. He also noticed that it was the best
performer in 1990. That prompted him to investigate
further.
He found that very often, the best performing sector
one year had a market-beating performance the
following year! The positive momentum from one year
continued to the next.
The system could not have been easier. To beat the
market, all you had to do was look at the one-year
returns of the different Fidelity Select Funds at the end
of the year, and buy the best performer for the following
year. [Note that back then, there weren’t as many Select
Funds as there are now. So it’s not nearly as simple
today.]
My dad and I discussed it and tweaked it till we
found that the positive momentum wasn’t just isolated to
the single best performing industry group. Positive
momentum seemed to apply to the top 10%. That is, if
you had 100 different industry groups, the top 10
performers from one year would outperform the overall

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market the following year. [I also found that it would be
helpful to apply some sentiment analysis, but that’s a
separate issue I cover in my Profit Power™ Home Study
Course.]

The Academic Community Discovers the Momentum

Effect

While all of this was going on between my dad and

me, the academic community was beginning to
investigate the momentum effect. The breakthrough
research was published a couple of years after my dad
spotted the industry-group momentum effect. In 1993, a
Journal of Finance article titled Returns to buying
winners and selling losers: Implications for stock market
efficiency1 contained this abstract:

This paper documents that strategies which buy

stocks that have performed well in the past and sell
stocks that have performed poorly in the past
generate significant positive returns over 3- to 12-
month holding periods. We find that the profitability
of these strategies are not due to their systematic
risk or to delayed stock price reactions to common
factors. However, part of the abnormal returns
generated in the first year after portfolio formation
dissipates in the following two years. A similar
pattern of returns around the earnings
announcements of past winner and loser is also
documented.

What these investigators found is that relative

strength is a powerful predictor of future price behavior
over 3- to 12-month time period. That is, if you were to
create a market neutral portfolio where you buy the best

1
Jegadeesh, N. and Titman, S. (1993), “Returns to buying
winners and selling losers: Implications for stock market
efficiency”, J. OF FINANCE, Vol. 48, No. 1, pp. 65-91.

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performers and sell short the worst performers, you
would create a market-neutral portfolio that generates
returns far higher than one would expect from a market-
neutral investment strategy.
That research was extended in a ground-breaking
article, also in the Journal of Finance, by EMH
developer Fama and Professor Ken French of Dartmouth
in 19962. Here’s the abstract:

Previous work shows that average returns on

common stocks are related to firm characteristics
like size, earnings/price, cash flow/price, book-to-
market equity, past sales growth, long-term past
return, and short-term past return. Because these
patterns in average returns apparently are not
explained by the capital asset pricing model,
(CAPM), they are called anomalies. The authors
find that, except for the continuation of short-term
returns, the anomalies largely disappear in a three-
factor model. Their results are consistent with
rational intertemporal CAPM or arbitrage pricing
theory asset pricing but the authors also consider
irrational pricing and data problems as possible
explanations.

The key phrase is “the continuation of short-term

returns”. That’s the momentum effect. In the article
itself, the researchers found that using a model they
developed that incorporated three factors, they could
explain a portfolio’s performance. But no matter what
they did, they could not explain the momentum effect. It
was an anomaly that just wouldn’t “disappear”.
Since then, there has been an avalanche of research
on the momentum effect. Not only has it been studied
on stocks here, but it’s also been studied on the stocks of

2
Fama, Eugene F. and French, Kenneth R. (1996),
“Multifactor Explanations of Asset Pricing Anomalies”, J. OF
FINANCE, Vol. 51, No. 1, pp. 55-84.

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foreign markets3. It’s even been studied on other types
of financial markets, such as currencies4 and even
commodities5.
Back to stocks. In 2007, Fama and French found
that the momentum effect still exists and remains quite
strong6.
Shortly after the discovery of the momentum effect,
researchers began to try to figure out why it works. One
reason people believe it works is what’s called feedback.
A very interesting Working Paper I came across looked
at feedback and found that the momentum effect was
most pronounced on stocks that had high volatility. The
researchers eventually presented their findings at a
conference in October 20107. Another study published
in the Journal of Finance suggested that momentum
works because the market responds only gradually to
new information8.
As you might imagine, this is a very small fraction
of the research done on the subject. The momentum
effect is one of the most well-known patterns in the

3
Asness, C.S., Liew, J.M. and R. L. Stevens (1997), "Parallels
Between the Cross-Sectional Predictability of Stock and
Country Returns", Journal of Portfolio Management Vol. 23,
No. 3, pp. 79-87
4
Nitschka, Thomas (2010) “Momentum in Stock Market
Returns, Implications for Risk Premia on Foreign Currencies”,
Swiss National Bank Working Papers
5
Erb, Claude B. and Harvey, Campbell R. (2006), “The
Tactical and Strategic Value of Commodity Futures”,
Working Paper
6
Fama, Eugene F. and French, Kenneth R., Dissecting
Anomalies (June 2007). CRSP Working Paper No. 610
7
Chiang, Thomas C, Liang, Xiaoli and Shi, Jian . “Positive
Feedback Trading Activity and Momentum Profits” The 2010
Financial Management Association Annual Meetings: New
York City, NY Oct 2010
8
Chan, Louis K. C., Jegadeesh, N. and Lakonishok, J. (1996),
“Momentum Strategies”, J. OF FINANCE, Vol. 51, No. 5, pp.
1681-1713.

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stock market. Because its profit-generating performance
is well known, and because investors are supposedly
rational, so many people should be trying to implement
the momentum effect that it shouldn’t be providing
abnormally high returns anymore.
Yet, even though nearly every professional investor
knows about it, the momentum effect remains. That
makes it a true anomaly.
One thing I want to make clear is that in the studies
here and in the hundreds of studies not mentioned, the
researchers didn’t just look at the one-year returns like
my dad and I did. They looked at all sorts of time
horizons, from as little as one month to as long as four
years. [For what it’s worth, back in the 1980s,
researchers found that when you looked back over very
long time horizons such as four years, there exists what’s
known as the reversal effect. That is, the best
performers do the worst and the worst performers do the
best.]
In some studies, researchers included what’s known
as a skip period. Let’s look at an example to show you
what that means. Let’s say you were looking at 11-
month returns with a 1-month skip. On December 31,
you’d look back a year ago at the price of a stock on
December 31 the prior year. That would be your starting
price. You’d then look at the total return of the stock
between the start point and the next 11 months ending on
November 30. You’d do that for every stock, then you’d
select the top performers (generally the top 10%).
Because you could perform this analysis immediately
after November 30, you could determine what stocks to
have in your portfolio at the close on December 31,
which is when you’d make your portfolio adjustments.

Application to Industry Groups

Not only have researchers investigated the

momentum effect on U.S. stocks, foreign stocks, foreign
currencies and commodities, they’ve also checked to see

15
if there is a momentum effect for industry groups.
That’s the effect my dad noticed nearly two decades ago.
Indeed, researchers have confirmed that there is a
momentum effect for industry groups9, 10.

Putting The Momentum Effect To Work

Bottom line is that there is overwhelming evidence

that the momentum effect is real and pervasive across
the globe and across all markets, and effective from the
stock level to the industry group level.
We’re going to put this knowledge to work by
focusing on the best performing stocks in the best
performing industry groups.
Our actual methodology is a little complex because
of the way industry groups are configured. For example,
the diversified technology sector has about 50
companies in that group while the tobacco has just a
handful. We take those differences into account, along
with a couple of other steps, such as only looking at the
performance of optionable stocks. We don’t measure the
performance of stocks that don’t have listed options
associated with them. Once that’s complete, we then
rank the industry groups according to performance.
From the rankings, we take the top performers.
Then we select the best stocks in the best performing
industry groups.
That is the final step of the first process. We now
we have our list of stocks that are likely to be
anomalous. That is, they’re very likely to outperform
the stock market over the short-term. The next step is to
find the proper option trade. And for that, we turn to
another anomaly.

9
Moskowitz Tobias J. and Grinblatt, Mark (1999), “Do
Industries Explain Momentum?”, J. OF FINANCE, Vol. 54,
No. 4, pp. 1249-1290.
10
Faber, Mebane T. (2010), “Relative Strength Strategies for
Investing”, Working Paper

16
Chapter 3
The Irrational Investor

This is a real puzzler. And it pokes a pretty big hole

in the “rational” part of the Efficient Market Hypothesis.
Remember, one of the key principles of the Efficient
Market Hypothesis, as well as mainstream economics, is
the concept of a rational participant, whether you’re
talking about an investor in the market or a consumer in
an economy. A rational participant should stop doing
things that are not in their best interest. For example,
someone driving down the street needs to buy gas. Gas
stations have signs displaying price. A rational
participant will factor in things like name brand, ease of
access to the station, even things like environmental
record of the oil company, and last but certainly not least
(in fact, it’s probably the most important part) price, and
then make a decision.
Here’s what will not happen: All things being equal
except price, economic theory says that a rational
consumer will not select to buy the gasoline at the higher
price. For instance, let’s say you’re driving down the
road and there are two Shell stations right next to each
other (this controls for perceived gasoline quality and
environmental record). The access to the stations is
identical. The facilities are both the same age. Taxes
are the same. There is absolutely no difference …
except that one station charges $2 per gallon and the
other charges $4 per gallon. They will not buy the
higher priced gasoline. They will avoid what’s not in
their best interest. Economic theory states that the
rational consumer will do what is in their best interest
and buy the lower price gasoline.
It’s the same thing with investors and the financial
markets. Investors drift to ideas that work (although, as
noted, the momentum effect is an exception). They
avoid things that don’t work. If an investment idea

17
doesn’t work, then people tend to shun that investing
idea.
We’ve seen this on display in the real world as
investors have embraced passive index mutual funds and
ETFs much more so than they have active mutual funds
that depend on the stock-picking skills of the manager.
Evidence of this also showed up in the asset flows of
bond funds in 2009 and 2010. With the S&P 500 in
November 2010 right back where it was in July 1998,
and dividends extraordinarily low during that time
frame, the return on stocks has been abysmal over a 12-
year period compared to bonds. So it’s no surprise … in
fact, it’s both rational and expected by EMH that
investors would have fled the stock market and
embraced the bond market.
Simply stated, a strategy that loses money over the
long haul will not attract money!

Is Buying Insurance Rational?

Do you buy car insurance? If you’re an adult living

in the U.S., the answer is probably yes.
Do you think you make money or lose money by
buying car insurance? Before you answer that, think of
it this way. Would you be better served if you self-
insured? That is, would you be better off putting the
premiums in a savings account and collecting the
interest. Later, if you don’t have a wreck and the money
starts piling up, you start investing in stocks and real
estate and commodities and maybe even start loaning
money to businesses. Heck, you’d be just like an
insurance company now!
The answer to the question as to whether or not you
would be better served financially by buying car
insurance is a definite no for the vast majority of the
population. Think of it. The proof is that insurance
companies actually exist! The insurance companies
have to make money somehow. They make money by

18
utilizing the investment proceeds from all that money
you give them.
Buying insurance costs the pool of policyholders
two things: loss of premium and loss of opportunity on
those premiums. In return, an individual policyholder
has the potential to recoup far more than he or she ever
paid in case there is ever a need to file a claim. In
aggregate, however, the pool of policyholders loses
money.
In other words, buying car insurance is bad when
measured as an “investment”. But the peace of mind
that comes with insurance makes it worth it.

Options As Insurance

What this shows is that people are willing to spend

money on things that aren’t necessarily in their best
financial interest. You could say the same thing about
vacations or any other luxury or hobby. Sometimes,
spending money on happiness is worth it. You could say
the same thing about spending money on peace of mind,
such as buying a fire extinguisher for the kitchen or
making sure you car has airbags. It’s unlikely you’ll
ever need either of them. Most likely, it’s a waste of
money. But you’ll be very glad you spent the money if
you ever need either of them.
For most people, spending money on something that
protects them, even though it’s unlikely they’ll ever need
the protection, is still worth it. In fact, they probably
haven’t even considered it as being irrational.
For many investors and traders, it’s a very similar
thing with respect to index puts.
A severe car wreck is similar to the bear market of
2008. The difference is, car wrecks occur every day.
But they impact only a small fraction of the public at any
moment.
Severe bear markets like those seen in 1929-1932,
1973-1975, 2000-2002, and 2007-2009 don’t occur

19
every day. But when they do occur, nearly everyone,
including non-investors, is affected.
The interesting thing is, the likelihood of these
events, and the financial consequences, are conceptually
similarly. That is, they are both: Low Probability, High
Severity.
For some people, buying protection from a high-
severity event is worth it, even though there is such a
low probability of it ever happening that it’s very likely
to be a money-losing proposition.

Financial Consequences of Buying Protection

As noted, the consequences of buying protection for

unlikely events are that you’re likely to lose quite
frequently. In fact, unless the totally unexpected
happens--even when a catastrophe does happen and a
claim is paid--at the end of the day, the insurance
company is likely to make a profit. The pool of money
paid to the claimants the insurance company collected
premiums from is less than what the total pool of
insureds would have had if they kept their money and
invested it themselves. The insureds lost.
It’s the same way with index puts. In an October
2004 study, Driessen and Maenhout found that buyers of
index puts lost money11. And it wasn’t just a little bit of
money. The study found that if an investor bought a
one-month index put whose strike price was nearest to
the level 4% below the price of the index at the time of
purchase, that investor would lose -41% a month.
That is not a misprint. It is not a loss of -41% a
year. It’s -41% a month!
If an investor bought the put that was further out-of-
the-money, say 8% below the index price … IT GETS
WORSE!! -48% a month.

11
Driessen J. and Maenhout P. (2004), “An Empirical
Portfolio Perspective on Option Pricing Anomalies”, Review
of Finance, Vol. 11, No. 4, pp. 561-603

20
 There is no way a rational investor would
persistently buy something that loses money so reliably,
especially when you don’t get any utility from it. You
wouldn’t buy a car that lost -41% of its value each and
every month! At that rate, a new $20,000 car would be
worth just $35 in a year. You wouldn’t buy gold if you
suffered that kind of compounded loss. If you bought
gold at $1,000 an ounce, a year later it would be worth
$1.78.
It is completely irrational for someone to pay that
much money for something that loses that badly. Yet
people still do it. This is completely contrary to EMH.
It’s an anomaly.
Another way of looking at this concerns the pricing
of the options; it means index option puts are extremely
expensive compared to the financial value they provide.
Buyers of index puts get hammered. Sellers of puts
make huge profits.
The reason index put buyers continue in their losing
ways is because every now and then, the stock market
suffers a catastrophe and the put buyers make big
money. Unfortunately, even though there is eventually a
big score, it’s never enough to make up for all the money
lost during those losing months. Kind of sounds like
people going into a casino hoping to hit the jackpot, or
someone playing the lottery, doesn’t it?
The thing is, someone playing the lottery or
gambling in a casino is not rational. They may be
having fun, but it’s only entertainment. It is not a very
good way to make a living [I’ll admit that card counting
is rational. But someone who tries it will get kicked out
if they’re caught. And I’ll also admit that a skilled poker
player can earn a positive return. But a poker player
isn’t playing against the house.]
Because there is no entertainment value in buying
puts and only economic value, EMH says that the
persistent losses should cause rational investors to stop
buying them … at least at that price.

21
 We can use a game of chance to illustrate what the
last part of that sentence means. Let’s say you have a
game where, when you win you win 4, when you lose,
you lose 1. The risk reward in this game sounds pretty
good, doesn’t it.
Now let’s add one more crucial ingredient. Let’s say
your odds of winning are 10%. That means 1 time in 10
you win 4, and 9 times in 10, you lose 1. If you play the
game 100 times, you’d have 10 wins of 4 for a total of
40. And you’d have 90 losses of 1 for a total of -90.
Ugh! You can see that you’d lose a lot of money
playing that game.
In a game with fair odds for both people playing the
game, the probability has to change. With a win amount
of 4 and a loss amount of 1, the win rate for you has to
be 20% for the odds to be fair. [I urge you to do the
math yourself to confirm this.]
What this tells us is that risk and reward can be used
to determine the probability assessment of the game.
It’s similar with insurance. As you age, the cost of
health insurance goes up because you’re more likely to
have a bad back as a 50-year old than you were when
you were 20. Of course, your car insurance premiums
go down as you age because you’re less likely to be
reckless than you were when you were 20.
In options, the price of the option can be used to
determine the probability assessments of the market
participants. Overpriced puts tells us that the put buyers
have a distorted sense of probability. They are
overestimating the likelihood of a market decline.
That is the anomaly! They’re behaving like the
insurance buyer--only more so--and paying so much for
protection that it allows the insurance seller--the put
seller--to make an abnormally large profit.
This phenomenon has been confirmed in a wide
variety of studies, including one by Constantinides G.,

22
Jackwerth and Perrakis S. (2009)12 and another by Doran
(2006)13.
Others have found that the overpricing of puts isn’t
just isolated to index options. It applies to selected
equity puts and even to calls as well14, 15.
The cumulative research shows that the persistent
overpricing of options, and of puts in particular, allows
abnormally large, risk-adjusted returns to option sellers.

12
Constantinides G., Jackwerth J. and Perrakis S. (2009),
“Mispricing of S&P 500 Index Options”, Review of Financial
Studies, Vol. 22, No. 3, pp. 1247-1277
13
Doran J. (2006), “Is There Money to be Made Investing in
Options? A Historical Perspective”, Working Paper
14
Goyal A. and Saretto A. (2007), “Option Returns and
Volatility Mispricing”, Working Paper
15
Doran J. and Fodor A. (2009), “Firm Specific Option Risk
and Implications for Asset Pricing”, Journal of Risk, Vol. 12,
No. 1

23
Chapter 4
Putting Two Anomalies Together

So now what? We have two anomalies: the

momentum effect and the overpricing of puts. What can
we do with that information?
Actually, for you the reader, the next step is short
and sweet.
Each night, our computers go through a step-by-step
process of finding those industry groups with the highest
momentum. Next, they look at the stocks in the industry
groups and find those stocks with the highest
momentum.
Next, our computers look for the most overpriced
puts on the stocks when the options are compared to
their normal volatility. We rank the options in order of
return on margin. We take the top ten and highlight the
trade that should be the most attractive to a short seller at
the top of the list.
We post this list on our web site for you to see so all
you need to do is log on and get the list of options that a
qualified option trader should consider selling.

But What About The Risks?

Option selling does involve risks. But if done with a

cash account, did you know that a naked put sale is less
risky than actually buying shares of stock?
That’s right. A naked put sale is equivalent to a
covered call. If a stock is at 40 and you sell the 35 put,
that has the same risk and reward characteristics as
buying the stock and selling the 35 call.
The reason people think put selling is so risky is
because the margin requirement on naked puts is much
lower than on covered calls. So you can play with more
borrowed money and use more leverage. Hey, isn’t that
the same thing that caused the housing crisis?

24
 The point is, it’s not the options that cause put
selling to be any more risky than covered calls or stocks.
It’s the leverage that causes the problem.
The Chicago Board Options Exchange has a very
interesting white paper on an index they created to show
what would happen if an investor were to adopt a put-
selling strategy. The index has a ticker symbol of PUT.
In the white paper, the CBOE reiterates what we’ve
noted in this publication: studies investigating the selling
of at-the-money, next-month index options have shown
that this strategy can “generate high risk-adjusted
returns”. They also report, as we do, that “reasons cited
for the excess returns are the negative risk-premium
garnered by volatility, and, in the case of puts, the high
demand for portfolio protection.”
Here is a graph of the S&P 500 Total Return Index
(includes reinvested dividends) compared to the CBOE
Put Index, which measures the performance of
repeatedly selling a one-month, near-the-money naked
put on the index, holding the position till expiration and
reestablishing the position each month, no matter what
the market conditions might be.

The orange line is the CBOE PUT Index

The white line is the S&P 500 Total Return Index

Note that the PUT (orange line) is at a new all-time

high, while the S&P 500’s total return (white line) is

25
lagging. Also note that this is a logarithmic scale, which
means the outperformance is even more striking.
To learn more about put selling, be sure to read the
other bonus book on this disk: Options For Beginners.
Also read the book you get (or got) when you open an
options account Characteristics and Risks of
Standardized Options. Finally, check out some of the
excellent educational material provided by The Options
Industry Council.

26
Chapter 5
Enhancing Momentum with “Market State”

So let’s summarize what we have: two anomalies

that provide unexplainable results. That is, the returns
gained from momentum and put selling give investors
profits that exceed the Capital Asset Pricing model.
Research by Devraj Basu and Chi-Hsiou Hung
investigated whether there were sub-periods where the
anomalies performed even better than the large overall
periods that prior studies measured. What they found
was very interesting. Best of all, the enhancement is very
simple to implement.
In their paper titled, Anomaly Timing16, they found
that the momentum anomaly performed exceedingly
well when the market was in a “Bullish State”.
When the market was in a “Bearish State”, the
momentum portfolio did not work as well.
When the market was in between the “Bullish State”
and the “Bearish State”, the momentum anomaly was
strong, but not as strong as when the market was in
“Bullish State”.
To make things simple, ODDS Proven Income
provides you with the market state every morning. That
way you can make a rapid, easy assessment.

16
Basu, D. and Hung C. (2008), “Anomaly Timing”

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