we draw a normal distribution, our goal with standard deviations is to measure the data from thecenter of the curve to the outlying tails.
Chapter 1616.1. Stephane Reverre, The Complete Arbitrage Desk Book. New York:McGraw-Hill, 2001.16.2. The point of this equation is to divide a 90-day MA by the standarddeviation of 90 days’ worth of data.
Chapter 1919.1. The CBOE Volatility Index (VIX) is a key measure of market expectations of near-term volatility conveyed by S&P 500 index options prices.Since its introduction in 1993, VIX has been considered by many to be theworld’s premier barometer of investor sentiment and market volatility.Source: http://www.cboe.com/micro/vix/index.asp
Chapter 2020.1. Lisa Sanders, “Apache Posts Four-fold Rise in Profit.”CBS.MarketWatch.com. Last update: April 24, 2003.20.2. Lisa Sanders, “Oil-drilling’s Outspoken Captain: At 80, Apache’s PlankRides Hard, and He’s Unapologetic,” CBS.MarketWatch.com, November 22,2002. http://cbs.marketwatch.com/news/story.asp?siteidmktw&guid%7BFF334005%2DCB6C%2D40E8%2DBD1B%2DDB20D04CAC41%7D&.20.3. Lisa Sanders, “Apache Posts Four-fold Rise in Profit.” CBS.MarketWatch.com, April 24, 2003. http://cbs.marketwatch.com/news/story.asp?guid{78DF8265-EB81-49C1-8185-5E221E821517}&siteidmktw&dist&archivetrue
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Chapter 2121.1. Investopedia.com. http://www.investopedia.com/terms/b/bookvalue.asp.21.2. Lisa Sanders, “Record Production Fuels Apache Q2. CBS.MarketWatch.com.” 7-24-2003
Chapter 2222.1. “Anadarko Petroleum Upped to ‘mkt perform’ at Wachovia.” CBSMarketWatch.com, October 7, 2003. http://cbs.marketwatch.com/tools/quotes/news.asp?siteidmktw&docty22.2. Yereth Rosen, “Independents Win Rights to Explore Alaska N. Slope,”October 29, 2003. http://cbs.marketwatch.com/tools/quotes/newsArticle.asp?guid{6C8B7FD3-A8CC-4B2A-B5C5-3ADDED58A303}&siteidmktw&archive thirdtrue&distRegSignIn22.3. Joseph A. Giannone, “Anadarko CEO Vows More Focused OverseasEfforts,” November 6, 2003. http://cbs.marketwatch.com/tools/quotes/newsarticle.asp?siteidmktw&sid582&guid%7B6A46A633%2D34B2%i2D4871%2DB927%2DD4192EB45881%7D.
Chapter 2626.1. Sheldon Natenber, “Option Pricing & Volatility,” McGraw-Hill, 1994.
GlossaryJonathan Crowell
Absolute return: A method of measuring investment results in terms ofpositive and negative, as opposed to comparing returns to a market index.Active management: An investment process in which the fund or accountattempts to outperform a benchmark. Active management is often referredto as the practice of market timing.Active manager: A money manager who participates in several aspects of theinvestment process. An active manager may have a hand in risk management,investment selection, and asset allocation.Accredited investor: An investor with a net worth in excess of $1 millionor who has made $200,000 per year the previous two years, or a householdthat has made $300,000 per year the previous two years.Alternative investments: Investments generally not available to the massinvesting public. A common example is a hedge fund.AMEX: The American Stock Exchange is the primary market for mostexchange-traded funds.Arbitrage: A low-risk strategy of simultaneously buying and selling securitieson different markets to take advantage of price inefficiencies. An examplewould be to buy a security on one exchange and simultaneously sell it onanother for a profit.Bear market: A market condition wherein prices are heading lower. If anindividual believes the market is going down, he/she would be considered“bearish on the market.”Blue-chip stocks: Large, well-known companies with long histories of dividends and earnings. Some examples are 3M, IBM, Disney, Alcoa, and CocaCola. The Dow Jones Industrial average is considered to be made up ofblue-chip stocks. They are considered to be less risky or volatile than otherclasses of stocks.Bond: A debt obligation of a corporation or a government. The bond isissued with a face amount and has a specific term. The issuer of the bond261
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will pay interest during the term of the bond. When the term is expired, thebond is considered mature and the issuer is obligated to pay back the faceamount of the bond. Bonds are similar to credit cards. When we use a creditcard we pay interest on the amount borrowed and pay back the balance at alater date.Market breadth: The measure of how many stocks on an exchange participated in a day’s move. If the market goes up and three fourths of the stockson that exchange go up as well, this would be considered good marketbreadth. It is used as an indicator to gain insight into potential future marketmovements.Breakout: Term used in technical analysis. Refers to a stock price movingabove a resistance level, important to technical analysts because it could be aprecursor to a major price move. A breakout can be used as a buy or sell signal and also aid in choosing your exit point prior to entering an investment.Bull market: A market condition wherein prices are moving higher. If anindividual believes the market is poised to move higher, he/she would beconsidered “bullish on the market.”Correlation: A statistical measure of two numerical values. The market isfull of correlations; for example, an increase in oil prices will increase an airline’s fixed expenses, leading to airlines having lower profit margins orcharging higher ticket prices. It could be said that the airline and oil sectorare negatively correlated. An example of a positive correlation would be PCsales and microchip sales. If PC sales are strong, it would stand to reason thatmicrochip sales would also be strong, since microchips power PCs.Debt-to-asset ratio: A ratio used to measure the amount of debt a companyhas in relation to its assets. This is important when performing fundamentalanalysis of a company. This is also important when looking at a market sectorbecause the level of debt may vary from sector to sector. The higher thedebt level, the more vulnerable a sector could be to interest rates andcredit problems.Debt-to-equity ratio: This is a measure of a company’s leverage. This is animportant number when performing fundamental analysis of a company.This measures the amount of debt a company has in relation to equity. It iscalculated by dividing a company’s long-term debt by market capitalization.Derivative: An asset whose value is derived from an underlying security. Anexample of a derivative would be a pork belly future. The current value ofthe future contract is derived from or contingent upon the current marketprice of pork bellies.
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263
Discount rate: The interest rate the Federal Reserve charges memberbanks for loans. This is the base rate used when banks set their loan rates.Diversification: The strategy of investing across many different asset classes.The logic is that different asset classes will perform differently, leveling outperformance and reducing the volatility of a portfolio.DIAMONDS: An exchange-traded fund designed to duplicate the performanceof the Dow Jones Industrial Average.Dow Jones Industrial Average: An index of 30 major companies, representing the majority of the U.S. economy. This is also known as “The Dow.”This is the most widely quoted and followed index in the United States.Enhanced indexing: This is a strategy used when simply trying to outperform an index.Equity: Represents ownership in a corporation. Also known as stock orshares in a company.Federal funds rate: This is a widely followed number because it is the bestindicator of the direction interest rates are headed. This is the overnight rateat which financial institutions lend money to each other. This rate is set bythe Federal Reserve.Federal Reserve System: Created in 1931 to regulate credit. Also knownas “The Fed.”Folio: A basket of diversified stocks, giving the investor the flexibility tomanage the stocks on an individual basis. Folios are made up of 30 to 50 individual stocks and can be quite difficult to track. Folios are better suited towealthy investors who can afford a professional to aid them in managing theindividual securities making up the folio.Fundamental analysis: An approach to investment selection focusing on acompany’s balance sheet, business environment, sales, and managements skills.Hedge: A strategy used to offset risk. The most commonly used hedgingtechniques are short selling, options, and futures. Hedging can limit downside risk, making it critical to risk management.Hedge fund: An investment product, similar to a mutual fund. Hedge fundsare usually set up for accredited investors only; they have high fees and alimited number of investors. Generally, the manager of a hedge fund willinvest his or her own personal money in the fund. Hedge funds, unlike mutualfunds, try to hedge or limit the risk they take on every investment.HOLDRs: A diversified basket of stocks, similar to an exchange-tradedfund. HOLDRs have an underlying basket of stock from which they derive
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their value. The owner of a HOLDR has the ability to convert from theHOLDR share to the basket of underlying stock. The tax consequences ofconverting a HOLDR to the underlying basket can be quite complicated andshould be done only under the guidance of an investment professional. Thecommissions charged on this strategy will make it cost prohibitive for mostsmall investors.How to Short a Stock:Written by aspiring author, Aaron J. Long (12 Years Old)Shorting a stock is like taking a loan. You borrow a stock, sell it, and atsome point you pay it back. Although unlike a loan, there isn’t always interest. Sometimes you have to pay back less than you borrowed because youdon’t pay it back in money, you pay it back in stock. So say Ed wants to sellshort 100 shares, of MGM stock. He finds the stock from the firm’s list ofstocks; he borrows 100 hundred shares, then sells them. Now at some pointhe has to pay it back. So he buys the stock again and pays it back to thefirm. Let’s say that in between this time MGM stock drops $1.27 per share.That way Ed has to pay $127 less to buy the 100 shares back. So he makes$127. But if he had shorted 1,000 shares, he would have made $1,270. In thesame way what if that stock’s value goes up? Ed would have to pay more forthe stock. And therefore he would lose money. Shorting a stock is just asrisky as buying and selling stock the old fashioned way. But as they say: “Noguts, no glory.”Index: A numerical value assigned to a representative group of stocks orbonds. The purpose of an index is to benchmark the market’s movement.Index fund: A fund designed to perform exactly as the underlying indexperforms. Many exchange-traded funds are designed to follow or trackspecific indexes.Indexation: The practice of a fund’s attempting to duplicate the performanceof an index.Institutional investors: A term used to describe banks, mutual funds, brokerage firms, pension funds, insurance companies, and so on. Basically, anylarge interest other than an individual could be classified as an institutionalinvestor.Investment banking: The practice of raising capital for entrepreneurs. Theterm is most often used on Wall Street when referring to initial public offeringsor raising money by selling new issues in securities.Investment Company Act of 1940: Legislation passed in 1940 to regulatefunds and investment advisors. This act gave birth to the modern-day mutualfund industry.
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Investment horizon: The length of time an investor plans to hold aninvestment.Investment objective: When referring to a fund or manager, it is theexpected result of the management. When referring to an investor, it is whatthe investor hopes to achieve by investing. Some examples would be growthor income. Investment objectives are important because different objectivesrequire different investments. Growth investors hope to see the value of thestocks in their portfolio increase, while income investors need a regularincome and would be better off owning an investment that paid regulardividends or interest.Leverage: Anything multiplying the effect of a price change in an underlyingsecurity. The most common form of leverage is margin borrowing.Limit order: An order in which you state a specific price you will be buyingor selling a security.Liquidity: The ease with which an investment can be bought or sold. Factorsaffecting liquidity are volume and the number of market participants.Market capitalization: The total value of a company’s outstanding stock.The number can be figured by multiplying the total number of shares outstanding by the stock price. This can also be referred to as capitalization ora company’s capitalization.Market order: An order to buy or sell a security in the open market at thefirst available price.Mutual fund: A professionally managed account in which investors canpool their money to accomplish a common investment objective.NASD: National Association of Securities Dealers, a self-regulatory agency,charged with maintaining high ethical standards and uniform practicesamong member firms.NASDAQ: A real-time quotation and trading system set up by the NASD.NYSE: New York Stock Exchange, the oldest and most prestigious market inthe United States. The NYSE is a self-regulatory agency similar to the NASD.Passive management: The opposite of active management. Passive management begins with a set portfolio that does not change. Indexation is acommon form of passive management.Pullback:Written by future novelist, Andrew C. Long (16 Years Old)A pullback occurs when the demand for a particular stock drops and withthe demand goes the price. This is good if you are waiting to buy the stock, butif you are already “riding the train” and trying to get off . . . you’re in trouble.
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GLOSSARY
QQQ: Also known as the Qs. An exchange-traded fund designed to duplicatethe performance of the NASDAQ 100 index.REIT: Real estate investment trust. They trade on an exchange and aremanaged portfolios of real estate.Risk/reward ratio: A basic concept used in determining the merits of aninvestment. It measures the expected return versus the maximum loss on aninvestment. If you make money on 50 percent of your investments, a minimum ratio for an investment should be 3 to 1. For every $3 you expect toearn in profits, you are willing to risk losing $1.RIA: Registered investment advisor. A company registered with a state orthe Securities and Exchange Commission. RIAs give investment advice on afee-based basis.Rule 12 (d)(1) Limit: Limits the amount of stock a mutual fund can holdin a particular issue.SEC: Security Exchange Commission, created by congress in 1931 to oversee the investment industry.Short sale: The practice of selling a security not currently owned in hopesof purchasing it at a lower price in the future.Short sale rule: Requires that certain market conditions be met prior to entering an order to sell short.Specialist: An exchange member responsible for keeping a fair and orderlymarket in a security during exchange hours. Specialists are located on thefloor of the exchange.SPDRs: Also known as the spiders. An exchange-traded fund designed toduplicate the performance of the S&P 500 index.S&P 500 index: Standard and Poors 500 index. An index comprised of 500industry-leading companies.Stop order: A two-part order. The stop price, the first part of the order, isa price the security must trade at before the second part of the order may beactivated. Once the stop price is triggered, the order converts into a marketorder. This order is difficult to understand, yet essential to your success. Besure to ask your broker for assistance when you are first learning to use thisorder.Stop limit order: This order works like a stop order, but when the secondpart is activated it turns into a limit order. This order is difficult to understand, yet essential to your success. Be sure to ask your broker for assistancewhen you are first learning to use this order.
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Systematic investment plan: An investment strategy used to invest inopen-ended mutual funds. This is a good strategy for low-dollar investors. Itallows investors to invest a regular amount on a regular basis, as little as $25and as often as twice a month. These plans are good for smaller investorsbecause there is generally no additional fee for the service.Technical analysis: The use of charts and graphs to identify trends andprice patterns that may predict future price movements.Ticker: The symbol used to buy and sell an investment.Third market: Trading of an exchange-listed security on the over-the-counter(OTC) market.Top-down investing: The practice of focusing first on major market trends,then narrowing the view to specific industries and finally to individual stocks.Value investing: Focusing on stocks with a low price-to-book ratio with agood dividend yield.Volatility: The price fluctuation of the market, a fund, or an individualstock.Volume: Usually measured on a daily basis. It refers to the total number ofshares traded on an exchange or an individual stock. This is an important factor in technical analysis. When compared over like periods, it is consideredto give insight into the strength of a price movement.
Index
AAmerican options, 195Anadarko Petroleum:fundamental analysis of, 138–142trading diary for, 119–131, 143–185Apache Oil:fundamental analysis of, 113–138trading diary for, 119–131, 143–185Arbitrage, defined, 1–2Average, in Excel spreadsheet, 75–80
building in Excel, 60–64explained, 41–42, 51–57, 59indices and, 65–67, 230where to find, 59–60Covariance, 53–54Covered call, 199pairs and, 208–210Covered puts, pairs and, 208–210Cuddie, Kevin, 101Current ratio, 19
BBeta:explained, 65–66how to apply, 66–67ratio and, 88Biotech stocks, 231Bloomberg terminals, 59–60Book value, 134Bubble, 237
DData, see Excel spreadsheet; StatisticsDay trading, see Intraday tradingDebt-to-equity ratio, 19, 257Density curve, 89–93, 95–96used in Apache/Anadarko analysis,145–184Derivatives, see OptionsDIAMONDS, GeneralElectric/ExxonMobil and, 189–193Diary, see Trading diaryDifferential, 42–44, 87–88Differential moving average (DMA),97–98applied to pairs, 212–213Divergence trading, 44–45, 112–113Doji star, 25, 26
CCall options, 195–200pairs and, 208–210Candlestick charting, 23–28doji star, 25, 26engulfing patterns, 26–28hammer bottoms and hangman tops,23–25shooting stars, 25–26, 27Cash, importance of company’s, 19CBOE Volatility Index (VIX), 258Chaikin Money Flow Oscillator, 35–36Charts, 83–86China.com, 6–8Churning, 113Classes of data, defining of, 69–70Convergence trading, 45, 112Correlation:
EEarnings:of Anadarko Petroleum, 140of Apache Oil, 134–135cautions about trading in earningsseason, 229, 231researching growth in, 12–15eBay, 225–227Economic indicator reports, summary of,239–253
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INDEX I
End-of-day (EOD) data, importing intoExcel, 47–50Engulfing patterns, 26–28European options, 195Evening Star pattern, 135–136Excel spreadsheet:analyzing statistical data in, 80–83,95–96building correlation using, 60–64charting statistical data in, 75–80,83–86density curve in, 90–91importing data into, 47–50monitor sheet in, 233–235syntax and command vocabulary in,60, 77volatility position sizing in, 201–203Exchange-traded fund (ETF), 189Exponential moving average (EMA),31–32ExxonMobil:correlating to General Electric,187–193PE and, 218volume and, 215FFear, as trading destroyer, 106Float, 10–11Foreign currency, options on, 196Forward PE, 133–134Frequency distribution, 69–70Frequency of date, in correlationcoefficient calculation, 56–57Fundamental analysis, 5–8, 19–20of Anadarko Petroleum, 138–142of Apache Oil, 113–138Apache Oil/Anadarko Petroleumtrading diary, 119–131, 143–185applied to pairs, 216–220growth/PE/PEG and, 15–19growth ratios and, 12–15of KBH Homes and Toll Brothers,220–225liquidity and shares outstanding, 9–11Futures, options on, 196–197GGaussian curve, 82–83, 258General Electric, correlating toExxonMobil, 187–193
Growth:growth ratios and, 12–15PE and the PEG, 15–19HHammer bottoms, 23–25Hangman tops, 23–25Hedge funds, 4IIndices, 3, 65–67, 187–193, 230Intel, 217Internet, using for earnings reports,12–14Intraday trading, 4, 113in earnings season, 229–230risks of, 115–117stock volatility and, 204KKBH Homes, 220–225LLagging indicators, 21Liquidity, and shares outstanding, 9–11Losses, cutting of, 101–103MMarket bubble, 237Market risk, defined, 66Marsh McLennan, 226, 227Mean deviation, 71Median, 71, 75–80Mode, 71, 75–80Money management, 96dangers of pairs trading, 103–104importance of cutting losses, 101–103principles of, 105–108Monitor sheet, 233–235Moving average convergence divergence(MACD), 213–214Moving average, 30–32, 97–98. See alsoSimple moving average (SMA)applied to pairs, 212–213stop loss points and, 225–227NNaked call option, 197Natenburg, Sheldon, 208Normalized standard deviation,99–100
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Index
OOil industry, see Anadarko Petroleum;Apache OilOn-balance volume (OBV), 36, 37Options:basics of trading, 195–200volatility and, 207–210Order flow, 116“Outside” days, see Engulfing patternsOvertrading, 113PPairs trading, see also Intraday pairs;Trading diaryauthor’s advice on, 226–231, 237–238explained, 2–3news events and, 110–113terminology of, 41–45work/attention required for, 109–110,114–115PEG ratio, 15, 17–19Percentage loss stops, 106–107Price-to-earnings (PE) ratio:applied to pairs, 216–219calculating, 15–17forward PE, 133–134Price-to-sales ratio, 219–220Put options, 195–200pairs and, 208–210QQQQ, 189Qualcomm, 219–220RRatio, 42–44, 88strategy discussed in Apache/Anadarkoanalysis, 182–183Relative strength index, 36, 38–39Research, see Fundamental analysisReverre, Stephane, 99Risk, defined, 65–66. See also MoneymanagementSS&P 500, beta and, 65–66Shooting stars, 25–26, 27Simple moving average (SMA), 30–32applied to pairs, 213used in Apache/Anadarko analysis,146–147, 171, 177–178, 180–181
Slippage, 257–258SmartMoney.com, 217Spread, 3, 42–44Spreadsheet, see Excel spreadsheetStandard deviation, 52–53, 72–73in Excel spreadsheet, 75–80normalized, 99–100stock volatility and, 204used in Apache/Anadarko analysis,148, 152–153Statistical arbitrage, defined, 2. See alsoPairs tradingStatistical stops, 108Statistics:of Anadarko Petroleum, 141analyzing/charting in Excel, 75–86,95–96of Apache Oil, 137defined, 69density curve and, 89–93, 95–96frequency distribution, 69–70mean deviation, 71mean/median/mode, 71risks of using, 103–104standard deviation, 72–73variance, 71–72Stochastics, 33–35, 213–214Stop loss points, 106–108moving averages and trend lines,225–227used in Apache/Anadarko analysis,144, 149–150, 161–162Straddle, 200Support and resistance, 28, 29, 225–227Swing trading, 4TTechnical analysis, 21–23of Anadarko Petroleum, 140–141,145–147of Apache Oil, 135–136, 145–147applied to pairs, 212–216candlestick charting, 23–28Chaikin Money Flow Oscillator,35–36of KBH Homes and Toll Brothers,220–225moving averages, 30–32on–balance volume, 36, 37relative strength index, 36, 38–39stochastics, 33–35
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Technical analysis, (Continued)support and resistance,28, 29trend lines, 28–30Technical stops, 107–108Time, in correlation coefficientcalculation, 56–57Toll Brothers, 220–225Topology.com, 59Trading diary, ApacheOil/Anadarko Petroleum, 119–131,143–185Trailing PE, 16Trend lines, 28–30,225–227
VVariance, 52–54, 71–72Volatility, see also BetaCBOE Volatility Index, 258defined, 201individual stocks and, 204options and, 207–210in sample spreadsheet, 201–203weighted volatility, 205–206Volume, 214–216YYahoo.com:exporting data into Excel, 47–50using for earnings reports, 12–14
About the CD-ROM
INTRODUCTIONTrading Pairs includes a CD-ROM with pairs spreadsheets/worksheets inExcel that aim to help investors track multiple pairs positions. The individual sheets are supported by market data that can be downloaded free fromYahoo.com. The worksheets aid investors in analyzing the descriptive statistics of their pairs. Each sheet is part of a larger network of sheets that funnelall data into one main sheet called the Monitor Page. By updating the dataon a weekly—or daily—basis, pairs enthusiasts have a way to easily trackwhere many pairs are at one time. Though the sheets are not intended todirectly produce trading signals, they assist in keeping a close eye on wherean investor’s pairs’ of interest are. The individual sheets include the historicalstatistics, standard deviations, the density curve, volatility measurements,data, and charts.An Excel viewer has been provided on this CD-ROM for readers who do notown MS excel software. However, MS Excel is recommended for optimumusage of this ancillary product.
CD-ROM TABLE OF CONTENTSExcel ViewerMONITOR PAGE.xls - Main tracking page for all spreadsheets.Individual sheets included on the Monitor Sheet (in alphabetical order):AA-AL.xls - ALCOA Inc & Alcan Inc273
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ABGX-PDLI.xls - Abgenix, Inc & Protein Design Labs IncABX-NEM.xls - Barrick Gold Corp & Placer Dome Inc