go straight through but bounces for a fewdays, then pierces the moving average.Another positive development in the pair, the differential and ratio havebacked off of the third standard deviation and are now just about midwaybetween the second and third standard deviations. Figures 22.39 and 22.40display the statistical progress.
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FIGURE 22.37 APA 10/27
FIGURE 22.38 Trade Summary 10/27
Wednesday, October 29Apache bounced again today, causing our spread to open up slightly (seeFigure 22.41). The event, however, is to be expected and gives the tradeno cause for concern, as it is still firmly in the black. Anadarko had somegood news, after the company (one of a few independent oil companies)was granted permission to explore the North Slope of Alaska. Publicannouncement of this news is great for the company (which was alreadyexploring the slope anyway), as it sorely needs development projects.(EN 22.2)
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FIGURE 22.39 Main Spreadsheet 10/28
FIGURE 22.40 Trade Summary 10/28
Thursday, October 30Anadarko was upgraded from Neutral to Out Perform at CSFB, just one daybefore the company announces earnings. Investors are clearly expectinggood news tomorrow, as the stock has gained a little over a point in the lasttwo sessions. Apache is showing more weakness and may now be setting upto fall through the 50-SMA in the next few sessions. Both technicaldevelopments are extremely positive for our pair. The density curve hasfinally broken 0.990 and is now at 0.988. This is a very encouraging statistical development and shows that the pair is definitely in contraction mode.With the ratio at 1.61 and the differential sitting at 26.33, I am expecting additional gains over the next week or so. Anadarko’s earnings announcementtomorrow should hopefully help the pair along. Because the publishing
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FIGURE 22.41 Trade Summary 10/29
FIGURE 22.42 Trade Summary 10/30
deadline is coming up, I will now begin looking for an exit point, and willmost likely scale out of the trade. I will look for a large up day, and then exithalf of the position, and let the other half ride into the deadline.As Figure 22.42 displays, the trade is now up 2.26 percent and hasbrought forward a profit of $2,530.
Friday, October 31Anadarko reported third-quarter earnings of $374 million, or $1.09 versus$189 million, or 74 cents a year earlier. The earnings are a 45 percentincrease year over year, and indicate that the company is slowly improving.What’s more, the company announced that it was bumping up its quarterlydividend to 14 cents, a 40 percent increase. For the third quarter, revenueincreased over 40 percent to $1.3 billion, with sales coming in at over 50million barrels moved. Oil production for the quarter totaled 189,000 barrels,down slightly from 191,000 barrels. Looking forward, the company expects
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fourth-quarter earnings of $1.10 a share, almost in line with the consensusestimate. The company also expects full-year earnings to total $5 a share,versus the expected $5.05 a share. Great news came in the form of anannouncement that the company plans on increasing its 2003 capital budgetby $100 million to $2.8 billion, while also eliminating debt by roughly $300million. With the exception of fourth-quarter and full-year guidance comingin under annual estimates, the report was very positive. The company’scapex budget increase is a good sign for the development and upgrading ofcurrent equipment. Overall, this report should be received very positively,and indicates that the company is working hard to turn things around.Looking at the daily chart of Anadarko, the stock is now testingdescending resistance in the $44 region. A move above the resistance linewill definitely gain the notice of technical momentum traders and willbring supplemental buying in off the fence. As Figure 22.43 displays, thestock has also just witnessed a bullish crossover of the MACD and is seeing strong momentum in daily stochastics.The differential has now fallen to 26.10, the lowest point yet, while theratio has also made a new relative low at 1.60. The trade is now yielding2.46 percent with a $2,760 profit. Unless some sort of crazy news eventtranspires over the weekend, I will close half of the position on Mondaymorning. (See Figure 22.44.)
FIGURE 22.43 Anadarko 10/31
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Monday, November 3This morning, I exited half of my position, Apache at $69.75 and Anadarkoat $43.50. The short half—Apache—earned $425, and the long side—Anadarko—brought forth $910. Both dollar figures are minus commissions. You will notice on the trade summary sheet (Figure 22.45) that Ihave already backed out the commissions; thus, they are zeroed out forthe open positions. When I close the trade, I will then subtract the closingcommissions as well.The differential is now at 26.18, while the density curve is at 0.987. Thetrade is now on the home stretch, and I will close the remaining half of thepositions (unless some major news event occurs) on Friday, November 14.With earnings out of the way, the two stocks will now be left to thirdquarter digestion and forward thoughts of the fourth quarter. There was nonotable news today, and both charts seem to be acting in a normal fashion.
FIGURE 22.44 Trade Summary 10/31
FIGURE 22.45 Trade Summary 11/3
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Tuesday, November 4Another day, a missed dollar. The pair collapsed a little more today, the differential is now at 25 and the density curve has fallen to 0.981, the lowestpoint yet. Even more amazing, the ratio has declined to 1.58 and is now just0.03 from the second standard deviation. The second half of the trade stillopen is yielding a total of 3.48 percent since the trade’s inception almostexactly one month ago.Though Anadarko tested—and failed—descending resistance, therewas much more significant profit taking in Apache. The stock has nowfailed the 50-SMA and is headed toward ascending support. Technicalmomentum sellers will most likely push the stock into the $66 area, wherethe stock will face critical support. A failure of the ascending trend line willcreate a near-term reversal and could cause the stock to find significantselling pressure. Figures 22.46 and 22.47 also display that the MACD iscrossing under the 0 line, and is indicating further selling pressure.
Wednesday, November 5The pair bumped back up a little today, with the differential rising to 26.29,while the ratio is now at 1.61.In an interesting development, Anadarko announced that its new platform Marco Polo is getting ready to pump oil out of a large find off the Gulf
FIGURE 22.46 APA 11/4
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FIGURE 22.47 Trade Summary 11/4
of Mexico. However, the platform is not being used to pump Anadarko’swell, but rather, that of the company GulfTerra Partners. This interestingtwist could provide additional revenue in the future. Apache Oil is doing itsbest to hold the 50-SMA and has ascended back just above the importantmoving average. Buyers will have to pull out some big guns to keep the stockfrom breaching the moving average. (See Figure 22.48.)
Thursday, November 6Today, the pair continued to expand; the differential is at 26.68 while theratio is now at 1.62. Figure 22.49 shows the differential data for the last fewweeks and indicates that the pair may be on its way back up. For the timebeing, I am glad that I booked half of the trade on the 3rd.In an interesting bout of news, the CEO of Anadarko vowed that thecompany will begin more “focused” overseas efforts. (EN 22.3)On a technical level, Apache has resumed its trend above the 50-SMA andmay now be headed back higher. Because the stock could not fall below the50-SMA with force, I am led to believe that the stock may soon retest highs.Anadarko, though, is still testing descending resistance, which may be the onlyreal hope for further gains in this trade. I have stated that I will leave the position open until the 14th. However, normally, I would close another half of theposition here, leaving only one quarter of the original trade open. Figure 22.50displays Anadarko’s attempt at breaking through descending resistance.
Friday, November 7With only one week left, the trade is looking as if it will continue to open up.The differential is now at 26.37, while the ratio still above 1.6. There was no
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FIGURE 22.48 Trade Summary 11/5
FIGURE 22.49 Anadarko 11/6
significant news today, though on a technical level, Anadarko looks to beheaded up. The stock has built a base above the 50-SMA, and with any luck,buyers will attempt to push the stock higher. (See Figure 22.51.)
Monday, November 10Today, the spread opened up a little more. This action is not boding well forthe trade and my instincts tell me that the trade will most likely close nearlyclose to flat, given the little amount to time that is left. However, the trade is
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FIGURE 22.50 Trade Summary 11/6
FIGURE 22.51 Trade Summary 11/7
still a winner, as Anadarko continues to pick up steam. The density curve isnot at 0.987, while the differential is at 26.60. If I had not already made theprevious commitment to close the entire position on the 14th, I would closeanother quarter of the pair tomorrow morning.Apache has held the 50-SMA and appears to be keeping its footing. Ifthe stock cannot punch through the major moving average in the next fewsessions, it is most likely setting up for another leg higher. Anadarko,however, looks very promising, as the stock has moved above thedescending resistance line and is setting up for a breakout. If I weresimply directional trading at this point, I would purchase the stock longwith a stop just under the near-term shelf and the 50-SMA. The actual stopwould be just under $42, thus inferring a 3.4 percent loss if the trade were
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FIGURE 22.52 APC 11/10
FIGURE 22.53 Trade Summary 11/10
to be stopped out. Figures 22.52 and 22.53 indicate the breach of thedescending resistance line and illuminate the possible breakout pending.
Tuesday, November 11The pair continued to open up today, and our profit has dwindled to $965,which translates to only a 1.72 percent gain on the second half of the
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position. The differential has moved up to 26.60, with no significant newsaffecting either stock. The density curve continues to expand as well, and isnow at 0.987, indicating a potential retest of highs on the horizon. As ageneral rule of thumb, when the density curve falls below 0.990 and thenbegins to expand, it may be a good time to take profits off the table. No matter how you slice it, though, we are only “managing money” now—whichmeans we are hanging onto profits. This is definitely a good position to bein. It’s sort of like having a three touchdown lead going into the fourth quarter of a football game. We are just trying to run the clock out, and keep asmuch of our lead as possible. As mentioned before, if I had not alreadydeclared that I was closing the position in three sessions, I would haveclosed a quarter of it this morning. The problem is that while Anadarko looksgreat long, Apache also appears to be gaining momentum. And becauseApache is the more expensive stock, if it really starts to ascend, it couldmove much quicker than Anadarko.This is one scenario that you could scale back on your trade using aratio strategy. By this I mean that you would trim your position to give eachstock equal weighting in your portfolio. Our ratio is currently 1.61, whichmeans that on a simple share valuation basis, we could either increase ourAnadarko position, or sell some of the Apache. Since Anadarko looks outstanding at this point, our best course of action is to sell some Apache.Using the ratio of 1.61, some simple math would get us to where we needto be. We would simply subtract 0.61 from 1, which leaves us with 0.39.Then, we would multiply our outstanding position for Apache (500 shares)by 0.39 giving us 195 shares to sell. If we did this, the remaining positionwould be 500 shares of Anadarko and 305 shares of Apache. Also, becauseit is much easier to move 100 shares lots, I would most likely just sell outof 200 shares, giving the trade a 500 to 300 ratio. What’s more, by takingthis action, we would book additional profit on the Apache side, coveringmore of our costs, while removing some of the risk from the position. Theimportant part to remember is that anytime you begin to shift the weighting of a position, you must put a tight stop on the other portion of the tradeto ensure that you hang onto the profit, or simply to detour large losses.If both stocks begin to fall south, we would lose out on profit opportunity from the short side, as we have eliminated some of our position. Ourlosses could quickly multiply, as the long portion of the trade has moreexposure simply because it is larger.Thus, looking at Figure 22.54 of Anadarko, we would utilize the samestop for the unbalanced portion of our trade—the extra 200 shares—at justunder $42, or $41.99.
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FIGURE 22.54 Trade Summary 11/11
Wednesday, November 12The pair continues to open up, and the Apache side is now negative. If wehad trimmed the short portion of the trade, our exposure would be limited,while we stand to gain on the long side. The trade is now presenting a $650profit, not quite outstanding dollars, but not a loser either. The density curveis now at 0.990, a prudent place for conservative traders to exit the entireposition. It is my impression that the second half of the trade will close flatat best.Anadarko announced that the company drilled a successful well in Algeria, which will only help to keep the long side of the trade moving along. Atthis point, more adventurous traders could remove the entire portion of theshort trade and put a tight trailing stop on the Anadarko long side of ourposition. This would be the riskiest thing to possibly do, as the position hasnaked exposure to the market, and defeats the entire purpose of the pairshedge. However, in certain circumstances, if the trader understands the market and the pair, then additional risk can be taken on. I would only recommend instituting this strategy in situations where the pair is profitable. If youare in a losing trade, the best course of action is usually to just close theentire position and move on. Being able to cut losers short is just goodmoney management. Taking on additional risk in winning positions is goodtrading. (See Figure 22.55.)
Thursday, November 13Clearly, the long side of the trade is picking up momentum, while the shortside is beginning to go sour. The differential is now at 27.73, while the density
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FIGURE 22.55 Trade Summary 11/12
FIGURE 22.56 Trade Summary 11/13
curve is at 0.990. The second portion is yielding 1.04 percent, certainly off thelarger percentage gain that we witnessed at the beginning of the month.The chart of Apache indicates that the stock will soon retest highs. Forthe directional investor trading with the trend, this would area of the currentmove is known as the “sweet spot.” The stock almost failed but held ground,and investors are still “buying the dip.”Our trade is now showing a profit of $585 and as tomorrow is the 14th, Iwill close the remaining 1,000 shares (500 on each side) in the morning. (SeeFigure 22.56.)
Friday, November 14This morning I exited Apache at $71.50 and Anadarko at $44.25, the closing differential was 27.25. The original differential was 28.90, thus we
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yielded a profit of 1.65, or $461 (less $40 in commissions) on the secondhalf of our trade. The total gain on the trade was $1796, or 1.6% on the original $112,100 invested. This is good money, and the trade was only open for41 days, or 30 business days. Chances are that if we had left the trade open,it would have come in even more. Though Apache is on its way up, thereare valuation concerns, while Anadarko has the possibility of ascendinginto range resistance at $50. The important part to remember here is thatthe trade was only negative for four days, and we had a “hedge” to boot.This trade was a very good example of what to expect from a properly setup pairs trade. Generally, pairs do not yield kazillions of dollars in profits,but instead can produce slow, consistent returns—better known as basehits. And as we all know, baseball games aren’t always won by homeruns,but by players making consistent singles and doubles to round the basesall the way home.
CHAPTER 23
CorrelatingStocks toIndicesGeneral Electric andExxonMobilGeneral Electric andthe DIAMONDSExxonMobil and the DIAMONDSThe Three Wise Men
n this chapter, we will go further into correlating stocks with indices tosee if we can find some other tradable opportunities—or at least see ifthe additional information can help you to make more informed directional trading decisions. First things first, we must set up a spreadsheet withthe proper information. For the sake of example, we will use the Dow JonesIndustrial Average, ExxonMobil, and General Electric. Figure 23.1 shows thethree together. Immediately, we can see a visual relationship, especially withExxonMobil and the Dow.
I
GENERAL ELECTRIC AND EXXONMOBILWhat we will do is first look at the relationship between ExxonMobil andGeneral Electric, and then cross-reference the two with the Dow. Figure 23.2shows that the two stocks are 0.58 percent correlated. While this is not anoutstanding relationship, what it does mean is that the two may provide asubstantial amount of trading opportunities, as there is plenty of divergenceand reconvergence.It is very important to note that we made a change to the spreadsheet.On the Pair Data page, we changed the reference cells of the sheets Stock 1and Stock 2 from cell E (closing data) to cell G, to reflect the adjusted closes.187
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FIGURE 23.1 GE-XOM-DOW
FIGURE 23.2 GE-XOM
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When first glancing at the differential chart, we notice that the twostocks have had a fairly tight trading range between 0 and 10 over the lasttwo years. Even though the two stocks are only 58 percent correlated, itshows that there was ample opportunity to trade. One area that would havenot helped us was the density curve, which never traded close to 0 or 1. Asmentioned earlier in the book, a trader would then want to move the densitycurve trade entry parameters to yield entry signals. However, by loweringthe entry points above or below 0 and 1, the trade takes on additional risk.
GENERAL ELECTRIC AND THE DIAMONDSThe DIAMONDS (NYSE: DIA) are the Dow tracking stock. The purpose of theDIAMONDS is to let investors purchase the entire Dow in one stock, withouthaving to purchase a mutual fund. The problem with mutual funds is that ifyou want to buy now, you have to wait until the end of the day before you getin, and then you will get the day’s closing price. By purchasing an ETF(exchange-traded fund) like the DIAMONDS, you can instead, enter yourposition at any moment during the day. And, you can short-sell the DIAMONDS also, if you believe that the Dow will go down. Even more exciting,the DIAMONDS and QQQ (NASDAQ composite ETF) do not require an uptick to go short. This means that in cases of rapidly descending trading youdo not have to wait for a buyer to step in before shorting the stock. However,the liquidity (even though they trade millions of shares) can present problems, and fills can be undesirable for the average investor. I have seen greattraders try and pick apart the DIAMONDS and QQQs on an intraday basis inan effort to make money. However, the only outcome I have ever heard of is alot of commissions and dwindled profits for the headache encountered.The correlation between the DIAMONDS and General Electric is 0.58,much like General Electric and ExxonMobil.What this means is that GE andthe DIA are not incredibly correlated but, much like GE and XOM, arevolatile enough to provide some trading opportunity. (See Figure 23.3.)
EXXONMOBIL AND THE DIAMONDSWhen looking at the spreadsheet of the DIAMONDS and ExxonMobil, wesee a different picture unfold. The two have a high correlation of 0.80. Wemay presume that the reason for the higher correlation is that ExxonMobilis not as volatile as General Electric, and GE has had much turbulence overthe last year.
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FIGURE 23.3 DIA-GE
In fact, if we look at the historical trading range of ExxonMobil and theDow, we see that there is a very clear range from roughly 40 to 60 that wouldhave provided some incredible trading opportunities over the last year.What’s more, on a ratio basis, the pair had a significant range from 1.30 to1.60. Figure 23.4 shows the pair’s range over the last two years.Now that we have seen the correlation possibilities, let’s take our thinking one step further. Imagine that the DIAMONDS are a large bomber flying astraight course to a destination. GE and XOM are fighter planes that traversethe sky all around the DIAMONDS to protect it from other fighters. However,they stay on course with the bomber, regardless of conditions. When they arein battle, they can stray far away, but as their only purpose is to assist thebomber, they always come back to the original course.Using this analogy, we can imagine that General Electric is a much morevolatile fighter, while ExxonMobil stays closer to the DIAMONDS. Thus,when General Electric strays far off course, and ExxonMobil moves in theother direction, we have a divergence situation. What’s more, instead of justbuying and selling General Electric and ExxonMobil, we can also take aposition in the DIAMONDS to further hedge the direction of our trade, whileoffsetting the capital used by decreasing our share size in the other two
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FIGURE 23.4 XOM-DIA
stocks. What we will have is a larger pairs trade consisting of three stocks.Let’s look at our data and see how this translates to making money.Looking at Figure 23.5, we see that on October 9, 2002, General Electricand the DIAMONDS were trading with a differential of 50.09, while ExxonMobil and the DIAMONDS had a differential of 39.76. Now, we know thatExxonMobil has a higher correlation to the Dow and is definitely trading onthe lower portion of the historical range.The problem is that we are thinking about buying ExxonMobil and shorting GE. However, further investigation points out that GE is trading barelyabove the mean, which is 57.16. Figure 23.6 displays GE’s statistics.On a simple pairs basis, we may be very worried about selling short General Electric, while the stock was also trading below the mean. And in reality, our instincts are well justified, as when we look at the General Electric–ExxonMobil pair, we see some very interesting developments. The pairis trading on the buy side of the mean and looks to be a notably promisingtrade if we were to buy General Electric and short ExxonMobil. However,ExxonMobil is trading below the mean in relationship to the Dow and looksas if it has the most potential in regard to a pairs trade with the index. Thebottom line here is that even though the General Electric–ExxonMobil trade
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FIGURE 23.5 XOM-GE
FIGURE 23.6 DIA-GE
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presents a situation in which we should short ExxonMobil and buy GeneralElectric, our data cross-referencing each stock to the Dow is not painting thesame picture. Have you figured out where we’re going? The solution is to doa three-part trade, wherein we buy General Electric and ExxonMobil, whileshorting the DIAMONDS. Let’s see how this works.
THE THREE WISE MENIn essence, instead of buying and selling just General Electric and ExxonMobil, we would instead buy both stocks, while shorting the DIAMONDS.The fact that we are benchmarking two stocks against their respectiveindices completely pushes our paradigm to another level. What we are saying is that we believe that the two stocks we have chosen will perform better than the conglomerate 30 stocks within the Dow. The point here is thatif you are long one stock like General Electric, what you can do to hedgeyour risk is look at your spreadsheet and figure out whether there are otherstatistical arbitrage opportunities to hedge your naked exposure. If you arelong General Electric, you could then look at the other two stocks, ExxonMobil and the DIAMONDS, and institute a larger position. You would sellshort a smaller position in the DIAMONDS, while implementing a long inExxonMobil. The point here is not to make a ton of money but, rather, toensure that you have some other type of hedge to protect your position.Thus, if the Dow continued to ascend, you would technically be market neutral, as your long position is hedged with ExxonMobil and short with theDIAMONDS. If the Dow falls, your position in General Electric will likelytake a nosedive as well. However, your short in the DIAMONDS will (hopefully) help to pad any losses—or possibly earn additional money. What’simportant here is that you are actually trying to trade the convergence ofthe pair as well; thus, you stand a good chance of making money on the differential collapsing, as well as earning money in your GE position. Then, ifthe pair does work in your direction, when it nears the mean, you canunlock the ExxonMobil long and DIAMOND short, and resume your nakedlong position in GE. However, it is important to remember that you haveincreased your commissions significantly and must make sure that you donot overchurn your account. After all, it would be a treachery if the onlypeople making money were the brokerage houses, while your accountdwindled south.
CHAPTER 24
Option BasicsScott P. Evans
ptions are financial derivatives that give the owner the right, but notthe obligation, to buy or sell the underlying financial instrument for acertain period of time, at a specified price. There are two types ofoptions: call options and put options. It is important to note that the owner ofan option never has an obligation, but the seller of the option does have anobligation to either sell the shares of the underlying instrument (in the caseof a call) or to purchase the shares of the underlying instrument (in the caseof a put). It is completely up to the owner of the option to decide whether toexercise the option or not. Once the seller has sold the contract he is at themercy of the contract owner. The owner can always just let the option expireworthless—he or she would lose the money invested, but has no further risk.On a more basic level, option contracts can be classified in one of twoways—as an American option or as a European option. With an Americanoption, the contract owner can exercise the option at any point in time upuntil the contract expiration date. Contrastingly, European options can onlybe exercised on the expiration date. Because of the added flexibility withregard to the ability to exercise the option contract, an American option willalways be worth more than a European option, except for on the expirationdate. On the date of expiration, both the American option and the Europeanoption will have the same value. The contract owner has until the optionexpiration date to exercise the contract. That given amount of time is knownas the time until expiration. Option contracts expire on the Saturday following the third Friday of each month (only for U.S. equity options).There are many reasons and strategies for trading options. For many people the primary reason is that it increases the leverage you can get out of a
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limited amount of money. Since the premium paid to purchase the option isusually a fraction of the cost of the underlying instrument, you can controllarger positions with a lot less money. Additionally, a single stock option(100 shares of stock) controls 100 shares of the underlying stock so you geteven more leverage out of your money. Another reason that people tradeoptions is to generate income. Options sellers receive a premium when theysell the options contracts; sometimes this can be a risky proposition, but incertain circumstances it can be a safe, income-producing strategy. One otherreason people trade options is to hedge a portfolio. This strategy is most commonly used by institutional traders and people who want to protect large portfolios. The most widely used strategy to hedge a portfolio is to buy puts. If youown a large portfolio and believe that the market is going to decline, insteadof selling out of all of your positions you can buy puts (usually on an index)and you will make up the money that you have lost on your portfolio during amarket drop with the gains you will make on the put options. Figuring out theexact put ratio can be a difficult task because you have to calculate how highlycorrelated your portfolio is to the returns on the index that you are using tohedge. Once you have figured out the relationship of returns between yourportfolio and the index, you purchase a proportionate amount of puts so thatthe value of your portfolio is protected. This sounds like a wonderful strategy,but it is actually difficult and expensive to execute. The relationship betweenthe volatility of your portfolio and the index underlying the put options willchange over time, and to remain completely hedged, put contracts must bebought or sold in order to keep the proportions in line. All of the buying andselling of put options generates large amount of transaction costs. Furthermore, when the put options expire they must be replaced with contracts thathave later expirations. This too adds to the expense of the strategy. That iswhy the strategy is primarily used by institutions.Options