, SPX might not decline because airlines account for only a fraction of the S&P 500 Index. As a general rule,the fewer stocks within the index, and the less diversification amongindustry groups, the greater volatility in the index.
Where to Find Index InfoThe components of various indexes and ETFs are always changing. In addition, sometimes the method used to compute an index changes. For example, Standard & Poor’s changed the method for computing the S&P 500Index in 2005, from a strict market value–weighted index to a ﬂoatadjusted market value–weighted index. These changes can be subtle orsigniﬁcant, depending on the modiﬁcations. For that reason, the strategistwill want to monitor the changes over time to better understand what ishappening within the index. There are several web sites to visit for information on components and methodology:• Standard & Poor’s: www.spglobal.com• Frank Russell Company: www.russell.com• The Chicago Board Options Exchange: www.cboe.com• The Philadelphia Stock Exchange: www.phlx.com• The American Stock Exchange: www.amex.com• The International Securities Exchange: www.iseoptions.com• The Options Clearing Corporation: www.optionsclearing.com
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PORTFOLIO TILTThe S&P 500 Index is a market value–weighted index consisting of 500 ofAmerica’s biggest companies. The index is also considered the bestbenchmark for the U.S. stock market. The pros are always trying to outperform or “beat” the SPX. Unfortunately, very few professional investment managers actually accomplish that feat on a consistent basis. Forthat reason, many investors prefer to use passive investments such as theVanguard 500 Index (see Chapters 8 and 14) or the S&P 500 DepositaryReceipts, which have been discussed throughout this book.If investors take a position in an SPX fund, they are using a passive approach that will track the market. They have created what is known as anequal-weighted portfolio. It is equal to the market. In many cases, thesepassive investors are content getting returns from their stock holdingsthat match the performance of the broad market. However, the SPX is amarket value–weighted index. Therefore, owning the SPDRs represents aposition that is also heavily weighted towards large companies.The largest stock in the S&P 500 Index is the Exxon Mobil Corp.(XOM), and that one stock alone accounts for 3.24 percent of the index.Table 15.4 shows XOM along with the other top 10 companies within theS&P 500 during 2005. Although these 10 stocks represent only 2 percent ofthe index (because 10 out of 500 equals to 2 percent), these companies account for approximately 20 percent of the value of the index. So, while the
TABLE 15.4 Top 10 S&P 500 Stocks (May 2006)TickerSymbol
CompanyName
% of S&P 500Index
XOM
Exxon Mobil Corp.
3.24%
GE
General Electric
3.03%
C
Citigroup Inc.
2.10%
BAC
Bank of America Corp.
1.95%
MSFT
Microsoft Corp.
1.81%
PG
Procter & Gamble
1.61%
PFE
Pﬁzer, Inc.
1.57%
JNJ
Johnson & Johnson
1.47%
AIG
American Int’l. Group
1.42%
JPM
JPMorgan Chase & Co.
1.33%
Total
19.53%
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S&P 500 Index is considered a benchmark for the U.S. stock market, largecompanies also dominate it. The top 100 stocks (or 20 percent) accountfor more than two-thirds of its current value.It is also possible to view a sector breakdown of the S&P 500 Index.Table 15.5 shows the market value of the S&P 500 sectors (as of Tuesday, January 11, 2005). The breakdown of the index is by market value.The financials sector included 82 companies and accounted for morethan 20 percent of the index. The financials were, therefore, the biggestsector within the index. The weighting will change over time due tochanges in the share prices and market values of the companies withineach sector.Once the makeup of the S&P 500 Index is understood, it becomesrelatively easy to overweight or underweight specific stocks or sectors.Since the SPX is a benchmark for the U.S. stock market and representsan equal-weight portfolio, 100 shares of SPY and 10 shares of GeneralElectric is overweight GE in the portfolio. However, a portfolio thatowns 100 shares of SPDRs and is short 10 shares of GE is underweightGeneral Electric.What about specific sectors? Table 15.6 shows the nine Select SectorSPDR Funds. Recall that these nine funds hold the same 500 stocks fromthe S&P 500 Index, but grouped by economic sector. Notice that the list issimilar to Table 15.5, with one exception. Using the SPDRs, it is possibleto underweight and overweight specific sectors. For example, buying 100shares of SPY and 10 shares of Select Sector Energy Fund (XLE) creates a
TABLE 15.5 S&P 500 Sector BreakdownSector
Number ofCompanies
Market Value(in millions)
Percent ofSPX
S&P 500
500
11,727,030
100.00%
Energy
29
1,156,216
9.86%
Materials
31
367,818
3.14%
Industrials
53
1,393,062
11.88%
Consumer Discretionary
87
1,208,761
10.31%
Consumer Staples
40
1,107,669
9.45%
Health Care
56
1,442,283
12.30%
Financials
86
2,540,071
21.66%
Information Technology
79
1,767,611
15.07%
Telecommunications Services
8
368,913
3.15%
Utilities
31
374,625
3.19%
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TABLE 15.6 Select Sector SPDRSSelect Sector SPDR
Symbol
Financials
XLF
Information Technology
XLK
Health Care
XLV
Consumer Discretionary
XLY
Industrials
XLI
Consumer Staples
XLP
Energy
XLE
Basic Materials
XLB
Utilities
XLU
portfolio that is overweight energy. However, buying 100 shares of SPYand selling short 10 shares of XLK is underweight technology.The goal behind underweighting and overweighting portfolios is togenerate returns that are superior to the S&P 500 Index, or to beat themarket. Many investors try to beat the market with aggressive trading andsuperior timing. However, with a modest portfolio tilt in favor of a strongstock or sector, the individual investor can also beat the market. This canbe done in a long-term portfolio holding the SPY combined with placingjust one stock or ETF trade each year.
BUY WRITE INDEXESAn alternate way to potentially enhance returns is through covered callwriting. A covered call, sometimes called a buy write, is a strategy that involves buying shares and selling call options. It was discussed in greaterdetail in Chapter 5. Traders interested in covered calls in the index marketcan track the strategy’s performance using the buy write indexes.The S&P 500 Index Buy Write Index ($BXM) is an index developedjointly by the Chicago Board Options Exchange and Standard & Poor’s.The index was created with the help of Professor Robert Whaley of DukeUniversity. Some investors consider the buy write as a separate unique asset class, and distinctly different from stock ownership. The BXM was created as a tool for monitoring the rewards of the covered call strategy.Traders can get the latest readings and create charts using the symbol$BXM. The changes in the index will give a sense of how the covered callstrategy is performing relative to the market.
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The BXM index is constructed using a hypothetical long positionconsisting of the 500 stocks of the SPX. Then one-month term ATMcall options are sold against the portfolio. The call position is held untilmaturity and then another round of calls are sold. Any dividends paidand any premiums received are reinvested in the S&P 500 long stockportfolio.According to the CBOE, the BXM outperforms the broader market(i.e., the S&P 500 Index) when stock prices fall or remain unchanged, butunderperforms when stocks move broadly higher. For example, when theS&P 500 rose 20 percent annually from 1995 to 1998, the covered callstrategy lagged the market. However, when the market fell in 1990 and2000, the BXM rose 4 percent and 7.4 percent respectively. In addition,from 1992 until 1994, while the S&P 500 gained 6.3 percent annually, theBXM rose more than 10 percent. The historical data for the index datesback to 1988 and can be found on the Chicago Board Options Exchangeweb site (www.cboe.com).More recently, this strategy has performed relatively well. In 2005, theBXM rose 4.7 percent, compared to a 3 percent gain for the S&P 500 Index. In 2004, both indexes performed the same, gaining approximately 9percent. However, in 2003, the S&P 500 Index rallied 26 percent. The buywrite strategy lagged, as the BXM rose 15.3 percent. Figure 15.1 graphs theside-by-side performance of the SPX and the covered call index during thepast few years.
FIGURE 15.1 BXM and S&P 500 Index (Source: www.ProﬁtSource.com)
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Two More Buy Write Indexes• The Dow Jones Buy Write Index ($BXD): The BXD is a benchmarkindex that measures the performance of a theoretical portfolio thatsells DJX call options against a portfolio of Dow stocks (Table 15.2).• The NASDAQ Buy Write Index ($BXN): The BXN is a benchmark index that measures the performance of a theoretical portfolio thatowns shares of the companies included in the NASDAQ 100 Index(NDX) and writes NDX call options.
INTER-INDEX SPREADINGInter-index spreading is used to take advantage of long-term relationshipsbetween two indexes. It is used in the same way as the pair-trading example discussed in Chapter 11. However, rather than using stocks, it uses index products. Larry McMillan outlined the strategy in his book Options asa Strategic Investment (Upper Saddle River, NJ: Prentice Hall, 2001) using futures. Let’s consider it with respect to exchange-traded funds andoptions.An inter-index spread is a bet that one market will outperform another. It doesn’t care about direction. For instance, a spread can be established with short shares of one ETF and long shares of another. For thestrategy to work, the two ETFs should have a history of correlation butalso experience a period of divergent performance. Once the divergenceoccurs, the strategist establishes a position that will profit when the divergence disappears. An example might clarify things a bit.Medium- and large-cap stocks tend to perform in a similar mannerover the long term but occasionally experience periods when the twoasset classes behave very differently. Figure 15.2 shows the performance of the MidCap SPDRs (MDY) and the iShares S&P 100 IndexFund (OEF) from 2000 to 2004. In late 2000, the MDY started tradinghigher. However, the large cap OEF, which holds the S&P 100 stocks,started trading lower.The strategist might, at that point, have determined that the divergentperformance was not sustainable. If so, an inter-index spread could becreated by shorting the MDY and buying the OEF. When this divergencewas initially observed, the mid-cap fund was trading near $100 and thelarge-cap fund could be bought for $52.50. Assuming the strategist wantsan equal dollar amount in both positions, two OEF shares are purchasedfor every MDY share sold short.
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FIGURE 15.2 MDY and OEF Divergence (Source: www.ProﬁtSource.com)
About a month after the trade is initiated, both indexes begin to fall.However, as expected, the gap begins to narrow, as the mid-caps beginfalling much faster than the OEF. By October, the divergence has disappeared on the charts. The strategist closes out the MDY short position for$76 a share, netting a profit of $24 a share. The long position is closed outfor $42.50, which results in a $10 loss per share. Two long OEF shareswere purchased for every short MDY share. So the net profit is $4.00 perMDY share (or $24.00 – $20.00).As an alternative approach, the inter-index spread can be createdwith options. For instance, rather than using shares, the strategist mightconsider using deep in-the-money options, or options with high deltasand relatively little theta decay. As an example, when the divergence isnoted in May, rather than buying shares, the strategist buys 20 OEF September 50 calls for $5.00 a contract and buys 10 MDY September 110 putsfor $10.90 a contract. The cost of the trade is equal to combined premium: [(20 × $5) + (10 × $10.90)] × 100 = $20,900. By mid-September, theOEF calls were almost worthless. However, the MDY 110 puts could besold for $30.60 a contract. At that point, the position is closed out for ahealthy $9,700 profit.With options, the inter-index spread becomes very similar to a strangle, but it uses two underlying indexes instead of one. On a percentage basis, the position has larger potential profits than the inter-index spreadwith shares because of leverage. In the MDY example, the September putsincreased in value from $10.90 a contract to $30.60. The position can alsobenefit from an increase in implied volatility. At the same time, the lossfrom the calls is limited to the premium paid. Obviously, this type of
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spread works best when the strategist expects an explosive move in theunderlying indexes, but is not sure about direction.Option Ratio FormulaThe formula for computing the correct number of contracts in an inter-indexspread is as follows:Ratio = (ν1 /ν2 ) × (d1 /d2 ) × (p1 /p2 )whereν = implied volatilityd = deltap = priceIn the example provided, the deltas of the OEF and MDY equal 0.70 and0.85, respectively; the volatilities are 0.165 and 0.18; and the prices are$100 and $52.50. The formula yields:(0.165/0.18) × (0.85/0.70) × (100/52.5) = 14.03/6.62 = 2.12So two calls are purchased for every one put.
THE INDEX EFFECTNo book on index trading would be complete without a discussion aboutthe index effect, which is our final strategy discussed in this book. Although the index effect doesn’t involve trading an index, profit opportunities are possible for savvy stock traders who want to identify the nextstocks to be added to the S&P 500 Index.When a company is added to the S&P 500 Index, the share price willoften rise. There is a large price move because many fund companies andother institutions try to mimic the performance of various indexes. As explained in Chapter 8, trillions of dollars are linked directly to the SPX. Examples of so-called index funds include the Vanguard S&P 500 IndexFund, which is one of the largest mutual funds in existence today, as wellas the S&P 500 Depositary Receipts (SPY), one of the largest exchangetraded funds today.When the Standard & Poor’s committee decides to add a new company to its index, the news triggers a flurry of buying in the company’sshares. All of the funds and other portfolios that try to mimic the index areforced to buy the stock. There is no choice in the matter. This sudden increase in demand for the new S&P 500 stock causes the share price torise. It is known as the index effect.
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Since the Standard & Poor’s index committee meets behind closeddoors, predicting which company will be added to the S&P 500 Index is noeasy task. While it is difficult to know what stock will next be added ascompanies are periodically deleted from the S&P 500 Index, traders knowa new company must be added in the event of a merger. If two S&P 500stocks merge and form one company, this creates a vacancy and the committee will seek a replacement candidate.The replacement will often come from within the same industry. S&Ptries to maintain a reasonable sector balance and will look first to the industry group from the deleted company when selecting its replacement.As an example, if two banks merge and open a spot in the index, the nextentrant into the S&P 500 Index may very well be a financial company.In addition, Standard & Poor’s establishes fairly strict criteria for S&P500 stocks. First, the company must be headquartered in the UnitedStates. Second, shares must have adequate liquidity. The stock must havea market capitalization of $4 billion or more. Initial public offerings (IPOs)must also be “seasoned” for 6 to 12 months before being considered. Finally, Standard & Poor’s wants to see financial viability, which they measure by four consecutive quarters of profitability.Therefore, in order to find the next SPX candidates, one must firstidentify those stocks that meet the criteria. The larger companies that arenot yet part of the index are the most likely candidates.As of this writing, Google (GOOG) has a market value of more than$120 billion, which would make it one of the top 20 SPX stocks. In addition, it is has been trading for more than 12 months and has a track recordof profitability. By the time this book is published, it will probably be apart of the S&P 500 Index. (In fact, shortly before this book went to print,GOOG was added to the S&P 500 as expected.) However, the same analysis can be repeated:• Create a list of large-cap stocks that are not yet part of the S&P 500Index.• See if they meet the criteria discussed in the previous paragraph.• Wait for a merger to create an opening in the S&P 500 Index.• Go long shares or set up bullish trades on the stock that seems mostlikely to get a boost from the index effect.
CONCLUSIONWhile it doesn’t take a PhD in indexes to make money trading them, understanding the products you trade is naturally important. For example,
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the NASDAQ 100 Index is one of the more actively traded index productsand has been since the late 1990s. However, the index is a lot differenttoday than it was when options started trading on the index. Understanding how it is constructed and what companies comprise the index will certainly help make sense of its daily movements, or nonmovement. For thatreason, early in this chapter, the reader was encouraged to learn about thedifferent methodologies used to construct indexes.Understanding how indexes are built can also open up trading opportunities. The index effect can be used to capitalize on the one-time pricemovement of a stock when it is added to an index. A modest portfolio tiltcan sometimes outperform the S&P 500 Index and provides smaller investors with the opportunity to do something most institutions can’t—namely, beat the market on a consistent basis. The buy write indexes canhelp traders identify periods of time when covered call writing makessense. Finally, inter-index spreading can be used to profit from long-termrelationships between two indexes, but the success of the strategy doesnot depend on market direction. Bottom line, all of these strategies can bequite lucrative as you endeavor to successfully trade the index market.
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Getting Started
N
ow that you’ve read the entire book, you’re raring to go and readyto start making trades. But hold on, we don’t want to rush into using real money until we’re totally prepared to do so. This chaptergoes through the various things every trader should understand beforeever putting the first amount of money into a trade.This final chapter is designed to empower you to successfully tradethe index markets. To get there, you’ll need to find the right broker, set upan account, and become familiar with the various types of orders available. We also highly recommend paper trading the markets in order to teststrategies before ever placing a dollar into a real trade. After all, airplanepilots use simulators to learn how to fly before ever risking their lives byflying a real plane. Likewise, we need to paper trade to gain the skills weneed to keep our financial lives intact. This being said, let’s get started.
FINDING A BROKERThere are many types of brokers, which is why it’s so important to be ableto identify exactly what we’re looking for as options traders. While wecover the basics here, readers are encouraged to read the plethora of information on various brokers on the Optionetics web site. (The link to thisfeature is www.optionetics.com/broker/review.asp.) This is a free servicegeared toward helping new traders find the most appropriate broker fortheir situation.343
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There are several things that a broker needs to provide a trader. Firstand foremost is the ability to make option trades and make them seamlessly and quickly. Many new traders look solely for brokers with theleast expensive commissions, but these aren’t necessarily the brokersyou should use. Price is important, but not at the cost of execution andease of use.Not all brokers cater to option traders, so it is important to find onethat does. The line between discount brokers and full-service brokers hasnarrowed in the past few years, but there are still some key differences.First, a discount broker is mainly there to allow orders to be processed.They do not provide advice, but the amount of research and tools theyprovide has improved dramatically. Full-service brokers provide adviceand numerous tools and research, but these extra services come at aprice: higher commissions.The Optionetics web site lists many brokers and ranks them usingvarious criteria, including site design, commission cost, and account minimums. After reviewing the various brokers, choose the one that seemslike a good fit for you. If you don’t like their services, you can always movelater. However, before choosing a particular broker, you might want to askaround with other traders about who they use and why. This can be doneon the Optionetics forum as well.
OPENING A TRADING ACCOUNTOnce you find the broker you want to use, you must fill out the paperworkto open the account. Then you have to get approval to trade options, asnot all traders are allowed this privilege. Most firms will allow you to apply online using the appropriate digital forms. Before applying for an account, a trader should assemble key information that will be needed.First, the type of account you are setting up is crucial. This can include individual, joint, custodial, and IRA accounts. There are differenttax laws for each of these types of accounts and you should consultwith your tax adviser to make sure you are entering the appropriateaccount type.Next, you must choose whether you want to use margin. This is onlypossible in a nonretirement account, and it requires extra paperwork andusually a larger minimum deposit. Margin can be a curse or a blessing, depending on how it is used. This is because it involves using leverage,which is a good thing if used properly. You can always add margin to youraccount at a future date, so there is no need to sign up for margin initiallyif you are not sure what to do with it.
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Besides setting up a brokerage account and choosing the accounttype, you must also fill out an options trading agreement. Brokerages needto gather information about potential traders before allowing them totrade options. At first, you might need to start with basic strategies, likebuying calls and puts. The highest level, as discussed earlier in the book,is Level Five, which is the ability to write uncovered equity and index callsand puts. Optionetics rarely touts using naked positions, so a Level Fiveaccount isn’t necessary. In order to get the experience you need to applyfor the level you want, you can start by paper trading.
PAPER TRADINGGetting experience trading options and the various strategies involveddoesn’t need to cost you a lot of money. We often hear how people havelearned to trade from the school of hard knocks. Why learn the hard waywhen there are ways to learn without losing a lot of capital?Everyone has probably heard the term paper trading, but there arevarious ways this practice can be done. One way is to use a portfoliotracker, like the one found on the Optionetics web site. Here you can enter mock trades, track them, and see how they fare over time using papermoney. Of course, the key is to treat the trade as if it were a real trade,trying to duplicate the feelings and decisions you would make if it werereal money. Emotions are a big part of trading and can cause traders todo things they shouldn’t do, so you need to treat paper trading like thereal thing.Another way to paper trade is to go back in time and see how a particular trade would have fared if we had entered it. This might seem hardto do, but with the Optionetics Platinum software, this is an easy andvery powerful way to learn to trade. Platinum allows us to go back intime, set up a trade, and then move forward in time to see how it wouldhave fared. By using this type of paper trading, you can learn strategies injust a fraction of the time it takes to paper trade in the present. In orderto see this more clearly, let’s review an example of a paper trade madeusing Platinum.In Platinum, we choose a date in the past, and the program handlesthe data from that date as if it were the present Once we have entered themock trade we want to paper trade, we can then move the date forwardone day at a time or until option expiration to see how the trade performed. By moving forward day-to-day, we can see how the market shiftsand try to visualize how we would feel and react to the trade. We also canexit when our stops are hit and/or our profit goal is realized. Once again,
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we must treat the trade as if it were real money to closely duplicate areal-world trade.
Paper Trade ExampleBack in late April 2005, the Nasdaq 100 Trust (QQQQ) experienced a bullish candlestick pattern called a hammer. This is when a stock or indexmoves sharply lower intraday, but recovers and finishes higher in a current downtrend. Once this pattern developed, we could enter a call on theQs to see how this trade would have fared.To paper trade this hammer pattern, we would set Platinum back toApril 29, 2005—the day this bullish formation developed. Let’s assume weget in at the open on April 30 for roughly the same cost. Though there aremany bullish strategies, let’s explore the use of a long call. Now whichstrike price and expiration should we use?When looking at the option data tables for QQQQ, there are a numberof option strikes to choose from. In general, when buying a call or put, it’spreferable to buy at least 60 to 90 days of time, as time erosion occursfastest in the last month of an option’s life. The Qs closed trading on April29 at $34.98. Let’s use the July options, as they give us 77 days until expiration. We now must choose the strike we want to use. We can choose anin-the-money (ITM) strike, an at-the-money (ATM) strike, or an out-ofthe-money (OTM) strike. Depending on our outlook for the stock, ourbest reward-to-risk ratio is found using an OTM strike. Many traders prefer to use the strike that has a delta near 25 to 30, which in this scenariowould mean using the 37 strike. The Qs are different from stock options,as they have strikes set at every point, making them very flexible. Thecost for the July 37 QQQQ option is about $0.50 per contract. (See Figure16.1 for a summary of the opening trade.)Now that we have decided on the trade, we need to decide where our
Nasdaq 100 Tr Series 1 (QQQQ) Option Trade Stock NewsLeg