begin to develop, so that wouldhave led you to exit the spread in December 1992.Figure 5.5 shows the spread the previous year—contracts expiring in February 1991. This time, the spread remained flat, or evenrose slightly (but not far enough to stop it out) until November 1.Then it began to work fabulously, plunging to a low by the end of theyear. In all, the spread made about seven points that year.Figure 5.6 shows a losing year, using the February 2000 contracts. The spread traded sideways for a long time, finally registeringa modest gain in December; but then it turned and reversed higherFigure 5.4HOG ⁄ HUG 1993 CONTRACTS
Spread
400
200
0O
N1992
D
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Figure 5.5HOG ⁄ HUG 1992 CONTRACTS
Ratio
Figure 5.6HOG/HUG 2000 CONTRACTS180016001400120010008006004002000–200–400O1999
N
D
J2000
F
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for the rest of the month. That move in December should havestopped the spread out for a loss. If you held on, though, you mighthave been lulled by another positive move in early January beforethings fell completely apart as the spread blasted higher in late January. There was almost certainly no profit that year.The 2001 contracts weren’t much better, as shown in Figure5.7. This was perhaps the most volatile year in the history of thisspread. Volatility typically takes place when the winter is muchworse than expected and the heating oil contracts rise much fasterthan unleaded gas contracts do. In this case, the spread traded backand forth between 6.00 and 10.00 from September 1 through earlyNovember. The “optimal” entry point, in early October, was a goodentry; and perhaps you might have taken partial profits by earlyNovember. However, it’s unlikely that you would have entirelyexited the spread before it moved decisively in the wrong directionin December. That move would certainly have stopped you out.Ironically, the spread then turned and fell by nearly 25.00 points. I
Ratio
Figure 5.7HOG/HUG 2001 CONTRACTS16001400120010008006004002000–200–400–600–800O2000
N
D
J2001
F
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suppose an astute trader could have reentered the spread when itsdirection turned south, but we don’t really have a systematic provision for that.Things have improved since then, as 2002 and 2003 contractshave all generated profits. The 2002 contracts are shown in Figure5.8. It was a “classic” year, as the spread never seriously markeddown from an early October entry point. Eventually, the spreadbegan to collapse in November, and it fell all the way into early January— declining by 8.00 points or more.Of the 12 contract years that comprise the composite chart, 8years produced a solid profit, while 2 years showed modest lossesand 2 showed larger losses (hitting the stop of 3.00 points). In yearswhen the spread works, you get moves of 3.00 or 4.00 points inyour favor (occasionally, more), which is $1,260 to $1,680 on aninvestment that is $2,000 or less. That is a phenomenal return, ofcourse. In years where you’re stopped out, the loss is limited; and we
Figure 5.8HOG/HUG 2002 CONTRACTS400300200
Spread
1000–100–200–300–400–500O2001
N
D
J2002
F
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generally don’t reenter that year—preferring to wait until the nextyear to try again.You have probably noticed that we haven’t mentioned optionsyet in this analysis. Options can be used in this spread strategy. Simplistically, you would buy a February unleaded gas call that was fairlydeep in-the-money, so as to minimize time value expense, and wouldalso buy a February heating oil put that was deep in-the-money.These options would be bought instead of the futures spread, sothe option position would be established in late September or earlyOctober of the preceding year. That brings us to our first problem:liquidity. These futures options are not that liquid four or five monthsprior to expiration. So, you may have trouble finding a striking pricethat is deep enough in-the-money to allow you to minimize your timevalue expense. Also, you may not be able to trade enough options toestablish the spread in the size that you want.Remember that the profit potential of the spread is three to fourpoints at best. So if you are spending nearly that much for time valuepremium when you buy options, then perhaps you should use futuresinstead. Admittedly, if you are going to remove the spread in December, then there will still be some time value premium left in theoptions when you sell them—so you might not lose all of the timevalue premium that you originally bought—but you can’t count onthat. Moreover, the options expire in January, so they will have onlya few weeks of life remaining when you try to sell them in December.Having stated all the caveats, let’s look at the positive side of theoption buy combination (we are buying a put and a call) as comparedto the futures spread. The advantage of the option position is that itcan make money when prices are volatile. The following example,from 1991 prices, shows how this might work.In mid-September 1991, the following prices existed:Feb unleaded gas: 62.50Feb heating oil: 68.00
HU Feb 56 call: 6.80HO Feb 74 put: 7.50
Futures spread: 5.50
Option combo: 14.30
The futures spread (5.50) is just the difference between the two futurescontracts, and the option combo price is the sum of the two option prices.
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Note that the time value premium in the Feb 56 call is 0.30 and is 1.50 onthe HO Feb 70 put. Thus, the option combo requires an expenditure of1.80 for time value premium. This might represent almost the entire profitof the spread if prices remain unchanged. However, the benefit of owningthe option combo was seen when prices became volatile.As the fall of 1991 unfolded, the futures spread was fairly flat, rangingup to nearly 6.00 in November and down to 4.00 in the first week ofDecember. From the original price of the spread, this would have been aprofit of 1.50, basis of the futures contracts.However, what you can’t tell from the spread price is that the absolutelevel of oil and oil product prices was in a very bearish market in Novemberand December of 1991. Figure 5.9 is a chart of heating oil during this timeperiod. You can deduce that the unleaded gas chart was quite similar, sincethe spread between the two was remaining relatively stable.By early December, Feb heating oil fell to 56.00. That means the Feb74 put had to be worth at least 18.00, which is parity. The Feb unleaded 56Figure 5.9HOG
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call could only fall to zero (in reality, it was worth 0.20). Thus, the optioncombo was worth at least 18 points in early December. Since the initial costof that combo was 14.30, the profit on the option combo was 3.70 points,substantially better than the 1.50 profit available solely from the futuresspread.As it turned out, prices fell even farther during December, which meansthat the long put generated even more profits.
This example also can be used to illustrate an even more important point in favor of the option combo. Suppose, just suppose, thatwhen Feb heating oil fell to 56.00 in early December, unleaded gashad fallen even more. Thus, the futures spread would have actuallylost money if that had happened. Despite that, the option combowould have had to make money because the option prices would stillbe the same: 18.00 for the heating oil Feb 74 put and zero for theunleaded gas Feb 56 call. Thus, the option combo can actually makemoney if prices are volatile (e.g., prices fell dramatically in this example) even though the futures spread might be losing money.The counterargument, of course, is that if prices remain stableand the futures spread widens by two points or so, you will make allof that two points if you have the futures spread in position, whileyou would lose time value premium in the same situation if you havethe option combo in place. In the preceding example, the time valuepaid was 1.80, so you wouldn’t really make anything from the optioncombo in that case.So, which is better, the futures spread or the option combo? Iwould use the time value premium of the options as the major factorin making that decision. In early September, if the options are trading with an inflated implied volatility or if the time value premium isjust plain “too big,” then start out by spreading the futures. You canalways roll over into an option position if implied volatilities decrease(i.e., if time value premium shrinks). This might happen in Octoberor early November. So, if you have the futures spread in place, Iwould always keep an eye on the options for an opportune time toswitch into the option combo. Thus, I favor the option combo, butonly if time value premium is small enough.So get out your calendar right now, and make a note for nextSeptember to evaluate the spread between the following February’s
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heating oil and unleaded gas contracts. This is a spread with a goodtrack record.
The January EffectThis is another seasonal spread that can actually be played in twodirections (not simultaneously, of course). The January effect is aterm that describes the phenomenon whereby small-cap stocks generally outperform large-cap stocks in the month of January. The reason that this effect takes place is that when the end of the yearapproaches, people are more apt to sell off their small stocks to takelosses (known as tax selling). This depresses the small-cap stocks, andthen they bounce back in January after the selling abates. However,when January arrives, you would not just want to buy the small-capstocks (Value Line Index, e.g.) because the overall market mightdecline. So the preferred strategy is a hedged one: buy a small-capindex and simultaneously sell a big-cap index (S&P 500, for example). Then if the small-caps outperform the large caps in January,you will have a profit.That seems simple enough, doesn’t it? Unfortunately, wheneveryone becomes aware of something, the market has a way of making it more difficult to make money. For example, the “conventional”wisdom is that the January effect takes place earlier now because somany people are anticipating it.In order to discern how this spread truly behaves, we decided todo some research on how it has really played itself out in recentyears. We didn’t want to go back too far because spreads such as thistend to implement themselves in different ways as the years go by.We felt that looking at the postcrash (i.e., post-1987) years might bebest, since that was sort of a turning point for many investmentphilosophies. This means that we are looking at data from November1988 through January 2003—15 examples of the January effectIn the following analyses, we are going to refer to the Value LineIndex as representing small caps and the S&P 500 Index as representing large caps. In the 1990s, this spread was easily establishedusing the Value Line futures versus the S&P 500 futures. Later, the“big” Value Line futures were delisted, and the mini-Value Line
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futures became very illiquid. Hence, there are a number of ways thisspread can be traded. They will be discussed shortly (in the sectionentitled “Implementing the Spread”); but for now, we will explain thestrategy using the Value Line and the S&P 500 indices.The specific prices are listed below, but two broad conclusionscan be drawn, and they are very important ones:Conclusion 1: Big-cap stocks distinctly outperform smallcap stocks from about mid-November to the end of the monthand all the way to year-end, in many years. Thus, you should buythe S&P Index and sell the Value Line Index (or equivalent) inNovember and unwind it three to six weeks later.Conclusion 2: The optimal time to play the January effectin recent years has been from about December 19 to January 5.You would buy the Value Line Index (or equivalent) and sell the S&PIndex on the December date, unwinding it in early January.Figure 5.10 shows the composite spread for the years 1989through 2003. Once again, recall that a composite chart is constructed by averaging the price for each year included. Thus, any oneFigure 5.10VALUE LINE/S&P 500 COMPOSITE: 1989–2003
B
“Normal”JanuaryeffectPre-Januaryeffect
AOct
Nov
Dec
Jan
Feb
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year might differ from the chart, but the usefulness of the compositechart is that it shows trends and tendencies that might not be obviousby looking at all 15 years individually. Figure 5.10 begins with thefirst trading day of October and continues forward by trading day.Thus, the monthly markings on the axis (October, November,December, etc.) are only estimates. In reality, one would count thenumber of trading days and determine the date from that number;but since there are approximately the same number of trading daysin each month each year, it is acceptable to put the month delineations on the lower axis.From the chart, you can see that the spread between Value Line(representing small-caps) and the S&P 500 (representing large-caps)shrinks, or declines, during November—certainly during the last halfof November, anyway—and remains low until late December (pointA on the chart). Thus, Conclusion 1 is verified by this chart: one canbuy the large-caps and sell the small-caps in early to mid-November,planning to unwind that trade anywhere from late Novemberthrough mid-December. In some years, the differential didn’t bottomout until nearly December 20 or so; but in other years, it bottomedshortly after Thanksgiving.Sometimes analysts in the financial media say that investorsshould begin establishing the January effect in November, because itoccurs earlier each year. They are wrong. Conclusion 1 and Figure5.10 clearly show that large-caps outperform small-caps duringNovember and possibly even December. This conclusion makes logical sense, since the original premise is that these small-cap stocks aresold heavily during tax-selling time in November and December.Unfortunately, some proponents of the January effect are in toomuch of a rush to establish their positions. Getting in too early canand will cost you.The proper time to actually enter the traditional January-effectspread is much nearer to the end of the year, when tax selling abates.This usually occurs around December 18 to 20; but in a couple ofthe years in the study, tax selling continued all the way until the endof the year.In Figure 5.10, you can see that the major portion of the Januaryeffect—when small-cap stocks outperform large-cap stocks— occursfrom point A (late December) to point B (early January). In fact, the
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time between the two points is rather short—about eight or ninedays. Actually, point A occurs 59 trading days after the end of September, and point B occurs 67 trading days after the end of September (remember, that Figure 5.10 is constructed by using tradingdays, not the actual calendar). Typically, 59 trading days after theend of September is December 18 or 19, and the exit date is typically January 5 or 6. Depending on when weekends and holidaysfall, of course, the dates can be slightly different than that.Over the years, the length of the January effect has compressedgreatly. When the effect was first gaining publicity—in the late 1980sand early 1990s—it used to begin just after the first of the year andlast until much later in January. But the starting date has moved forward into late December because traders want to get “a jump” on therest of the crowd. As for the end date, even now one can see fromthe composite chart (Figure 5.10) that the actual peak occurs moretoward the end of January; but the bulk of the gains are over by earlyJanuary. So perhaps a good tactic would be to take some of the position off in early January and hold the balance with some sort of trailing stop until later in January. These concepts are expanded in thenext section.
Implementing the Spread. The reason that we spread the effect,rather than just buying a small-cap index, is that there is no guarantee that the market will rise in January; but whether it rises or falls,the January effect has a good track record going back over 60 years,because small-caps outperform large-caps during the time periodstated, even in a falling market.In years past, we implemented the spread in a very simple manner, by trading Value Line March futures against S&P 500 Marchfutures. Today, that is not necessarily the best choice, since theValue Line futures are quite illiquid. However, let’s look at an example using futures, and then we’ll discuss alternatives.Currently, the only Value Line futures contract is the mini-ValueLine (base symbol: MV), which is worth $100 per point of movement in the Value Line index (VLE). So, the simplest thing to use asa reasonable spread against the mini-Value Line would be the S&P emini futures (base symbol: ES). On the surface, then, one MV con-
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tract would be spread against two ES contracts, which would giveboth sides of the spread $100 of value per point of movement. Wewill later show that this ratio might have to be refined somewhat.When trading the spread with futures, one must be aware of thefact that because futures are a derivative product, they may anticipatethe January effect and, thus, have a large spread on them. I haveseen the Value Line futures have as much as nine points of premiumbuilt into them in late December (where fair value might be twopoints, say). That is because the marketplace is already anticipatingthe January effect. If that is actually the case (overly large premium inValue Line futures), then one might want to use an alternativemethod of trading the spreads—Exchange-Traded Funds (ETFs), tobe discussed shortly.In late December, a trader is thinking of establishing the January effectspread—buy the mini-Value Line futures and sell the S&P e-mini futures.He would use the March contract in both cases since that is the “frontmonth” (most active) contract. The following prices exist:VLE: 1351.13March mini-Value Line futures: 1358.00
SPX: 1082.07March e-mini futures: 1084.00
The spread between the cash indices is 269.06 (VLE minus SPX), but thespread between the futures is only 264.00. This difference is due to the factthat the Value Line futures, which you are going to buy, are trading with apremium of nearly seven points. Meanwhile, the S&P futures that are beingsold have only a two-point spread (roughly). Thus, the trader is paying fivepoints of extra premium for the futures spread. Alternatively stated, thefutures marketplace has already discounted a widening of the differentialbetween the two indices (the January effect) and has built in a five-point premium because of it. This extra premium is a theoretical disadvantage for thetrader. If he expects the spread to widen more than that, he may go ahead;but if he feels this has already robbed the spread of most of its potential,then he should look for other instruments with which to establish thespread.Let’s suppose that he goes ahead. To keep things simple, suppose thetrader:Buys one March mini-Value Line future @ 1358Sells two March e-mini S&P futures @ 1084
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In early January, the expected movement occurs, and these prices exist:VLE: 1346.53March mini-Value Line futures: 1348.00
SPX: 1067.44March e-mini futures: 1069.00
It is obvious that the market went down: both VLE and SPX are lower.However, the January effect has taken place anyway, because the spreadbetween Value Line and S&P has widened (again, remember that the January effect says nothing about whether the market will rise or fall—merelythat the small-caps will outperform the large-caps, no matter which way themarket goes).Furthermore, notice that the premium in the mini-Value Line futuresand the e-mini futures are about equal now—a little over a point in each.Let’s see how our spread fared:ContractLong one MV futureShort two ES futures
Current Price1348.001069.00
Entry Price1358.001084.00
$/Point10050
Profit–$1,000+$1,500
Thus, the spread has profited by $500. In reality, the difference in the cashindex prices widened by 10.03 points, but you only profit by five pointssince you paid a five-point premium to establish the spread. Still, it is aworthwhile trade.
The futures spread is eligible for a reduced margin requirement,although many brokers may not be aware of it. You should requestthat your futures brokerage firm review the position, recognize it as aspread, and allow you reduced margin—typically something on theorder of $2,000 for the spread, as shown in the preceding example.Note that there are no longer any options trading on the VLE, sowe cannot implement the spread with options. That is probably not abig detriment, however, since we are planning on staying in thisspread for only eight or nine days. The bid–asked spread in indexoptions contracts would be too onerous for such a short-term trade.However, without the use of options, our risk is very large; sosome sort of stop loss needs to be used. Ideally, a person would lookat the near-term history of the spread and place a stop accordingly,or perhaps just use a “money stop” (i.e., stop himself out when he
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loses a predetermined amount of money). A money stop shouldprobably be at least 5.00 points in spread value (or $500 in the oneby-two MV versus ES spread shown in the example).Now, let’s take a look at other ways the spread might be implemented. For the large-cap side, I would still use the SPX. However,there are at least three other ways one could establish a position inthe SPX besides futures: (1) futures options, (2) SPX options tradedon the CBOE, and (3) S&P depository receipts (SPDRs, symbol:SPY), which everyone calls “spiders.” SPY is an exchange-tradedfund that mimics the SPX, but trades at one-tenth the price.Spiders are very liquid and are a favorite of institutions. They canbe shorted on minus ticks, which makes them very similar to futures.Their biggest detriment is that they are margined like stock (at 50percent margin), which is considerably more than the 10 percentmargin required for S&P 500 futures contracts. The only otheracceptable alternatives for large-caps would be the iShares S&P 500Index (symbol: IVV), the OEX, and its accompanying ETF (symbolOEF), and their options.There are several alternative choices for small-caps. There are anumber of small-cap indices that trade options, and there are severaliShares (ETFs issued by Barclays, if you will recall) that representsmall-cap indices. To verify which iShares are available at any pointin time, visit the site www.ishares.com and click on the Market Cap,Small Cap tabs on the left of the home page. Table 5.2 shows a listof the currently available products that you might consider as a wayto trade a small-cap index during the January effect.
Table 5.2SMALL-CAP INDEX PRODUCTSRussell 2000 Index Fund (IWM)*S&P 600 Small Cap Index fund (IJR)*S&P Small Cap Index ($SML) optionsRussell 2000 Index ($RUT) optionsRussell 2000 Index futures (base symbol: RU)*Both are iShares; both have listed options.
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In late December 2003, the following prices existed:VLE: 1460.2
SPX: 1075.1
Difference: 398.1
A trader wants to trade the January effect, but he wants to use listed optionsto do so. At the time, the Russell 2000 Index ($RUT) was tracking quite wellwith the Value Line Index and, therefore, was a reasonably good proxy forthe small-caps in general. The iShares (IWM) had modestly priced options.Meanwhile, the OEF exchange-traded fund was chosen as a proxy for thelarge-caps because it tracks the SPX almost exactly and has listed options aswell. As with any intermarket spread, we use in-the-money options to tradethis position. These were the relevant prices:RUT: 537.70IWM: 107.12IWM Feb 105 call: 5.60
OEX: 534.70OEF: 53.51Feb 55 put: 2.20
Let’s make the assumption that we’ll buy two OEF puts for each IWM callwe buy, even though that might not be completely correct (a formula forincorporating volatility into an intermarket spread is presented later in thischapter). So, we buy two OEF Feb 55 puts at 2.20 and buy one IWM Feb105 call at 5.60—a total outlay of $1,000, plus commissions.In early 2004, the January effect worked very well, and the spreadbetween VLE and SPX widened to 445 points by January 8. Moreover, thespread was expanding at the time, so if a trader merely stayed with it until itnarrowed one day, he would have remained in until January 21, 2004,when it stood at 471.70. At that time, the relevant prices were:VLE: 1619.3RUT: 598.00IWM: 118.91IWM Feb 105 call: 14.1
SPX: 1147.6Difference: 471.7OEX: 563.70OEF: 56.56Feb 55 put: 0.35
So, the combined value of the two OEF puts plus the one IWM call is now$1,480, less commissions. Thus, the spread profited by $480, or 48 percent in this case. One of the reasons that the profit was so large was thatnot only did the spread between small-caps and large-caps widen (whichwas profitable for our trade), but OEF also rose through the striking price,which means that the put stops losing money (it can’t trade below zero, ofcourse)—an added advantage.
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It should be noted that the large movement in the indices madethe option spread especially profitable. If the prices had remainedrelatively unchanged, then the time value spent for the options plusthe relatively wide bid–asked spread in the options would probablyhave produced a loss, whereas a January-effect spread utilizingfutures would have done much better. So it’s not always optimal touse options; but if the time value is relatively small, that’s the way Iwould generally lean—toward using options to establish the spread.Before leaving this subject, observe Figure 5.11. It is a long-termgraph of the differential between the Value Line Index (VLE) and theS&P 500 Index (SPX). Note that the spread remained very stablefrom 1990 into 1998—with SPX generally being less than 100points higher than VLE. Actually, the two were about equal in 1995.From that point forward, during the rest of the huge bull market ofthe late 1990s, SPX dominated. Eventually, SPX was over 400points higher than VLE by the year 2000. Then, the bear markettook over, and small-caps reasserted themselves—and have continued to do so ever since, even after the bear market ended in 2002.Figure 5.11VALUE LINE INDEX MINUS S&P 500
400300200Ratio
1000–100–200–300–400–50091 92 93 94 95 96 97 98 99 00 01 02 03 04
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Since then, small-caps have outperformed large-caps by such a widemargin that most small-cap indices have made new all-time highs—exceeding their bull market tops of 2000, even though SPX, theNasdaq, and the Dow are all well below their respective bull markethighs.This resurgence of the small-cap indices has biased the spread inrecent years. The pre-January effect (where one buys large-caps andsells small-caps, beginning in November of each year) has donepoorly, whereas the “normal” January effect (traded in the reversemanner) has been much more profitable than its historical norm.Hence, as long as small-caps continue to be such a large outperformer during the entire year, one might be leery of the Novemberportion of this spread (perhaps trading a lighter position or usingtechnical entry points, such as a decline in the spread, as entrypoints—if there is no decline around the optimal entry date, thendon’t enter the spread). Conversely, one might pursue the regularJanuary effect spread more aggressively as long as this longer-termtrend persists, as shown in Figure 5.11. In other words, enter theregular spread on the appropriate date near the end of Decemberwithout regard to the short-term technical pattern in the differentialof the two indices at that time; but when it comes to the Novemberportion of the spread, only enter it when it begins to look like SPX isstarting to outperform VLE. If it doesn’t look that way around theentry date, then don’t enter that portion of the spread that year.In summary, the spread can be traded with either futures oroptions and can be traded in both directions (long large-caps andshort small-caps in November, and the other way around over theend of the year). I feel that both portions of the spread can betraded each year, for both have a generally successful