When addingsecurities to your portfolio, note the beta value so you have a basic feelfor how that security moves relative to its appropriate benchmark. Thisis usually the S&P 500 for equities. The addition of high beta securitieswarrants additional attention to portfolio management. By recognizingthis impact, you can build some mechanism into your plan that allowssuch management.
TRADINGTrading diversification can occur on a smaller scale and uses markets,sectors, securities, and strategies to minimize the need for a trader to beright. One of the best things you can do for yourself as a trader is to trulyrecognize that being wrong about the direction of a security (and having aposition that declines in value) does not equate to being a bad trader. Ashift in your reaction to losses must occur.Being wrong actually provides an opportunity for an individual to display his talents as a good trader. All that is needed is to properly cutlosses. It’s like a professional golfer who hits his ball into the rough; itwasn’t his goal to get the ball in that position, but once there he’s able todisplay his skills by chipping the ball to a nice position on the green.These are the shots that are truly appreciated by the gallery.Great traders are great money managers. This includes allocating appropriate amounts to individual trades and identifying a maximum loss.
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Such an approach minimizes the impact of being wrong and helps traderswithstand losses and keep trading another day. If it were really that easyto do, every new trader would be a good trader. Since this isn’t quite thecase, there must be some pretty powerful forces a new trader must overcome to reach the point of effectively trading the markets. These powerfulforces are most often tied to emotion.The experience part of money management includes spendingenough time in the markets to recognize good opportunities and to havefelt the pain financial markets can inflict. When failing to trade with discipline is more agonizing than having a loss, you begin to evolve as atrader. We teach strategies, rules, and exit strategies for this very reason. Experienced and successful traders have learned to depend onsuch discipline.
HAVING A PLANSuccessful traders have an approach that has been developed and refined,as well as a collection of rules for money management. Although themoney management portion reflects the individual’s personal experience,risk tolerance, and markets traded, there are a couple of components thatwill appear on many different lists: (1) Know your cut loss/exit point, and(2) execute an order to close a position if that point is reached.Following these simple two rules will provide a launching point formaking adjustments that improve the trader’s overall results. It is notwithin the trade that adjustments should be made if the maximum risk fora position has been reached—approaching a position in that manner is arecipe for undisciplined, emotional trading. The exit strategy should beknown in advance. This often includes placing a stop-loss order or maybeeven reversing the trade. For example, using the Volex example fromChapter 9, the sell signal might trigger an order to close out the long position and, at the same time, a new order to short the SPY. These orders canbe placed with the brokerage firm as soon as the position is opened.(Chapter 16 provides additional information about order entry.)Stop-losses and exit strategies will reduce stress. After many stressfultrade exits—those that include the “should I or shouldn’t I get out” debate—it is great to see a cut-loss level reached and know there is no decision to make. The rules say to close the position, so the trade is closedout. This creates a significant shift in emotions that makes for a much better mind-set for market and position analysis. Importantly, once the stopor exit strategy is in place, only in rare circumstances should it bechanged.
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The next big shift in trading psychology comes about when an individual establishes rules for trade entry that include maximum cash allocatedper position. The percentage allocation will vary by market. Many stocktraders will not risk more than 5 percent of their trading capital on onetrade. In the options market, that percentage might drop all the way downto 2 percent. Risking a relatively small percentage of the total portfolio onone trade reduces emotion and stress at the front end of the process bycreating a trade that won’t make or break the account. The exact percentage is an individual’s decision. Some traders try to shoot for the moon,risking a large amount of capital on a highly leveraged trade. These are thesame ones who tend to play slot machines or the lottery. There are farfewer winners than losers.
TRADE MANAGEMENT EXAMPLEWe now examine trade management through an example that reviews atechnical trade and a trade system. Keep in mind that similar to investment allocations, there is no one-size-fits-all money management approach for traders. Understand that the amounts and percentagesidentified here should be seen only as a possible framework for you tocreate your own plan.Assume a trader has allocated $40,000 to an equity trading account.The plan is to use a combination of technical analysis and a trading system. Thirty percent of the account, or $12,000, is allocated to a long-onlytrending system the individual backtested. The remaining 70 percent ofthe account ($28,000) is allocated toward other trending and nontrendingtrade opportunities.Since there are two approaches to trading this account, the trader firstidentifies the rules that manage risk and are rational for both approaches.Additionally, both the size of the account and the allocations will changeover time. As a result, an annual review of the account is made to assesstrade performance, reevaluate allocations, and make adjustments to reflect those allocations. During the review, balances in excess of $50,000will be removed from the trading account and placed with the trader’sinvestment assets (see Table 14.3).
Technical Trading Portion of the AccountThe technical trading portion of the account is available for directional equity trading, directional option trading, and option strategies that benefitfrom sideways trading or serve as a short-term position hedge. Aggressive
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TABLE 14.3 Trading Account SummaryAccount SizeCurrent System Trading AllocationCurrent Technical Trading AllocationReview Period
$40,000 to a maximum of $50,00030% or $12,00070% or $28,000Annual in July
money management rules for these particular assets include maximumallocation per strategy (80 percent), maximum allocation per stocktrade (30 percent) and maximum loss criteria based upon the tradevalue (15 percent).To help the trader put the “maximum loss” criteria into action, exitprices are written down as soon as the trade is executed. Physical stoploss orders are entered when consistent with the strategy. Money management requirements are reviewed on an annual basis to determine if theyremain suitable for the trader’s risk tolerance and sustainable for the account. When possible, a 3:1 reward-to-risk ratio will be sought by thetrader. Hence, for every $1.00 at risk the trader stands to gain $3.00. Technical price levels, options premiums, and maximum risk per trade determine the right level. Since the trader will not always be able to project aprice target, this rule is not required for each trade (see Table 14.4).The basic technical system is a moving average crossover system tocapture moves in the NASDAQ 100 Index Trust (QQQQ) and other ETFs.When the 10-day exponential moving average (EMA) crosses up above the20-day EMA, the trader buys the underlying ETF at the open on the nexttrading day. When the ETF price closes below the 10-day EMA for twoconsecutive days or the 10-day EMA crosses down below the 20-day EMA,the trader exits the position at the open on the following day.The chart in Figure 14.5 shows a buy signal generated for the NASDAQ100 Index ETF (QQQQ). The dotted line is the 10-day EMA and the solid lineis the 20-day EMA. Assuming no other positions are currently held in thisportion of the account, the trader can allocate up to $8,400 for this trade.The signal occurs when QQQQ closes at $35.85, so this value is used as toestimate the number of shares purchased ($8,400 ÷ $35.85 = 234 shares).
TABLE 14.4 Summary of Technical Trading DataAllocationStrategy AllocationPosition AllocationMaximum Loss per TradeReview Period
$28,00080% or $22,40030% or $8,40015% of position or $1,260Annual in July
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FIGURE 14.5 Daily Chart for QQQQ with a 10-day EMA and a 20-day EMA—View (Source: www.ProﬁtSource.com)
Rather than buying an odd lot of 234 shares, the trader rounds downto 200 shares and goes long at the open. QQQQ opens on May 13, 2005, at$35.99 and the trader buys 200 shares of QQQQ at $36 for a position valueof $7,200. Once a trade confirmation is received electronically, the traderenters a “good till cancelled” (GTC) stop order to sell the shares at $30.60[$36 – ($36 × 0.15)]. This represents a relatively high 15 percent maximumloss, or approximately $1,080, which translates to a potential loss of 2.7percent of the total account ($1,080/$40,000 = 2.7%).On June 7, the QQQQ closes below its 10-day EMA, generating analert for the trader. The next day, the second consecutive close occurs below this level, which generates a sell signal at the next day’s open. Thetrader exits on June 9 at $37.66, resulting in a $332 profit, less commissions. (See Figure 14.6.)As can be seen, the reduced allocation of $28,000 for the technicalportion of the account results in high trade allocations when tradingstock. Individuals with smaller accounts who are trading stock will likelyhave higher trade allocations and need to manage their risk extremely effectively to continue trading. Position allocations for options should besignificantly smaller.To trade with discipline, individuals need to make sure their moneymanagement requirements are satisfied for each trade—not some trades ormost trades, but all trades (see Table 14.5). It was possible for the actualloss to exceed the stop-loss amount provided by the example. The Qs mayhave gapped down through the level of $30.60, triggering a sell order for a
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FIGURE 14.6 Daily Chart for QQQQ with a 10-day EMA and a 20-day EMA—View 2 (Source: www.ProﬁtSource.com)
TABLE 14.5 EMA Trade ReviewStrategy AllocationPosition AllocationMaximum Loss Allowed
$7,200 or 25%$7,200 or 25%$1,040 or 15%
Satisﬁes 80% allocationSatisﬁes 30% allocationSatisﬁes 15% allocation
loss greater than 15 percent. This is simply an inherent risk of trading andone that must be recognized as a possibility. For the most part, however, aplain stop-loss should provide traders with the risk protection they seek.
The Trade System Portion of the AccountWhile the technical system of the account used a 10-day/20-day EMAcrossover, the trade system includes signals based on the rate of change(ROC) and average directional index (ADX) indicators, as well as a stoploss component based on system testing. We discussed this system in Chapter 9. Recall that the settings used are based on backtesting for the S&P 100(OEX) index components from 1980 to 1998. The ROC is a basic momentumindicator that measures the rate of ascent and descent for price. Tradealerts and signals can be generated using a chart that combines ROC with asimple moving average (SMA) line. These two indicators—ROC and anSMA on ROC—were used to create a base trading system. The ADX indicator measures the trendiness of the price (see Table 14.6).
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TABLE 14.6 Momentum Trading SystemMomentumSystem
Long only13-day ROC & 20-day ROC-SMA with ADX ﬁlter
Trade Entry
Buy when 13-day ROC crosses above the 20-day ROC-SMA andADX is above 18 and increasing for 3 days.
Trade Exit
Sell when 13-day ROC crosses below the 20-day ROC-SMA andADX is decreasing for 3 days.
In this case, the system will be used on the S&P Depositary Receipts(SPY), or SPDRs. This ETF was created in 1993. The trader used the SPYin a system backtest ranging from 1993 to 2002. The SPDRs were selected to capture trending trades when the broad market indexes weremoving upward. A system-dictated stop of 13 percent is used. The brokerage assumptions for the 1993–2002 SPY backtest included those inTable 14.7.The results of the backtest (see Table 14.8) indicate that the systemcreated by the trader can result in losses up to approximately 4 percent ofthe account, given the existing allocations (30% × 15% = 3.9%). This valuecan be even higher if gains in the system portion of the account or lossesin the technical portion of the account occur and the allocation balancesare skewed. At some point, consecutive losses of 4 percent or greater mayimpact the trader’s ability to continue using this system.Table 14.9 gives a breakdown of the results by profitable versus losing trades. Losses at this level are only slightly higher than the potentiallosses for the technical portion of the account, which are approximately
TABLE 14.7 Brokerage AssumptionsAccount SizeTrade SizeStop LevelBrokerage
$12,000100%13%$20 (roundtrip)
TABLE 14.8 System ResultsSystemNetProﬁt
Total #of Trades
AverageP/L %
MaximumDD %
AverageDD %
TotalCosts
$4,886
21
9.8%
–13.2%
–4.6%
420
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TABLE 14.9 Results BreakdownGrossProﬁt or Loss
# ofTrades
% P or LTrades
AverageP or L %
ConsecutiveP or L Trades
$12,005
14
66.7%
5.9%
6
($7,119)
7
33.3%
(5.3)%
4
3 percent of the account [(70% × 30%) × 15% = 3.2%)]. In each case, a stringof losses will impact the value of the next position for the trader and theaccount allocations for each type of trading.
CONCLUSIONTrading requires a disciplined approach toward risk management and aplan that addresses both long-term investments and trading assets. Bycompleting a reasonable, periodic assessment of a diversified investmentportfolio, the trader minimizes stress. This can only serve to improve yourtrading results. Extending portfolio logic to a trade approach may alsoimprove results.You can’t play if you don’t enter, and you can’t win if you don’t stay inthe game. Many trading accounts get wiped out due to poor risk management. The first step in establishing a sound management plan is obvious:Don’t use a losing trading system. Use strategies and approaches to themarket that work. If a trader suffers a string of losses using a plan or system, it’s time to move on. There are enough systems that work that youdon’t want to waste time and money using something that doesn’t.Asset allocation and diversification are key risk management factorsin both investing and trading. Betting the ranch on one trade can lead to abig lottery-type gain, but it can also quickly wipe out your account. Therefore, spreading funds across different types of investments or into inversely correlated groups can help mitigate some risk. Importantly,however, the strategist generally doesn’t want to focus on too many markets at one time. Spending 100 percent of your time analyzing one marketwill probably produce better results than spending 20 percent of your timeon five different markets.Try to pay as much attention to detail when exiting a trade as whenentering one. If you don’t have a specific exit plan, don’t open a position.An exit strategy can involve using price targets for the underlying index,stop-losses, or reversing the trade. Plan the exit and then exit the plan.
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ImportantIndex Factsand Strategies
N
ot all indexes are created equal. As we have seen, some are proxiesfor the broader market, like the S&P 500 Index and the Dow JonesIndustrial Average. Other indexes track specific sectors or industrygroups, such as the AMEX Biotechnology Index and the PHLX Semiconductor Index. Still others are created around specific segments of the market. For instance, the Russell 2000 Index holds small capitalization stocksand the S&P Mid Cap Index consists of medium-sized companies.In order to truly understand an index, however, the strategist needs toconsider some of the details including the methodology used to constructit, as well as the number of components within the index. This chapterseeks to highlight these factors and show how they have an important influence on the price action and volatility of the index. Once that has beenestablished, we can move on to discussing the last remaining strategies inthe book, including portfolio tilts, the buy write indexes, and a phenomenon known as the index effect.
INDEX CONSTRUCTION AND METHODOLOGYUnderstanding the methodology used to construct an index can be important because it often determines how much influence one specific company can have on the index. For instance, with market value–weighted orcapitalization (cap)-weighted indexes, the larger companies will have agreater influence on the index. However, if an index is created using the327
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price-weighted methodology, higher-priced stocks will have a greaterweighting within the index.The S&P Retail Index ($RLX) is an example of an index that is heavilyinfluenced by the performance of one or two stocks. It is a market value orcap-weighted index of 35 stocks, but, due to the methodology used to createthe index, big retailers will account for a larger percentage of the index whencompared to smaller companies. Specifically, the two largest—Wal-Mart(WMT) and Home Depot (HD)—represent half of the value of the index.Another example of a lopsided index is the iShares BiotechnologyFund (IBB). It is actually an exchange-traded fund. However, IBB tracksthe NASDAQ Biotechnology Index, which is a market value–weighted index consisting of biotech stocks. Notice from Table 15.1 that the top 10stocks within the fund account for a little less than half the index. Amgen(AMGN), the largest company by market value, represents one-fifth of thevalue of the index. Naturally, this one stock will have an important influence on the performance of the IBB.The S&P 500 Index, S&P 100 Index, and Russell 2000 Small Cap Index($RUT) are all examples of cap-weighted indexes. The NASDAQ 100 Index (NDX) is another example. As of this writing, the top two stockswithin the NDX are Microsoft (MSFT) and Qualcomm (QCOM). Together,those two companies represent approximately 14 percent of the NASDAQ100, which means MSFT and QCOM determine 14 percent of the NASDAQ100’s price movements. The top 20 stocks represent 56 percent of thevalue of this index of 100 stocks.In October 1999, when the NASDAQ was screaming to all-time highs,
TABLE 15.1 IBB Component IssuesIBB Component
Symbol
Weighting
Amgen
AMGN
17.96%
Gilead Sciences
GILD
4.91%
Teva Pharmaceuticals
TEVA
4.13%
Genzyme
GENZ
3.76%
Biogen Idec
BGEN
3.48%
Celgene
CELG
2.82%
Medimmune
MEDI
1.88%
Chiron
CHIR
1.69%
Sepracor
SEPR
1.58%
Vertex Pharmaceuticals
VRTX
1.51%
Total
43.72%
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19 of the top 20 consisted of technology companies. The only nontechcompany was Amgen (AMGN). In addition, some stocks that were amongthe top 20 three and a half years ago have since fallen sharply in rank. Forexample, Sun Microsystems (SUNW), previously the sixth-largest marketcapitalization stock, now ranks 59th. Some companies, like WorldComand Global Crossing, don’t even trade anymore.In short, remember that the NASDAQ 100 (and therefore the Qs) haschanged a lot over the years. Unlike during the late 1990s when the NDXbecame America’s favorite index, it is no longer a pure play on technology.Instead, retail, biotechnology, and other nontechnology groups play an important role in determining the day-to-day price movements. All indexeswill change over time, and therefore traders should try to consider thosechanges if they incorporate indexes regularly on a discretionary basis oras part of a system.Deﬁning the DivisorMany indexes are computed using a divisor. In a price-weighted index, forinstance, the sum of all the stock prices is added together and divided bya number, the divisor. In Table 15.2, we can see that the divisor for theDow Jones Industrial Average is 12.56. To arrive at the value of the Dow,the stock prices are added together and the sum is divided by 12.56. Market value indexes are also computed using a divisor. This helps to ensurethat stock splits and dividends do not affect the value of the index.
While the market value–weighted index is probably the most common, there are two other types of indexes. The Dow Jones Industrial Average, for instance, is a price-weighted average. The computation is similarto computing the mean or average. As a result, the higher-priced stockswill have a greater influence on the performance of the overall index.Table 15.2 shows the components of the industrial average, their shareprices, and their weighting (in May 2006). 3M Company has the highest shareprice and accounts for more than 6 percent of the average. Traders using theDow Jones Industrial Index or Dow Jones DIAMONDS need to know the respective weightings because weakness or strength in the higher-pricedstocks can have a significant influence on the performance of the Dow.The equal-dollar-weighted method of creating an index has becomethe method of choice for many sector indexes. Using this methodology, allof the components of the index have approximately the same weightingwithin the index. Table 15.3 shows an example of an equal-dollar-weightedindex. The components of TheStreet.com Internet Index ($DOT) share analmost equal percentage within the DOT. As a result, one stock will notinfluence the index a great deal more than any other.
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TABLE 15.2 Dow Components and the Divisor (May 2006)Dow Jones Industrial AverageAs of 5/17/06Current Divisor = 12.49Symbol
Name
Last Price
Weight
AA
Alcoa, Inc.
33.64
2.36%
AIG
American International Group Inc.
64.05
4.49%
AXP
American Express Co.
52.98
3.71%
BA
Boeing Co.
86.40
6.06%
C
Citigroup
49.54
3.47%
CAT
Caterpillar Inc.
77.64
5.42%
DD
E.I. Du Pont de Nemours & Co.
44.68
3.13%
DIS
Walt Disney Co.
30.35
2.13%
GE
General Electric Co.
34.79
2.44%
GM
General Motors Corp.
25.53
1.79%
HD
Home Depot Inc.
38.45
2.70%
HON
Honeywell International Inc.
43.24
3.03%
HPQ
Hewlett-Packard Co.
31.11
2.18%
IBM
International Business Machines
82.16
5.76%
INTC
Intel Corp.
19.06
1.34%
JNJ
Johnson & Johnson
60.25
4.22%
JPM
JP Morgan Chase and Co. Inc.
44.32
3.11%
KO
Coca-Cola Co.
43.84
3.07%
MCD
McDonald’s Corp.
34.70
2.43%
MMM
3M Company
86.76
6.08%
MO
Altria Group Inc.
71.75
5.03%
MRK
Merck & Company Inc.
35.12
2.46%
MSFT
Microsoft Corp.
23.01
1.61%
PFE
Pﬁzer Inc.
24.90
1.75%
PG
Procter & Gamble Co.
56.04
3.93%
T
AT&T
25.77
1.81%
UTX
United Technologies Corp.
65.19
4.57%
VZ
Verizon Communications Inc.
31.70
2.22%
WMT
Wal-Mart Stores Inc.
48.07
3.37%
XOM
Exxon Mobil Corp.
61.96
4.34%
Source: Dow Jones.
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TABLE 15.3 Components of TheStreet.com Internet Index(May 2006)Stock
Symbol
Weighting
Adobe Systems
ADBE
3.97%
Amazon.com, Inc.
AMZN
4.15%
Avocnet Corp.
AVCT
3.54%
Check Point Software Tech
CHKP
4.64%
CheckFree Corporation
CKFR
4.41%
Cisco Systems, Inc.
CSCO
4.32%
eBay, Inc.
EBAY
3.57%
FedEX Corp.
FDX
4.61%
Google, Inc.
GOOG
4.26%
Emdeon Corporation
HLTH
4.79%
InterActiveCorp
IACI
4.04%
International Business Machines
IBM
4.52%
Intuit, Inc.
INTU
4.37%
Internet Security Systems, Inc.
ISSX
4.61%
McAfee, Inc.
MFE
4.62%
Monster Worldwide Inc.
MNST
4.80%
Microsoft Corp.
MSFT
3.87%
Oracle Corp.
ORCL
4.65%
Research in Motion
RIMM
4.24%
Symantec Corp.
SYMC
4.65%
Time Warner Inc.
TWX
4.72%
Verisign Inc.
VRSN
4.11%
Yahoo!, Inc.
YHOO
4.53%
Source: The Philadelphia Stock Exchange (www.phlx.com).
NUMBER OF COMPONENTS AND VOLATILITYTrading indexes is different than trading stocks because an index is diversified, since an index includes shares of several different companies.The fact that an index can hold many companies also reduces volatilitybecause gains in one stock or sector can offset losses in others. Recallfrom Chapter 11 that there can be times when the major averages movesideways but specific sectors are moving higher or lower. The extent of
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diversification and volatility will vary by index and is largely a function of(1) the method used to compute the index, and (2) the specific components within the index.A market value–weighted index or a price-weighted index that isheavily influenced by just one or two companies will be more volatile thana similar equal-dollar-weighted index. For example, we saw that Amgenaccounts for more than 20 percent of the IBB. As a result, a large move inAMGN will have a significant impact on the volatility of the iSharesBiotechnology Fund. The fund is not very well diversified.The number of components and the industry group representationwithin the index will also affect volatility. For instance, the S&P 500 Index($SPX) holds 500 stocks from nine different economic sectors and a largenumber of industry groups. However, the AMEX Airline Index ($XAL)holds only 10 stocks from the airline industry. Therefore, if airline stocksfall, XAL must also. At the same time