. The individual components of CRX at this time are shown inTable 5.4.
Pairs TradingOther relationships that you might consider are between sectorsthemselves (particularly if they have listed ETFs) or between stocksthat are related to each other. The original concept of “pairs trading”was applied only to stocks. Statisticians found correlations between
OTHER SEASONAL TENDENCIES
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one stock and another that had a reliable relationship over time(General Motors versus Ford, as one simple example). In recentyears, that concept has been applied to sector trading as well (semiconductors versus pharmaceuticals, for example). And now, the concept of what we call “intermarket spreads” is also considered a “pairstrade” by some in the field. So the concept of pairs trading hasevolved to the point where it is used to define any strategy in which atrader buys one entity and sells another against it, where the trade isbased on historical relationships between the two.The point with which I want to conclude is that anything that isconsidered a pairs trade—any hedge between two instruments thathave some relationship to each other—can best be constructed withoptions instead of using the underlying instruments themselvesbecause you then have two ways to profit: (1) if the relationshipimproves or (2) if the prices are volatile and both markets move inthe same direction. Only an option spread will produce profits underthe second condition. Isn’t it better to have two ways to make moneyrather than one?
OTHER SEASONAL TENDENCIESI’d like to conclude this chapter with a discussion of three strong seasonal tendencies regarding the broad stock market. Ironically, they alloccur in the last third of the year; and if you include the ValueLine/S&P spread—which sets up in November—you would havethree seasonal trades that you can watch for from August throughthe end of the year. These don’t necessarily overlap, although theycould at times. We will discuss the three in chronological order,beginning with the one for August, followed by the SeptemberOctober one, and finally—our favorite—a very short-term seasonaltendency at the end of October and beginning of November.
August: The Dull Month—Or Is It?There is a common perception that August is a dull month for thestock market because many traders go on vacation. As a result,implied volatility of options, especially index options, tends todecrease in late July and on into August. However, there have been
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a surprisingly large number of market explosions that have started inAugust. In fact, the fall of the year is the most volatile period in general, primarily for the stock and the bond markets. Volatile marketsmake straddle buying—the purchase of both a put and a call with thesame terms—attractive. The fact that some of that volatility in thestock market comes as prices fall (sometimes suddenly) onlyenhances the strategy, because implied volatility increases andinflates the price of the straddle that is owned.The August–September time period is a pretty volatile one if youconsider the data for the 23-year period from 1981 through 2003 asshown in Table 5.5. You can see that August has been the start ofserious market movement in most years. In some years, the DowJones Industrials made a sizable move that was self-contained in themonth of August. In other years, August was the beginning of amove that lasted through September or October (we’ll discuss September and October in the next section). Only in 1990 was the movealready underway when August began. That was the year Iraqinvaded Kuwait in late July. August was still a volatile month thatyear, but the move actually began in July. Table 5.5 doesn’t eveninclude the fact that a crash occurred in October 1987, furtherextending the 8 percent loss shown in the table for that year.The movements have continued almost every year since. InAugust 2001, the period from August 1 to September 30 includedthe terrorist attacks, but the market was already down about 600points (5.7 percent) before the attacks occurred. In August 2002,the market rallied (as it was coming off a July oversold condition); butthen it peaked and fell sharply through the end of September, soboth moves are shown in Table 5.5 for 2002. Ironically, by 2003, Inoticed for the first time that the media, in late July, was saying thatAugust can sometimes lead into volatile movements by the market.So, adopting a contrarian attitude, perhaps this strategy will notwork as well for the next couple of years, until the masses once againdecide that August is a dull month.What makes the data in Table 5.5 extremely interesting is thatthe implied volatility of index options—particularly OEX options—traditionally drops in July and August. Since volatility is low enteringwhat has proved to be a rather volatile time period, option buyingstrategies (such as straddle purchases or backspreads) are favored
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Table 5.5AUGUST–SEPTEMBER VOLATILITY DURING1981–2003Date
General DowLevel
Aug 2003Aug 2002
83008600
Aug 2001Aug 2000Aug 1999Aug 1998Aug 1997Aug 1996Aug 1995Aug 1994Aug 1993Aug 1992Aug–Sep 1991July– Oct 1990Aug–Sep 1989Aug–Sep 1988Aug–Sep 1987Aug 1986Aug–Sep 1985Aug 1984Aug– Oct 1983Aug 1982Aug 1981
1050010600107008600820056004700330035003300300030002700210027001800160011001200800950
Movement
PercentLevel
+600+400, then–1700–2400+700+600–1100–600+280–160+200+80+140–90–640+130+120–220+160–60+150+125+160–130
+7.2%+4.7%, then–18.9%–22.9%+6.6%+5.6%–12.7%–7.3%+5.0%–3.4+6.1+2.3+4.2–3.0–21.3+4.8+5.7–8.1+8.9–3.8+13.6+10.4+20.0–13.7
strategies for this time of the year. Traders often speak about volatility, since it is the most important influence on an option’s price. Ifyou own options and volatility increases, it works very heavily inyour favor.Even if implied volatility doesn’t increase, the market movementsas shown in Table 5.5 are large enough in most years to generateprofits on their own. In a rising market, you may not get much of anincrease in implied volatility in OEX options, so you are going to be
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heavily dependent on the market rising far enough to make yourstraddle purchases profitable. However, in a declining market,implied volatility will normally increase; so you may get a double benefit in that case—increasing implied volatility as well as a falling market—that makes your straddle purchases profitable by falling adistance greater than you paid for your straddle.In Chapter 1, we related the story of how an OEX call barely lostany money during the crash. The following example is a more everyday one.Example: You might be wondering just how much of an influence an increasein implied volatility can have on the price of a long straddle. Suppose that astock is trading at 100 and a three-month straddle is selling for 8, which is a20 percent implied volatility. If the stock is still at 100 in a month and impliedvolatility is still 20 percent, then the straddle will have lost 1.25 points to timedecay, and it will then be selling at 6.75. However, if the implied volatilityincreases to 24 percent at the end of that month, then the straddle will still beselling for 8. Thus, an increase in implied volatility from 20 percent to 24 percent completely offsets the time decay that occurs in that one month.If the straddle has a shorter life span to begin with, time decay will bemore rapid. During the next month, if volatility remains at 20 percent andthe stock is still at 100, the straddle will decay to 41⁄2. Thus, it would havelost 31⁄2 points of its original value due to two months of time decay. Anincrease in implied volatility can offset this loss as well, but it now takes amore dramatic increase to overcome the time decay that occurs during twothirds of this straddle’s life. In fact, implied volatility would have to increaseto 36 percent in order for the straddle to again be selling at 8 with onemonth of life remaining.Obviously, it’s a lot easier for volatility to increase from 20 percent to24 percent in one month than it is for implied to increase from 20 percentto 36 percent in two months. Still, these examples show that implied volatility is indeed a powerful factor on the price of an option.
In the next chapter, we discuss methods of identifying whenvolatility is “too low” and how to trade it. However, in this seasonalexample, you can generally figure that OEX implied volatility is goingto be low on August 1. Refer once again to Figure 4.24, whichshows the composite level of S&P (or OEX) options implied volatilityduring the year; and note that it is relatively low on August 1 (not as
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low as on July 1, however) and then increases during the ensuingmonths. You can easily tell how expensive or cheap OEX impliedvolatility is, merely by looking at a chart of the CBOE’s VolatilityIndex (symbol: $VIX). If volatility is indeed low when the beginning ofAugust rolls around, you should buy three-month, at-the-money OEXstraddles and hold them for the course of the month. Actually youmight want to hold for two months, since September is a volatilemonth as well. Furthermore, since the composite volatility chart (Figure 4.24) shows that index option implied volatility typically is lowestin early July, you might even want to consider buying your straddlesthen—before the market heats up—since even if the market goesnowhere during July, we have seen that modest increase in impliedvolatility can raise the price of a straddle quickly.Other markets often display similar characteristics: implied volatility is low in the late summer, but prices can be volatile in the fall of theyear. In particular, these three are also good candidates for straddlepurchases of other option buying strategies, beginning near August1: (1) gold, (2) the CRB Index, and (3) T-bonds (or 10-year notes).Not every one of these three markets has a major move in the fall ofevery year, but moves do occur with frequency. Gold has oftenmoved $40 or more in the August-September time frame. Similarly,the CRB Index has moved 10 points (and as much as 25 points incertain years), and T-bonds routinely move 5 points and generallymore—a substantial move for that market. In fact, a $50 move ingold, a 10-point move in CRB futures, and a 5-point move in T-bondfutures are each worth $5,000 per contract.
Determining the History of Implied Volatility. Thus, there isplenty of profit potential in looking for low-cost straddles in thesemarkets. The optimum way to analyze the situation would be to evaluate the implied volatility of each market in July, up to August 1. If itis low or at least not above normal, you can buy December futuresoption straddles. By owning the intermediate-term straddle, youwon’t be so subject to time decay during the early portion of yourholding period. If the underlying market makes a quick move, youwill benefit; and you might even get an extra boost if the impliedvolatility of the options you own increases as well.
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In order to determine what is “normal” volatility, you need toknow where the implied volatility has been trading over at least thepast few months. This information is available in a number of places.It is available for free on our web site, www.optionstrategist.com,where we list the percentile of implied volatility for every stock,index, and futures contracts that last listed options. This free data isupdated weekly. For a more complete picture, we also offer volatilitycharts of these markets and many others, as well as a lot of additionaloption-oriented data, on the subscriber section of our web site, calledThe Strategy Zone.As we said, these sources allow you to look at where the impliedvolatility has been trading. This is important, and it is different fromthe historical volatility. As we have noted before, implied volatility insome markets continually trades at higher levels than actual volatility.So what you want to do at the beginning of August is to see if impliedvolatility is at or below average with respect to where it has beentrading over the past few months. The data on our web site alsoshows historical volatility over several time periods (20-day, 50-day,and 100-day) so that you can easily compare its implied volatility levels at the time.
September–October: A Very TradeableTime Period for the Stock MarketWe now take a look at another seasonal trading pattern during theperiod from Labor Day through mid-October. Some of the biggestmoves have come during this time, and there are some patterns thatstand out. This information does not conflict with what we just discussed regarding the August time period. In fact, it may help to finetune your exit points for positions that you already have in placewhen Labor Day arrives.As many analysts and media types have observed, September isoften a month of decline for the stock market. The period of timesurrounding the Labor Day holiday often marks a short-term markettop. However, “often” is too vague a term, for there have also beensome good rallies in September. Thus, you need to analyze the datamore carefully in order to be able to construct a trade.
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431
There is normally a rather substantial broad-market correction ofabout 5 percent or more that begins in either September or October.The market usually begins a correction on or about Labor Day, butnot every September is a down month. What we did find, however,is that even if September is a rising month, a correction will oftenoccur in October.There are three main scenarios that the market has followed forthe past 30-some years: (1) a top is formed near Labor Day, and theensuing bottom occurs in September (occasionally, the bottom doesnot come until October); (2) a top is formed in mid-to-late September, with the ensuing bottom occurring in the first week or two ofOctober; (3) a top is formed in early-to-mid-October, with the bottomcoming in early November. The data are summarized in Table 5.6.Table 5.6SUMMARY OF MARKET DECLINES,SEPTEMBER/OCTOBER 1973–20031Year
HighDate
MaximumCorrection (%)
1973197419751976197719781979198019811982198319841985198619871988
Oct 123Aug 30Aug 25Sep 212Sep 7Sep 6Oct 53Sep 222Aug 26Sep 152Oct 163Aug 29Aug 28Aug 27Sep 2Oct 203
–14.4–12.5–3.5–7.4–7.1–11.4–10.0–5.4–9.6–5.5–6.8–4.2–4.9–8.8–35.3–7.1
1
Year
HighDate
198919901991199219931994199519961997199819992000200120022003
Sep 1–7.9Aug 29–9.1Aug 28–5.3Sep 4–5.3Sep 2–3.3Aug 29–5.7Sep 292–2.3(No correction at all)Oct 73–9.7Sept 232–6.4Sept 9–9.6Sept 6–11.8Sept 5–14.6Sept 10–15.3Sept 182–4.0
Entries are scenario 1 except for the following:Scenario 2.3Scenario 3.2
MaximumCorrection (%)
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Of the 31 years worth of data, scenario 1 (top near Labor Day)has occurred 19 times; scenario 2 (top in mid-to-late September) hasoccurred 6 times; and the final scenario (top in October)has occurred 5 times. That leaves one left over: in 1996, there wasno correction at all to speak of, as the Dow rose about 300 points(from 5600 to 5900) in more or less a straight line. Note how severethe downdrafts were during the bear market (2000–2002).So now that it has been established that a correction typicallytakes place, beginning at one of these three times, we must decideon how the beginning of that correction can be identified. Eitherthat, or utilize a strategy that will make money when the correctionfinally occurs. Obviously, we don’t just want to rush in and buy putson the trading day before Labor Day. That might be a losing trade inany year that followed scenario 2 or 3.The put–call ratios that were described in Chapter 4—both theindex and the equity-only—and the short-term oscillator that wedescribed early in this chapter are useful in making timing decisionsof this sort, especially when you have an inkling of which way youexpect the market to go. You only need confirmation from theseindicators.A good case in point is 1995 because the market rallied quite stronglythrough the first half of September, eventually topping out for a small correction on September 29. This fits into scenario 2. When Labor Dayarrived, the put–call ratios were all on buy signals; that is, the trend of theratios was down, from a previous peak. In addition, there was no particularreading one way or the other on the oscillator. Thus, no bearish positionswere taken at that time.As the market rose dramatically in the two weeks after Labor Day, theoscillator became overbought, and a sell signal was generated on September 22. This was a bit premature; and since there was not yet a confirmation from the put–call ratios, I bought bear put spreads: with OEX near 551,the Nov 550 puts were bought and the Oct 540 puts were sold (the reasonthat Octobers were sold was that they were very expensive in terms ofimplied volatility and were therefore a better sale than the Nov 540 puts atthe time).The market sputtered a little at that point but eventually worked higherinto September 29. The put–call ratios finally gave sell signals at that time—
OTHER SEASONAL TENDENCIES
433
on September 28 actually. So we then had the confirmation we wanted.More put spreads were bought, this time using a wider difference in thestriking prices and also using higher striking prices: the Nov 560 puts werebought and the Nov 545 puts were sold.Finally, the market broke—swiftly, but briefly—and OEX traded downto 544 in a matter of a few days. At that time, the oscillator actually becameoversold and generated a buy signal. That buy signal was used to take someprofits, although the positions weren’t completely closed out until theput–call ratios also issued buy signals with OEX near 553 in the final weekof October.
There is an additional corollary to this seasonal pattern: there isusually a good trading bottom in late September or October. Conventional wisdom holds that the best buying opportunities occur atthe October bottoms. That may be true, when the bottom indeedoccurs in October. What is, in fact, more correct to observe is thatthere is often a good bottom at the end of the declines that are partof this seasonal trading pattern. Under scenario 1, when the top isnear Labor Day, the eventual bottom is often reached in mid-to-lateSeptember—although the decline sometimes stretches into October—whereas under scenarios 2 and 3, the bottom is indeed in October. Some of the most spectacular bottoms have come inOctober—1974, 1978, 1979, 1985, 1989, 1990, 1992, 1997,1998, and 2000. In 2001, the bottom came in late September; andin several other years, October was a trading bottom, just not a"spectacular" one.In sum, then, you should be alert for an opportunity to buyputs or short the futures in the time period near Labor Day. If atop does not develop at that time, then a trading top shoulddevelop in late September or early October. However, these topsare generally not major tops, just good trading opportunities.Eventually, they give way to good buying opportunities in lateSeptember or October. This information confirms the observations made in the previous section: sectors of the market arevolatile in the fall of the year. In the next section, a short-term seasonal buying opportunity is described, and it meshes well withthese other seasonal patterns also.
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Late-October Buy PointIn 1994, the magazine Technical Analysis of Stocks and Commodities printed an article that pointed out a peculiar phenomenon:if you buy the S&P futures on the close of trading on October 27 andsell them on November 2, you would have made money every yearsince 1982, except for one in which you would have lost 0.45 point.The article detailed the years 1982 through 1993, when profitsmostly were in the range of two to four points, although two yearshad much larger profits. The article pointed out that you may want touse your own judgment in exiting the trade, as a rather large moveoccurred in only one or two days in some years.I liked this concept and have kept up the data on this spreadover the years. It is by far the most important short-term seasonaltime of the year that I have found—better than a similar one at theend of January and better than the “Santa Claus rally” near the endof the year.Using this as a guideline, we decided to go back farther than 1982(that’s the year the S&P 500 futures were first listed, so there is nohistorical data prior to that time for those futures). In order to go backin time, we used the S&P 500 cash index. What we found was thatthe S&P 500 cash index has advanced between October 27 andNovember 2 in every year between 1978 and 2001— an extraordinary streak of 24 years— except one in which it was unchanged. Thedata in Table 5.7 show this remarkable phenomenon. It should benoted that if October 27 falls on a weekend, you buy the S&Ps atclose of trading on the Friday before October 27. However, ifNovember 2 falls on a weekend, you don’t sell until the close of trading on the Monday after that weekend.Why does it work? There is no good reason, except the ubiquitous one: “seasonality.” It reminds me of the best football “system” Iever saw: it was merely to bet on Syracuse the week after theyplayed Penn State. The system worked for 19 years in a row (unfortunately, Penn State terminated their series with Syracuse when theyjoined the Big Ten).Actually, there is some logic behind this trade. First of all, as wehave recently shown, the market often bottoms out in October andhas staged a strong rally by the end of the month. This system seems
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Table 5.7BEHAVIOR OF THE S&P 500 CASH INDEX FOROCTOBER 27 TO NOVEMBER 2, 1978–2003Year
S&P Advance(Oct 27–Nov 2)
Year
1978197919801981198219831984198519861987198819891990
+1.53+1.95+1.16+4.90+2.220.00+2.13+4.00+7.03+22.56+1.78+3.43+7.15
1991199219931994199519961997199819992000200120022003
S&P Advance(Oct 27–Nov 2)+7.12+4.26+3.83+0.66+10.02+5.81+62.01+46.26+51.03+48.74–17.41+10.70+18.90
Average profit: 11.95 S&P points, or 1.84 percent.
to work especially well in those years. Institutions, who have a herdmentality, generally were sellers during the September-Octoberdecline; but when they see that the market has rallied strong by theend of October, they buy stocks to get something “on the books” forthe end of the month. That’s called “window dressing,” and it’s verycommon near month-end— obviously and especially in October. As acorollary, note that the one year that the system lost—2001—themarket actually bottomed in September, shortly after the terroristattacks. The institutions that year bought near the end of September,and by the time the end of October rolled around, they didn’t feel theneed to window dress nearly as much. Another reason that this system works is that the end of October is the fiscal year-end for manymutual funds, and they might want to buy stocks on the strong rallyto window dress their year-end portfolios even more than at a typicalmonth-end.I would use a trailing stop if you get a move in your favor rightaway—in order to lock in profits, and you might want to take partial
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profits if the S&P moves three or more points in your favor. As far asa trading vehicle goes, if you don’t want to use the futures, I wouldsuggest buying the nearest in-the-money November OEX or SPXcall, since you will be exiting the position on November 2, at the latest. By using the in-the-money call, time decay shouldn’t be toomuch of a problem for a five-day trade. As always, though, youshould check the implied volatility of the OEX options before you buythem, since that is what can have the greatest effect on option pricesin such a short time. If the options are overly expensive in terms ofimplied volatility, I would stress using the futures instead as your trading vehicle. I don’t think I would use a bullish call spread for this system, since the movements were quite large in several of the yearsand you might be unnecessarily limiting your profit potential with thebull spread.So, there you have three good seasonal patterns to trade withduring the late summer and early fall of the year. Those, coupledwith the January effect, should keep you busy and profitable right oninto the new year.
Late-January Buy PointIn the preceding discussion, a reference was made to a late-Januarybuy point. The theory is similar in this case: buy “the market” on theeighteenth trading day of January, and sell your position out at theclose of trading, five days later. The reasoning behind this systemwas solid: institutions generally receive heavy cash inflows at thebeginning of a new calendar year. Typically, they don’t invest all thatmoney right away; but as the end of the month rolls around, theydon’t want to have a lot of cash showing on their balance sheets, sothey buy stock heavily at the end of the month to use up the excesscash. While that reasoning seems sound, this system has a muchspottier track record than the late-October buy system discussed inthe previous section.Perhaps that’s because institutions are a little more aggressivenow and have been putting the money to work as soon as possiblein recent years. That was certainly the case in 2004, but it’s doubtful in the bear-market years that they were rushing to buy stocks
OTHER SEASONAL TENDENCIES
437
early. In any case, the track record for the system in shown inTable 5.8.You can see from the table that the system had an exceptionaltrack record from 1986 through 1998. There was one losing year(1992), but in general there was not even any drawdown from theentry price on closing basis (the far right column in Table 5.8 showszero drawdown in nearly every year through 1998). In fact, in someyears, there was not even an intraday drawdown from the entryprice, that is, on the first day, the market opened higher the nextmorning and just kept going up from there.But in recent years, this system has run into problems. Most ofthem, though, are related to the fact that you can’t hold for five daysTable 5.8JANUARY SEASONAL TRADE HISTORY
Year
Buy
Five DaysLater
1986198719881989199019911992199319941995199619971998199920002001200220032004
207.4273.8249.4291.7326.1336.1415.0438.1473.2468.3617.0765.0977.41265.41398.61354.91133.1858.51128.4
214.0276.0257.2296.8328.8343.0409.5447.2482.0472.8638.5786.71006.91248.41425.01349.41094.4848.21126.5
*Most of loss occurred on the last day.
Gain+6.6+2.2+7.8+5.1+2