21/19895/19/19897/21/19895/18/19902/15/19914/19/19912/17/19953/17/19954/21/19955/19/19959/15/19959/20/199611/15/19962/20/19987/16/199911/19/1999
286.63309.61321.24335.9354.64369.06384.2481.97495.52508.49519.19583.35687.03737.621,034.211,418.781,422.00
0.972.742.361.220.752.710.111.22–0.15–1.211.860.950.930.981.11.86
–0.43–0.220–0.33–0.01–0.01–0.43–0.12–0.04–1.58–1.610–0.22–0.38–0.63–1.2–0.27
1.422.742.41.681.823.112.850.851.450.550.672.160.961.520.981.12.1
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30.0028.0026.0024.00
22.3822.0020.001,450.001,440.001,430.001,420.001,410.001,408.111,400.001,390.001,380.001,370.001,360.001,350.001,340.001,330.001,320.001,310.001,300.001,290.001,280.001,270.001,260.001,250.001,240.001,230.00
Volume
10.00M7.50M5.00M2.50M
FIGURE 14.1
S&P on November 12, 1999.
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OED SYSTEM #2: DON’T FIGHTTHE TREND, PART IIIf the day before option expiration day the market is up 1.5 percent (on theS&P 500), then buy the close and sell the close the next day. Table 14.3 andTable 14.4 show the results.
TABLE 14.3
The ResultsAll Trades
All TradesAverage Profit/Loss %Average Bars Held
120.70%1
Winning TradesAverage Profit %Average Bars HeldMaximum Consecutive Winning TradesLosing TradesAverage Loss %Average Bars HeldMaximum Consecutive Losing Trades
TABLE 14.4
12 (100.00%)0.70%1120 (0.00%)0.00%00
The Trades
Entry Date
EntryPrice
Exit Date
ExitPrice
%Change
10/20/198810/19/198910/18/19901/17/199112/19/199611/20/199710/15/199812/17/19983/16/200010/19/200010/17/200211/14/2002
282.88347.13305.74327.97745.76958.981,047.491,179.981,458.471,388.76879.2904.27
10/21/198810/20/198910/19/19901/18/199112/20/199611/21/199710/16/199812/18/19983/17/200010/20/200010/18/200211/15/2002
283.66347.16312.48332.23748.87963.091,056.421,188.031,464.471,396.93884.39909.83
0.280.012.21.30.420.430.850.680.410.590.590.61
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OED SYSTEM #3: SHORT THE NASDAQFirst of all, it should be noted that the Nasdaq 100 and OED are not friends.In general, shorting the Nasdaq 100 (through QQQ or NDX futures) on theclose before OED and covering at the close of OED has had the resultsshown in Table 14.5. These results are significantly different from the average result of –0.07 percent, if one were to short the NDX on a random day.The results get better the more ^NDX is down the day before OED(see Table 14.6). Even better, if the QQQs, on OED, gap up higher than theclose the day before, one can short with impunity and close out at the endof the day (see Table 14.7 and Table 14.8).
TABLE 14.5
OED System #3—ResultsAll Trades
All TradesAverage Profit/Loss %Average Bars Held
1760.42%1
Winning TradesAverage Profit %Average Bars HeldMaximum Consecutive Winning Trades
99 (56.25%)1.44%17
Losing TradesAverage Loss %Average Bars HeldMaximum Consecutive Losing Trades
77 (43.75%)–0.89%14
TABLE 14.6
The Results
NDX Down More Than
1%1.50%2%3%
Result
AverageReturn
25 out of 3818 out of 2913 out of 188 out of 11
0.99%1.06%1.48%1.70%
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TABLE 14.7
OED System #3 With Gap UpAll Trades
All TradesAverage Profit/Loss %Average Bars Held
170.72%1
Winning TradesAverage Profit %Average Bars HeldMaximum Consecutive Winning Trades
14 (82.35%)1.09%18
Losing TradesAverage Loss %Average Bars HeldMaximum Consecutive Losing Trades
3 (17.65%)–1.05%12
TABLE 14.8
OED System #3 With Gap Up—Trades
Entry Date
EntryPrice
Exit Date
ExitPrice
%Change
9/17/199912/17/19991/21/20002/18/20006/16/20008/18/20009/15/200011/17/20001/19/200112/21/20013/15/20024/19/20025/17/20029/20/200212/20/20023/21/20034/21/2003
62.0384.596.5102.6294.7595.9493.1273.1968.1439.4236.8935.0533.2921.8325.3327.2126.94
9/17/199912/17/19991/21/20002/18/20006/16/20008/18/20009/15/200011/17/20001/19/200112/21/20013/15/20024/19/20025/17/20029/20/200212/20/20023/21/20034/21/2003
63.3183.7896.2598.4494.2595.2591.3172.8366.3139.4837.2334.4632.9321.6725.3227.1726.92
–2.060.850.264.070.530.721.940.492.69–0.15–0.921.681.080.730.040.150.07
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CONCLUSIONThroughout the history of the markets there is a ubiquitous character,somewhat shady, called “They.” Every now and then I hear: “They” are taking it up today. “They” are going to push it down. “They” are going to screwthe most people they can. Most of the time this master manipulator fadesinto the background and lets the markets do what they will. But if there isever a day where “They” makes a grand appearance, it is option expirationday. By testing and asking the right questions one can make the most of thisappearance.
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TECHNIQUE 15
ExtremeConvertibleArbitrage
n the X Games, what makes extreme sports such as snowboarding, bikestunts, skateboarding, and the like so fascinating is that the risks oftenseem much greater than normal sports such as baseball or football. Thereality is that more athletes are injured in those more mainstream sports,but the thrill of the X Games keeps people coming back for more each year.In extreme convertible arbitrage we see that the public basically thinks acompany is going bankrupt and hence prices the preferred stocks of thosecompanies to give exorbitant yields. These extreme yields keep us on theedge of our seats, and, hopefully, the rewards are great.Convertible arbitrage consists of the simultaneous buying of a longconvertible security and shorting of the underlying common stock. Theidea is to hedge the long position with the short so that any changes in priceare neutralized. Meanwhile, one can collect the yield and ideally benefitfurther if the convertible is in the money, that is, the stock is trading higherthan the conversion price, in which case the convertible should rise fasterthan the stock.There are many esoteric ways to value a convertible security, none ofwhich we concern ourselves with in this technique. The system describedhere plays a mean reversion strategy combined with traditional convertiblearbitrage. We buy a pair after the underlying stock does down significantlyin a single day. The reasons it might go down are varied—perhaps an SECinvestigation, perhaps an asbestos lawsuit, perhaps an earnings warning. In
I
163
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many cases, the convertible bond will irrationally follow the stock down,resulting in a yield up to 2,000 basis points higher than the 10-year Treasurynote.Funds specializing in convertible arbitrage usually have relationshipswith the various bond desks on Wall Street. When a company issues a convertible, the bond desks call the funds and say “company XYZ is issuingconvertible ABC yielding 5 percent and converting at 50 in 2007.” The fundsmake a decision to buy or sell, and when they buy, they hedge part of theirposition by shorting the underlying common, hence locking in the 5 percentyield and participating in upside if the stock moves higher than the convertprice. If the company falters in its plan and spirals into bankruptcy, thenthis is often the best situation as the convertible is almost certainly seniorto the common stock. So when the common goes to 0, the convertible willstill have some value left and the fund has probably made more money onthe short side than the long side (of course, “men make plans and Godlaughs”).However, this scenario is too complicated for our purposes. Many convertible securities (and other bondlike instruments) trade on the main exchanges as preferred stocks. Focusing on just preferred stock arbitrage hasmany advantages:• One does not have to call bond desks to get obscure prices on illiquidbonds. Using any broker or electronic trading platform, one can tradepreferred stocks.• Unlike bonds, the prices of preferred stocks are often correlated to thecommon stock. As we will see, this correlation is often irrational andcan lead to successful mean reversion strategies on preferred stocks.• There is less interest rate risk. The universe of preferred stock holders(including mutual funds, 401(k)s, etc.) intersects more broadly withthe universe of common equity holders. This intersection combinedwith an increased correlation to the underlying equity leaves preferredstocks less susceptible to price changes in response to large changes ininterest rates. With interest rates, as of this writing, at 45-year lows,anything we can do to avoid interest rate risk is helpful at this point.• Flight to quality is less of a concern. Convertible arbitrage in 1994 and1998 was affected by a flight out of riskier bonds and into blue chip socalled safe stocks. While partially shielded by the hedges on the shorts,convert arbitrage strategies faltered in these years. Again, since there isa large overlap between preferred holders and common equity holders,we are less affected by these redemptions.
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165
PREFERRED ARBITRAGE SYSTEM• Identify preferred stocks where the preferred and the common haveboth fallen 10 percent on a single day. Only play pairs where the preferred is now yielding greater than 8 percent.• At close, buy the preferred and short the common by a factor of 2:1 dollar ratio. The ratio leans toward the bullish side (even taking into account the fact that preferreds move slower than the common) to takeadvantage of mean reversion tendencies in both the common and thepreferred, but hedges the risk against a free fall. Typically a 2:1 ratiomight not be good enough because preferreds sometimes move muchslower than the underlying common. However, the fact that both thepreferred and the common have fallen 10 percent in one day demonstrates that they are, at least temporarily, moving in sync.• Sell at the sooner of a 10 percent profit on the pair or one dividend payment, or if you decide to hold longer to maximize the benefits of thehigher dividend yield, then after one quarter seek to neutralize the riskby adjusting the hedging ratio as follows:% Change in Common Stock over Prior Month
—————————————————% Change in Preferred over Prior Month
So if the common is moving three times as fast as the preferred, thenew ratio should be 3:1. If the common is moving half as fast, thenthe new ratio should be 1:2.Do preferred stocks tend to mean revert? When plugging in a list of 150preferreds into the pullback system described in Technique 3, the result ofbuying a 10 percent pullback in one day and holding for one month is 13.33percent average profit per trade with a standard deviation of 35 percent.The standard deviation alone is enough to make me want to hedge. Although the 13 percent per trade is nice, a string of below average returnscould cause some pain. Hedging the volatility while locking in the yield isthe goal.
THE RISKSBefore analyzing an example, it is important to understand further all therisks in the trade.
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• Bankruptcy of the company can occur. This risk is hedged by the use ofthe short position as well as various option strategies that can be applied. In a bankruptcy the preferred often does not fall as far as thecommon. Depending on the type of security, there is also protection viaassets as well as insurance guaranties.• The dividend is deferred. It is important to understand that the dividend cannot be cancelled but only deferred; interest is also earned onthe deferred portion. The short position offers protection in the case ofa price decrease (in most cases, the common has decreased faster invalue on a deferral which might imply bankruptcy).• The spread is not aligned. Unfortunately hedging is more often art thanscience. The 2:1 ratio mentioned previously is a best guess in general.However, if this ratio does not appear to be working, then adjust according to the recent percentage price change of the common over therecent percentage change in the preferred.• Interest rate risk exists. Because of the drop in price of the preferred,the preferred security has more characteristics of an equity than a bondin terms of the way it trades. The yield is so much higher than standardinterest rates that it would require a much greater than normal move todissuade investors from pursuing the higher yield.
EXAMPLE: SEE/SEE-AOn July 29, 2002, shares of Sealed Air closed at 37.77. The maker of bubblewrap was enjoying consistently improving cash flows and the stock wasacting accordingly. Nevertheless, the next morning it was announced thatan asbestos case that was affecting WR Grace was potentially going to haveramifications on Sealed Air because of the acquisition of Cryovac fromGrace. The question at hand was, did Grace avoid paying off the asbestosresponsibilities of Cryovac by spinning it out to SEE and then going intobankruptcy? In the agreement with Sealed Air, Grace assumed all responsibility for any debts incurred from the asbestos claims on Cryovac, but itis unclear what this meant once Grace went into Chapter 11. A judge ruledthat Sealed Air might be responsible, and the shares crashed the next day,opening at 19.80 and going as low as 13.29 before closing at 14.51 on triplethe average daily volume (see Figure 15.1).Many people were playing the dip-buying strategy of buying SEE, andthis strategy would have paid off handsomely since the next day the sharesclosed over 20 percent higher at 17.25. However, the more interesting playwould have been to buy shares of the preferred, SEE-A and short the common. SEE-A fell from a close to 39.50 on July 29 to a close of 25.25 the next
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FIGURE 15.1
SEE/SEE-A.
167
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day, and to 18.05 the day after that. At that level, the preferred stock waspaying a dividend of 11 percent.On the one hand, if SEE’s problems were sufficient to send it into bankruptcy, then the shares of Sealed Air common stock would have sufferedmuch more than the preferred as the common comes below the preferredin the capital structure of the company. In other words, if the companyhad any chance at all of emerging from bankruptcy, the preferred shareholders would get paid before the common shareholders. On the otherhand, if the company was going to emerge unscathed, then the purchasersof the SEE preferred would get the benefit of purchasing an 11 percentyielding instrument that also had the potential of going up quickly in facevalue.Sure enough, it was quickly ruled that Sealed Air had no liability in theasbestos case. As of this writing, shares of SEE preferred are at 51.06 andSEE common is 46.99.
CONCLUSIONAs we have seen in many of the systems in this book, people tend to panicfirst, think later. In the case of preferred arbitrage, the yields get so farfrom what can be perceived as reasonable that it is worth examining andseeing if we can benefit. Since the common and the preferred are oftenclosely correlated in these cases, it is possible to largely nullify the bankruptcy risk while still attempting to grab the benefits of the huge yields.
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TECHNIQUE 16
IntradayBollinger Bands
here is a good reason why most day traders go broke. The marketdoes not really like to give up too much money in very short periodsof time. Most of the systems described in this book are for one ormore days. Even these systems make the mistress of the markets anxiousand require constant overseeing and testing to confirm that they stillhold true. To shorten the length of time from days to minutes is perhapstesting the wrath of the markets too much. Nevertheless, there are moments when the fears and petty greeds of the market participants are toomuch and opportunity is allowed to strike.Even if one uses a purely systematic approach, day trading and tradingin general is not for the faint of heart. Drawdowns are a fact of life, losingtrades are a fact of life, stresses beyond any normal day job become commonplace. I have never been described as a particularly athletic person, butevery morning I wake up early (between 4:00 AM and 5:00 AM), take a severalmile walk, read a couple of the morning papers, and then by 7 AM I amready to start plugging in my systems to see if the futures markets or the equities pre-markets are giving me any signals. By 8 AM I usually have my morning plan all ready and have outlined what I am going to do for as manycontingencies as possible. Without thorough preparation and a healthybody and mind there is essentially zero chance of success in this game.In Technique 5 we looked at what happens when one buys a stock if itgoes lower than the 10-day Bollinger band using 1.5 standard deviations. Inthis technique, rather than looking at daily bars, we look at 5-minute barsand ask the question: What happens when a stock goes decisively throughits 10-period Bollinger band using 2 standard deviations?
T
169
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FIVE-MINUTE BOLLINGER BAND SYSTEMOn a chart of 5-minute bars for a stock, plot out the 10-bar moving averageand the Bollinger bands for 2 standard deviations on either side of the average. Then apply the following system:• Buy when the stock falls 3 percent below its lower band. Hold until atleast the end of the 5-minute bar where the stock was bought.• Sell when the stock hits a 1 percent profit target or at the end of thesecond bar after the stock was bought.The critical issue is how to keep track of all the stocks one is interestedin. Before the open, use charting software such as eSignal or TradeStation,or Wealth-Lab (which is the software I use for all of my testing) to identifythe Bollinger band levels for each stock. It is then possible with all of thesepackages to set up alerts and even interface with direct-access brokers,such as Interactive Brokers or Cybertrader, to actually make the tradesautomatically.
EXAMPLESThe key in all of these examples is time. Basically, the market has such anextreme and quick selloff in order to trigger this system that the stock either bounces back immediately or flounders about. If the latter, then wepromptly get out since we are only looking for our profit target within theten minutes following the entry bar.
ORCL, 5/20/2002, 10:30 AMMerrill Lynch, in a post-Blodget fury of tech pessimism, reiterated a broadsweeping recommendation the morning of May 20, 2002, to sell technologystocks into any strength. While their prediction proved mildly prophetic forall of two months, anybody short technology at May 2002 levels would havebeen killed over the following year. Nevertheless, the panic to get out of thepopular tech issues, for instance ORCL, was enough to trigger a signal onORCL at 10:30 AM at 8.73 (Figure 16.1). In a brief flurry of selling, it hit 3 percent below its lower band, which it had been steadily walking down allmorning. Buying at the critical level and holding until the open of the next5-minute bar would have resulted in a quick 3.3 percent profit with the saleat 9.02.
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171
9.209.189.15
9.149.139.10
9.099.089.089.069.059.029.008.988.958.938.908.888.858.828.808.778.768.738.708.688.658.638.608.57
Volume
1,000K800K600K400K200K
FIGURE 16.1
ORCL on May 20, 2002.
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MSFT, 4/3/2000Many of examples occur close to the open of the day, which is the timewhen there is the most volatility and also the most panic. The market hashad all night to hear and absorb news, and thus the open is when the mostparticipants at once are acting on that news.Look at Figure 16.2. On April 3, 2000, MSFT gapped down and triggeredsignals for two five-minute bars in a row, at 9:30 AM at the open and 5 minutes later at 9:40 AM. The first signal was sold off at the close of the secondbar at 47.69 for a 1 percent profit, and the second signal, which was boughtat the open of the second bar at 47.44, was promptly sold at 47.91 for a 1percent profit.
AMAT, 11/12/01On the morning of November 12, 2001, a plane crashed near Kennedy airport. The crash was not apparently an act of terrorism but nobody knewthat at the time. Futures spiked lower and the tech stocks, which were hithardest during the week after September 11, 2001, suffered a minicrash immediately prior to the open. Being alert and capitalizing on the panic wouldhave enabled one to buy AMAT, which triggered a buy signal at its premarket low at 18.20 when it hit 3 percent lower than its lower Bollingerband (Figure 16.3, page 174). Holding to the close of that 5-minute bar wouldhave enabled one to sell immediately at 19.33 for a 6.15 percent profit.
PROFITING FROM PANICWhat if on any of these occasions when there is a selling panic, the panic isjustified? There are essentially two answers:1. Almost every time in the past century when there has been a selling
panic, it has been unjustified.2. Even the justified selling panics often are still worth buying.
Take a look at what happened to the Dow after the following eventsthought to be world-class disasters at the times of their occurrences:• John F. Kennedy’s assassination, November 22, 1963—Day 1: –3 percent; one month later: +7.6 percent.• Start of Korean War, June 26, 1950—Day 1: –4.6 percent; two monthslater: –3 percent.
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173
54.0053.5053.0052.50
52.3252.0051.5051.0050.5050.0049.5049.0048.5048.0048.0047.5047.0046.50
46.0946.0045.5445.50
Volume
10.00M8.00M6.00M4.00M2.00M
FIGURE 16.2
MSFT on April 3, 2000.
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20.00
19.80
19.60
19.4319.40
19.20
19.00
18.9718.9018.80
18.60
18.5018.40
18.20
Volume17.