listed onthe U.S. exchanges (see Table 2.6). For example, the AMEX lists optionson the AMEX Japan Index ($JPN), the Hong Kong Index ($HKO), and theEurotop 100 ($EUR). Meanwhile, the CBOE trades options on the CBOEChina Index ($CYX), the CBOE Asia 25 Index ($EYR), the Euro 25 Index($EOR), and the CBOE Mexico Index ($MEX).The Five-Year Note Index ($FVX), the Ten-Year Note Index ($TNX)and the Thirty-Year Bond Index ($TYX) are vehicles some traders use to
TABLE 2.5 ISE Sector IndexesISE Indexes
Ticker
ISE Bio-Pharmaceuticals Index
RND
ISE Gold Index
HVY
ISE Homebuilders Index
RUF
ISE Integrated Oil and Gas
PMP
ISE Oil and Gas Services
OOG
ISE Semiconductors Index
BYT
ISE SINdex
SIN
ISE U.S. Regional Banks
JLO
ISE-CCM Homeland Security
HSX
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TABLE 2.6 Rate IndexesInternational Indexes
Ticker
Exchanges
AMEX Japan Index
JPN
AMEX
Hong Kong Index
HKO
AMEX
Eurotop 100
EUR
AMEX
Asia 25 Index
EYR
CBOE
China Index
CYX
CBOE
Euro 25 Index
EOR
CBOE
Mexico Index
MEX
CBOE
monitor and profit from changes in interest rates. The indexes actuallyrepresent the current rates afforded to various government bonds. For example, the Ten-Year Note Index reflects the current rate on the benchmark10-year Treasury note multiplied by a factor of 10. Figure 2.1 shows the index’s performance from May 2004 through April 2005. Notice that it hasbeen rising. This tells us that the price of the Ten-Year Note, which movesin the opposite direction of the actual bond, has been falling.
FIGURE 2.1 10 Year T-Note, May 2004 to April 2005 (Source: www.ProﬁtSource.com)
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EXCHANGE-TRADED FUNDS (ETFS)An index can be used to track markets and sectors of the market. Whenoptions are listed on an index, they can also be used to trade the market.Similarly, exchange-traded funds (ETFs) can, and often are, used to trackand trade markets and sectors of the market. As we will see, ETFs haveone important advantage over indexes: Shares can be bought and sold likeshares of stock. Let’s consider a few examples of some of the more actively traded exchange-traded funds.
The Big Three: Qs, Diamonds, and SPDRsThere are three exchange-traded funds that all options strategists shouldknow and understand. The NASDAQ 100 Index Share (QQQQ), or “Qs,” isamong them. It is one of the most actively traded investments today. Unlike an index, the Qs trade on the AMEX similarly to a stock. In essence,the fund represents a pool of money that invests in the same stocks, in thesame proportion, as the NASDAQ 100 index. As we saw earlier, the NASDAQ includes the top 100 nonfinancial stocks that trade on the NASDAQStock Market.Basically, the QQQQ is an investment vehicle known as a trackingstock because it tracks the performance of a specific index. In addition,the QQQQ is designed to equal 1/40th of the value of the NASDAQ 100 Index. For instance, on Thursday, February 27, 2003, when the NASDAQ 100was quoted at 1,000, QQQQ was trading for $25 a share (or 1/40th of$1,000.00). Therefore, the QQQQ is a fund that allows investors to buy theentire 100 stocks of the NASDAQ 100 index in just one share at a relativelysmall share price.The Dow Jones Industrial Average (DIA), or “diamonds,” made its debut in 1998, with options on the fund initiated in 2002. Similar to theQQQQ, the diamonds trade on the exchanges like shares of stock. However, the DIA holds the same 30 stocks as the Dow Jones Industrial Average. Therefore, it is a tool for trading the Dow. Diamonds are designed toequal approximately 1/100th the value of the industrial average.The S&P 500 Depositary Receipts (SPY), or SPDRs (pronounced“spiders”), is an exchange-traded fund that holds the same stocks as theS&P 500 Index. The AMEX began trading the S&P Depositary Receiptsin 1993. Each share of the SPY is equal to approximately to 1/10th thevalue of the S&P 500 cash index (SPX). Therefore, when the SPXreaches 1,200, the SPDRs will trade near $120 a share. Options on thefund didn’t begin trading until 2005 due to licensing issues but quicklyjoined the DIA and QQQQ options as some of the most heavily tradedcontracts.
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iSharesAnother family of exchange-traded funds is called iShares. Each iSharesfund closely tracks a specific market index. They are similar to the Qs, thediamonds, and the SPDRs in that each iShare is an exchange-traded fundand can be bought and sold like shares of stock. In addition, the fundholds a selection of stocks, which is a portfolio created around a specificindex. For example, while the DIA tracks the Dow Jones Industrial Average ($INDU), the iShares S&P 100 Fund (OEF) attempts to mimic the performance of the S&P 100 Index ($OEX). There is also an iShares Mid CapFund (MDY) and iShares Russell 2000 Small Cap Fund (IWM).
Sector ETFsSome iShares funds are used to track popular market averages while others are created around specific sector indexes. For example, the iSharesDow Jones U.S. Financial Sector Index Fund (IYF) tracks the price andyield performance of the Dow Jones U.S. Financials Index, which consistsof bank, insurance, real estate, and general finance companies.Table 2.7 lists the iShares sector funds and ranks them by tradingvolume (in early 2005). The iShares Biotechnology Fund (IBB) is the
TABLE 2.7 iShare ETFsSymbol
iShares Exchange-Traded Fund
Average Daily Share Volume
IBB
iShares NASDAQ Biotechnology
1,517,200
IYR
iShares Dow Jones Real Estate
969,600
IGV
iShares Goldman Sachs Software
206,000
IYH
iShares Dow Jones Healthcare
153,900
IYE
iShares Dow Jones Energy
140,700
ICF
iShares C&S Realty
137,200
IYZ
iShares Dow Jones U.S. Telecom
88,600
IGW
iShares Goldman Sachs Semiconductors
71,200
IGN
iShares Goldman Sachs Network
54,600
IYW
iShares Dow Jones U.S. Tech Index
54,100
IDU
iShares Dow Jones U.S. Utility Sector
44,300
IGM
iShares Goldman Sachs Tech Fund
30,400
IYF
iShares Dow Jones U.S. Financials
1,700
IWC
iShares Small Cap Index
1,500
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most actively traded. Other funds are created around health care,telecommunications, semiconductors, and software. Interestingly, thereare two iShares that track real estate stocks. One of them, the iSharesDow Jones Real Estate Fund (IYR), is the second most actively tradediShares fund today. This fund is one of the few ways investors can trade abasket of real estate stocks.The iShares Russell Microcap Fund (IWC) consists of some of thesmallest companies that trade on the U.S. stock exchanges. It offers tradersa unique way of playing trends related to lowest capitalization stocks.Traders interested in trading specific sectors of the market can usethe iShares as tools for placing bets. Options are listed on most of thesefunds. However, not all of the contracts see very much trading volume.Therefore, investors will want to focus on those funds with the most activity, or the ones that appear closer to the top of the list. In addition, Table2.7 doesn’t include all of the iShares. It includes only those created aroundU.S. sectors. For a complete list and the product specifications for eachETF, readers are encouraged to visit the American Stock Exchange website (www.amex.com).
Select Sector SPDRsShares of the nine Select Sector SPDRs trade on the American Stock Exchange and can be bought and sold like stocks. Like SPDRs, they represent ownership in a basket of stocks. However, rather than holding thestocks of the S&P 500 Index, Select Sector SPDRs are created around specific sectors—financials, technology, utilities, etc. Collectively, the ninesector SPDRs hold all 500 of the S&P 500 stocks. Table 2.8 lists the nine
TABLE 2.8 Select Sector SPDRSelect Sector SPDR
Symbol
Health Care
XLV
Materials
XLB
Energy
XLE
Financials
XLF
Industrials
XLI
Technology
XLK
Utilities
XLU
Consumer Staples
XLP
Consumer Discretionary
XLY
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Select Sector SPDRs. Options are listed on the nine funds and are used inexamples later in this book. Therefore, options strategists seeking to participate in the rise and fall of specific sectors can implement strategies onthe various Select Sector SPDR funds.
Holding Company Depositary ReceiptsHolding company depositary receipts (HOLDRs) are unique investmentvehicles that allow investors to buy and sell entire baskets of stocks injust one transaction. Created by Merrill Lynch and trading on the American Stock Exchange, HOLDRs are a type of exchange-traded fund that allow investors to buy and sell stocks in a particular industry, sector, orgroup. Again, semiconductors, oil services, and biotechs are represented,among other industries and groups. Additionally, while investors can useHOLDRs as specific groups of stocks, there are options listed on most ofthese investment vehicles, so they can be useful to the option strategistas well.Table 2.9 provides a complete list of HOLDRs. Notice that each fund iscreated around fairly narrowly based industry groups. For example, thereare business-to-business (B2B) Internet HOLDRs, broadband HOLDRs,and software HOLDRs. Each holding company depositary receipt holdsshares in 20 different companies.Each investment has a unique ticker symbol and trades on the American Stock Exchange like stocks. For example, an investor might instruct abroker to buy 100 shares of BBH. Once the transaction is completed, thatinvestor will own 100 shares of biotech HOLDRs.
HOLDRs stands for holding company depositary receipts, which areexchange-traded funds that hold baskets of stocks from speciﬁc industry groups. HOLDRs trade on the American Stock Exchange andcan be bought or sold in lots of 100 shares. For example, investorscan buy or sell, Biotechnology HOLDRs (BBH), Semiconductor HOLDRs(SMH), or Oil Service HOLDRs (OIH). In all, the American Stock Exchange offers trading in 17 different HOLDRs. Options are also available on these exchange-trade funds and can be used to proﬁt fromtrends related to speciﬁc sectors or industry groups.
Holding company depository receipts can only be purchased inround lots of 100 shares. Each 100-share purchase gives the buyer ownership interest in a specific number of shares in different companies.For instance, Table 2.10 shows the number of shares of each company
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TABLE 2.9 Various Holding Company DepositaryReceipts (HOLDRs)Holding Company Depositary Receipt
Symbol
Biotech HOLDRsBroadband HOLDRsB2B Internet HOLDRsEurope 2001 HOLDRsInternet HOLDRsInternet Architecture HOLDRsInternet Infrastructure HOLDRsMarket 2000+ HOLDRsOil Service HOLDRsPharmaceutical HOLDRsRegional Bank HOLDRsRetail HOLDRsSemiconductor HOLDRsSoftware HOLDRsTelecom HOLDRsUtilities HOLDRsWireless HOLDRs
BBHBDHBHHEKHHHHIAHIIHMKHOIHPPHRKHRTHSMHSWHTTHUTHWMH
within the Internet HOLDRs (HHH): A 100-share purchase gives theowner 18 shares of Amazon.com (AMZN), 8 shares of RealNetworks(RNWK), 24 shares of eBay (EBAY), and so on.After purchasing a 100-lot of any given HOLDRs, investors can elect tobreak apart the investment vehicle into its individual stocks. That is, theycan instruct their brokerage firm to deliver their HOLDRs to the trusteeand pay a cancellation fee of up to $10 per round lot of 100 HOLDRs.Then, the shares of each individual company within the holding companydepositary receipt are delivered to the brokerage account. In short, bycanceling their HOLDRs, the investor can take delivery of the individualstocks that comprise the fund.According to the American Stock Exchange, with HOLDRs, you canown a group of stocks as one asset or unbundle them to own each ofthe underlying stocks and then trade them individually to meet yourtax or investment goals. This feature also facilitates more advancedportfolio strategies without requiring you to monitor each of the individual stocks.As mentioned previously, options are also available on most HOLDRs,so traders can use these investment vehicles to implement bullish, bearish, or neutral trades on specific industry groups. We provide some specific trading examples using HOLDRs in later chapters. Once again, it’s
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TABLE 2.10 Various Internet HOLDRsHHH Component Stock
Symbol
Share Amount
Ameritrade Holding Corp.Amazon.com Inc.CMGI Inc.CNET Networks, Inc.DoubleClick Inc.eBay Inc.EarthLink Network, Inc.E*Trade Group Inc.McAfeePriceline.Com Inc.RealNetworks, Inc.Time Warner Inc.Yahoo Inc.
AMTDAMZNCMGICNETDCLKEBAYELNKETMFEPCLNRNWKTWXYHOO
9.018.010.04.04.024.06.212.07.01.28.042.026.0
worth noting that when implementing a trading strategy, we seek liquidcontracts.
International FundsTrading on the New York Stock Exchange under the ticker symbol FXI,the iShares FTSE/Xinhua China 25 Index Fund (FXI) is an exchangetraded fund that holds the same 25 stocks as the FTSE/Xinhua China 25Index. The China 25 Index, in turn, is a benchmark developed jointly bythe firm FTSE and the Xinhua Financial Network. It was created to trackthe performance of China’s leading companies. Options on FXI are available and provide a tool for trading trends related to the Chinese equitymarket.In October 2005, the American Stock Exchange announced that itwould begin listing options on the iShares MSCI Japan Fund (EWJ). Thefund provides investors with a unique way of participating in the performance of the Japanese stock market. It is an exchange-traded fund thattracks the performance of the MSCI Japan Index.The EWJ is one of several country-specific indexes created byMorgan Stanley Capital International (MSCI). According to the firm’sweb site (www.msci.com), “each MSCI Country Index captures 85 percent of the total country market capitalization while it accurately reflects the economic diversity of the market.” Therefore, the stockswithin the EWJ represent roughly 85 percent of the market value of theJapanese equity markets. Table 2.11 shows the fund’s top 10 holdings.
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TABLE 2.11 Top 10 Stocks of the iSharesMSCI Japan FundStock
Weighting
ToyotaCanonTakeda PharmaceuticalMitsubishi Tokyo FinancialHonda MotorSonyMizuho FinancialNTT DoCoMoMatsushita Electric IndustrialSumitomo Mitsui Financial
5.68%2.392.272.071.991.961.881.731.641.51
Investors interested in owning a piece of the Japanese market can buyEWJ shares.The listing of options on the EWJ is noteworthy because the fund isone of a family of international ETFs that trade on the AMEX. Table 2.12shows the full list of funds. Investors can buy and sell shares of each fundthroughout the day based on the outlook for the specific country. For example, if investors expect markets in Germany to move higher, they canbuy shares of the EWG. Alternatively, if Hong Kong stocks are expected tofall, the EWH can be sold short. Later we describe a trading system thatcan be used to trade these international funds.Until October 2005, options on the international funds were not available. That changed, however, when the AMEX introduced EWJ options.The move opened the door to options trading on some of the other funds.The timing of future listings will probably depend on the success and popularity of EWJ options.
Gold PlayThe streetTRACKS Gold Shares Exchange Traded Trust (GLD) made itsdebut on the New York Stock Exchange (NYSE) in November 2004. “Weare very proud to list the streetTracks Gold Shares on the New York StockExchange,” said a November 18, 2004, press release posted on the exchange’s web site (www.NYSE.com). Trading under the symbol GLD, thisnew exchange-traded fund holds gold bullion. It is therefore unlike othergold funds and indexes such as the PHLX Gold and Silver Mining Index($XAU), which hold shares of gold mining companies. This new fundholds the yellow metal itself—it is a pure play on gold prices. The price isset at 1/10th the value of gold. So if the precious metal is near $441, the
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TABLE 2.12 AMEX InternationalETFsTicker
Country
EWAEWOEWKEWZEWCEWQEWGEWHEWIEWJEWMEWWEWNEWSEWYEWPEWDEWLEWTEWU
AustraliaAustriaBelgiumBrazilCanadaFranceGermanyHong KongItalyJapanMalaysiaMexicoNetherlandsSingaporeSouth KoreaSpainSwedenSwitzerlandTaiwanUnited Kingdom
fund will trade around $44.10 a share. As of this writing, there are no options available on the GLD; however, that will probably change over time.
Bond FundsIn April 2003, the CBOE and AMEX both announced the launch of optionson the iShares Lehman 20+ Year Treasury Bond fund (TLT), the iSharesLehman 1–3 year Bond fund (SHY), and the iShares Lehman 7–10 yearBond fund (IEF). All three funds hold government bonds, but each is different in terms of maturity. For instance, SHY holds short-term notes thatmature in 1 to 3 years, but TLT holds long-term bonds like the 30-yearTreasury bond. The funds started trading in 2002 and options on the bondfunds started trading approximately a year later.
Most Active by Share VolumeIndeed, the success of any index or ETF options contract will dependon investor interest. Some simply don’t fly, and the lack of volume and
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TABLE 2.13 2005 ETFs Ranked byTrading Volume (Shares)Name
Symbol
NASDAQ 100 QQQSemiconductor HOLDRsDow Jones DiamondsRussell 2000 Small Cap FundSelect Sectors SPDRs FinancialsSelect Sectors SPDRs EnergyMidCap SPDRsSelect Sectors SPDRs Basic MaterialsiShares Long-Term Bond FundOil Service HOLDRs
QQQQSMHDIAIWMXLFXLEMDYXLBTLTOIH
liquidity makes them unattractive. The NASDAQ QQQ is the most actively traded, and most liquid, ETF today. Average daily share volume isin the millions.Table 2.13 ranks other exchange-trade funds by trading volume during2005. The Dow Jones diamonds (DIA), which holds the Dow 30, also madethe list. The Select Sector SPDRs are gaining popularity. These funds holdthe same stocks as the S&P 500 Index, but grouped by sector. For example, the Select Sector Financials (XLF) and Energy (XLE) funds areamong the most active ETFs today. Many of the holding company depositary receipts also trade actively. Examples include the BiotechnologyHOLDRs (BBH), the Semiconductor HOLDRs (SMH), and the Oil ServiceHOLDRs (OIH).Table 2.13 shows only exchange-traded funds because it is not possible to buy and sell shares of an index like the S&P 500 Index or the DowJones Industrial Average. However, it is possible to trade options on manyof the cash indexes. In Chapter 4, we list the ETFs and indexes with themost active options contracts. Most of the strategies discussed later inthis book focus on this group of index products, along with the onesincluded in Table 2.13.
CONCLUSIONGiven the increasing interest in exchange-traded funds and index trading,exchanges have been quick to launch a variety of new products designedto appeal to investors. As a result, index traders have a large number of investments to choose from. The downside, however, is that there are too
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many to track and trade. Savvy strategists need to understand what products exist in order to apply the perfect tool to fit a particular need. For example, as we demonstrate later, a strategist who is looking to protect orprofit from rising interest rates might set up bullish strategies on the TNXor bearish trades on the TLT. However, when looking for products to useregularly, like in a trading system, it is better to use those that have themore active shares and options contracts. And that includes those on thelist in Table 2.13 and in Chapter 4.
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Tradingthe Market
D
uring a bull market, the stock market is buzzing with activity. Theinvestment public is actively buying and selling shares and tradingvolume increases. For example, in March 2000, technology stockswere on fire; on the NASDAQ Stock Market, average trading volume approached 2 billion shares a day. Today, a little more than 1.5 billion sharestrade hands daily.The dollar volume related to trading activity is even more telling. Atits peak, the dollar value of daily trading activity on the NASDAQ surgedto $100 billion! By the end of 2002, the number had fallen to only $20 billion. The rise and fall of the NASDAQ from 1998 to 2002 provides an example of two different types of market environments: a surging bullmarket and a tumbling bear market.Bull and bear markets have existed throughout history and will continue to exist far into the future. Prices rise and prices fall. As prices movehigher and lower, trends develop. These trends can last from a few days toa few decades. More often than not, the development of the trend is basedon fundamental developments. For example, bull markets in stocks beginwhen the economy is expanding, corporate profits are growing, and investors are willing to buy shares.At the same time, trends can only last as long as investor psychologyremains supportive. Bull markets continue as long as investor sentimentremains positive and upbeat. In fact, bull markets often end when investoroptimism reaches unsustainable levels, or when bullishness reaches anextreme. It is the dynamic interaction between fundamental developments and crowd psychology that dictates the strength and duration of29
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bull markets. Understanding this dynamic, and how to view events asthey unfold with index charts, is a key element to becoming a successfulindex trader.
BULL VERSUS BEAR MARKETSA bull market is characterized as a period of rising prices. It gets its namefrom the fact that bulls buck up with their horns. A bull market can occurin stocks, bonds, gold, or even in the market for a fine red wine like aChateau Margaux. Any investment, asset, or security that has a marketwith changing prices can witness a period of rising prices, a bull market.In the stock market, bull markets are easy to identify. Investors feelconfident, as stock prices rise and portfolios increase in value. You canhear colleagues or acquaintances boast about their stock returns at workor dinner parties. The media pays greater attention to the stock market’sperformance and there is a general sense that all is going well in the corporate world and the economy.During bull markets, investment banks are selling shares of initialpublic offerings (IPO) faster than hot dogs at the ball park. For example,in March 2000, investors were falling all over themselves for the latesttechnology IPO. When trading activity is robust and the public is active inthe market, investment banks can generate hefty fees for bringing newcompanies to the market.As a result, in 2000, a record number of new offerings hit the market,as more than 400 companies brought new stock to the public. In addition,shares would sometimes jump 100, 200, or 300 percent during their firstday of trading. The IPO market died a couple of years later and investordisinterest kept the market quiet for years thereafter.Mutual funds have steady inflows of cash during bull markets. Wheninvestors see their 401Ks and retirement accounts increase in value, theyadd more money to their mutual funds. In March 2000, investors poured$35.6 billion into stock mutual funds according to the Investment Company Institute (ICI). In addition, total assets rose from $4.22 trillion to$4.43 trillion during the month of March 2000. A couple of years later, ICIreported that investors withdrew $466 million and stock fund assets fellfrom $2.67 trillion to $2.6 trillion in January 2003—a far cry from theMarch 2000 levels.While investors feel a general sense of optimism and wealth during abull market, the opposite occurs in a bear market. During bear markets,prices are falling and investors are losing wealth. A sense of uneasinessdevelops and, if the trend persists, can give rise to high levels of anxiety or
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angst. As this happens, buyers are less likely to surface and investors willsell off some of their holdings to avoid further losses.A long-term bear market is often accompanied by negativity and pessimism. The news headlines are often grim and the stock market gets lesscoverage from the media. As the bear market reaches its final stages, however, the selling can become extremely heavy, causing volume to rise, asthe last remaining bulls finally throw in the towel. This is sometimescalled a final “washout” or a phase of “capitulation” that occurs at the verybottom of the end of the bear market. At that time, the media is clearly focused on the gloom and doom. Headlines about market crashes make thecover of major magazines. But at that point, the selling begins to ease andseeds are planted for another bull market.Getting SentimentalThere are a number of trading tools that traders use to gauge market sentiment. The goal behind sentiment analysis is to gauge prevailing levels ofbullishness and bearishness related to an investment or market. Traderswant to go with the prevailing sentiment until it reaches an extreme. Forexample, bullishness often reaches an extreme just before the marketturns south. Several sentiment indicators are discussed and explained inChapter 10.
ALWAYS A BULL MARKET SOMEWHEREHistory rhymes but never repeats. While there are often similarities between two time periods, two time frames are never exactly alike. Therefore, while we can learn from past experience, we can never predictexactly what will happen next. This is true in everyday life and also in thefinancial markets.Fortunately, one thing is almost certain: There are always trendingmarkets somewhere. For example, specific sectors can move in bull andbear markets. In fact, some traders like to say that there is always a b