ullmarket somewhere. You can always find one if you look hard enough. Indexes and exchange-traded funds can help you spot these trends. Optionscan be used to generate profits from them.In 2004 and 2005, the major averages such as the Dow Jones IndustrialAverage and the S&P 500 Index traded sideways, but energy stockssoared. At times, most of the market faced selling pressure, but oil and oilservice stocks performed well. For instance, Figure 3.1 shows that fromJanuary to May in the year 2005, the S&P 500 Index fell 5 percent, but the
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FIGURE 3.1 SPX/XLE Chart, January 2005 to June 2005 (Source: www.ProﬁtSource.com)
Select Sector Energy Fund (XLE) rallied more than 10 percent. In thiscase, the market was experiencing a pullback, but the bull market inenergy continued.Conversely, there is almost always a bear market somewhere. Inother words, there is almost always one sector or asset class that is experiencing a bear market. Even when the stock market is performingwell, some sectors fail to participate. For example, Figure 3.2 showsthat from October 2003 to February 2004 the S&P 500 traded higher, butthe AMEX Airline Index ($XAL) moved sharply lower. In Chapter 11, weexplain what factors to consider when looking for bullish and bearishsector trades.In conclusion, indexes allow investors and traders to compartmentalize the market and view the performance of different areas of the marketseparately. Sometimes small caps will perform better than large-capstocks or technology will outperform financials. Gold and bonds can perform well when the stock market is in a slump. The possibilities are almost limitless. Indexes, however, give investors the tools to help makesense of what is going on and, more importantly, anticipate what willhappen next.
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FIGURE 3.2 SPX/XAL, September 2003 to February 2004 (Source: www.ProﬁtSource.com)
S&P Market Cap IndexesMarket capitalization or market value refers to the value of a companybased on its stock price. It is computed by multiplying the number ofshares outstanding by the market price of the stock. For example, if yourcompany has 1 million shares outstanding and the stock is trading for $50a share, the market value of your company is $50 million. Sometimesshares of smaller companies will behave differently than the shares oflarge companies. For that reason, it makes sense to monitor indexes thatrepresent each asset class. Standard & Poor’s has created the followingfour indexes.1. S&P 600 Small-Cap Index ($SML). This index accounts for less than5 percent of the total value of the U.S. stock market. It consists of 600companies with market values between $600 million and $3 billionand is considered to be the leading small-cap companies in the marketplace today. The iShares Small-Cap 600 (IJR) is an exchange-tradedfund that tracks this index.(Continued)
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S&P Market Cap Indexes (Continued)2. S&P Mid-Cap Index ($MID). This index includes 400 companieswith market values ranging from $1 billion to $4 billion. It is the mostwidely used gauge for the performance of mid-cap stocks. An ETFtracks the index and trades under the symbol MDY.3. S&P 100 ($OEX). The S&P 100 is one of the more popular indexcontracts and includes the top 100 companies that also have listedoptions. According to the Standard & Poor’s web site (www.standardandpoors.com), “Since its introduction in 1983, an important criterion for index inclusion has been the availability of individual stockoptions for each constituent.” The individual stocks within the index have an average market value of approximately $60 billion,ranging from $2.25 billion to almost $400 billion. The iShares S&P100 Fund is listed under the symbol OEF.4. S&P 500 Index ($SPX). The best-known S&P index consists of 500stocks from a diverse set of industry groups. The market value of thecombined companies equals 80 percent of the U.S. stock market. Thecompanies within the index have an average market cap of $22.6 billion, with the smallest sporting a market value of $425 million andthe largest, $375 billion. The S&P Depositary Receipts (SPY), or SPDRs,is an exchange-traded fund that tracks the S&P 500 Index.
GOING LONG AND SELLING SHORTIn the index market, traders can go long or sell short. Going long is theeasiest strategy. It simply involves buying shares, hoping they go up inprice, and then selling them for a profit. Importantly, however, going longcannot be applied to an index. Indexes like the S&P 500 Index, the DowJones Industrials, or the NASDAQ Composite cannot be bought or sold!They are simply benchmarks for tracking the stock market.Instead, investors can go long using exchange-traded funds. “Goinglong” simply means buying shares. When investors do this, they buyshares of the fund and hope that it increases in value. If so, shares can besold later at a higher market price. This goes along with the old adage“Buy low and sell high.”For example, let’s say the SPDRs are trading for $100 a share andthe strategist expects a move higher within the next few months. In order to profit from these expectations, 100 shares are purchased for $100a share. The cost of the trade is $10,000, or 100 × 100. If the SPY rises to$125 a share, the trade yields a $2,500 profit [($125 – $100) × 100 shares].However, if the SPY falls to $80 a share, the trade loses $2,000 [($100 –
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$80) × 100 shares]. Ideally, the share price will move higher and the stockcan be sold for a profit. This is the basis of stock trading, and it also applies to buying, or going long, ETFs.Exchange-traded funds can also be sold short. Short selling is a bearish market strategy that yields profits when the share price declines.When selling short, traders actually borrow shares from their brokeragehouses. After the position has been opened, traders receive a credit intheir account for the amount of the selling price.Risk Graphs 101A risk graph, or risk curve, is a graphical depiction of the risk and reward associated with a trade. It shows the possible outcomes, including the potential proﬁt and loss, or risk. Risk graphs are used extensively in optionstrading, including in this and our other books. The chart in Figure 3.3 provides an example. It shows the risk/reward associated with buying 100shares of SPDRs. On the left-hand side we see the stock chart, which is simply the price move in the SPDRs over the past few months. The actual riskgraph appears on the right-hand side. In this case, it is a straight line slopingupward from left to right because, as the SPY moves higher, the proﬁt fromholding the shares increases. The proﬁt is plotted along the bottom axis andthe stock price is on the vertical axis. Basically, the graph tells us how muchmoney we will make or lose as the price of the asset moves higher or lower.
FIGURE 3.3 Risk Graph of 100 Shares of SPY (Source: www.Optionetics.comPlatinum)
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As an example, let’s say a trader wants to place a bearish bet on theNASDAQ 100 Index Trust (QQQQ) with the expectation that the shareprice will fall sometime during the next six months. An order is placed tosell short 100 QQQQ at a price of $35 a share. The broker then lends the100 shares to the account and the Qs are then sold short. The proceeds of$3,500 ($35 × 100 shares) are credited to the account. Now, if the price ofthe QQQQ falls to $30 a share, the strategist can buy back the 100 sharesand return them to the broker. The cost is $3,000 to “cover” the short position. Therefore, the net profit, or the amount that is retained in the account, is $500 [($35 – $30) × 100 shares]. What if shares rally? If the Qsmove to $40 and the trader exits the position, the loss is also $500 becauseit costs $4,000 to buy back the stock and the credit from the short sale wasonly $3,500 [($40 – $35) × 100 shares].Figure 3.4 shows the risk graph of the QQQQ short sale. The lefthand side of the chart shows the movement in the underlying asset during the past few months. The right-hand side of the chart shows thepotential profit or loss from future price moves in the QQQQ assumingan investor sells short 100 shares at $35 a share. For instance, at $40 ashare, the loss is $500. However, if the price falls to $31 a share, theprofit is $400.
FIGURE 3.4 Risk Graph of 100 Short QQQQ (Source: www.Optionetics.comPlatinum)
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Hopefully, the reader now has a good understanding of buying shares(going long) and selling shares (going short). This is basic material thathas been covered in greater detail in our earlier books. If the reader needsfurther clarification on these two strategies, we suggest reading two ofour previous books—The Stock Market Course and The Options Course—for additional information.
CHARTS AND QUOTESTrading indexes without charts is like driving a car without your hands.While it might be possible, it isn’t necessarily a good idea. Basically, chartsmake trading a lot easier. In addition, understanding and using charts canhelp identify trading opportunities that can’t be found by simply watchingthe news or reading the newspaper.The process of finding a quote or a chart for an ETF or an index is thesame as for a stock. For example, many web sites offer free quotes, andfinding the current market price for an exchange-traded fund is a simplymatter of punching in the ticker symbol and hitting enter. For example,just enter “QQQQ” in the quote box at the top of the Optionetics.comhome page, hit enter, and voilà, the system pulls up the latest quote for theQs, as shown in Figure 3.5.The snapshot quote in Figure 3.5 shows that the QQQQ last traded at$40.92 for the day, which was down 66 cents from the day before. The high
LastOpenHighBid52 Week HighEarnings Per ShareShares OutstandingR/E Ratio
Delayed Quote as of DEC 19, 2005 4:00:09PM (E.T.)40.920Change↓ –0.66041.680% Change↓ –1.59%41.710Low40.90040.870Ask40.91042.31052 Week Low34.350–9,999.00Volume75.42M729.80MMarket Cap29.868N/AExchangeNASDAQ NM
FIGURE 3.5 Snapshot Quote of the Qs (Source: www.Optionetics.com)
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price of the day is $41.71 and the low is $40.90. The QQQQ was bid for$40.87 and the ask price is $40.91. So an investor could buy shares for$40.91 and sell them for $40.87. This quote service is delayed, but it offersother information such as the exchange-traded fund’s 52-week high andlow, the day’s volume, the total market value of the fund, and the exchange where the fund trades. Since the QQQQ is an exchange-tradedfund, the earnings-per-share data is meaningless.Getting the latest quote for an index is just as simple. However, forindexes, many web sites and quote vendors require the dollar sign before the symbol. For example, to retrieve the latest quote for the S&P500 index, traders must enter the symbol $SPX. Therefore, if the symbolrequires a dollar sign, it is an index. If not, it is a stock or an exchangetraded fund. Figure 3.6 shows an example of a quote for the S&P 500Index. Since it is a cash index, the bid and offer as well as a lot of otherdata included in Figure 3.5 are not present.Many web sites offer free charts as well. However, to perform regularanalysis of the index market, a more advanced software package is recommended. As we see in later chapters, looking at charts, plotting indicators, and performing analysis on a variety of different indexes can helpto quickly identify profit opportunities. While advanced software is notrequired, it simplifies this process a great deal.First, let’s cover the basics of charting. The bar chart—also referred toas open-high-low-close, or OHLC—is the most widely used type of chart today. Figure 3.7 shows a bar chart using the NASDAQ 100 Index Trust(QQQQ). On the left side of each bar is a small horizontal line that represents the opening price. The highest and lowest points of each bar represent the high and low for the day. Finally, the close is indicated with a smallhorizontal line on the right side of each bar. This type of chart is sometimescalled a range bar chart and can be created for any stock or index.
LastOpenHighLow52 Week High
Delayed Quote as of DEC 19, 2005 4:59:57PM (E.T.)1,259.92Change↓ –7.401,267.210% Change↓ –0.58%1,270.510VolumeN/A1,259.360ExchangeINDEX1,275.80052 Week Low1,136.220
No news currently available for S&P 500 Index
FIGURE 3.6 Snapshot Quote of $SPX (Source: www.Optionetics.com)
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FIGURE 3.7 Daily QQQQ Chart (Source: www.ProﬁtSource.com)
When studying the stock market as a whole, the first step is to look atthe trend. Is it moving higher or lower? Bull market or bear market? As ageneral rule, a market qualifies as bullish if it experiences a 20 percent advance from a previous low. A 20 percent fall from a previous high indicates a bear market. Traders should focus on long positions during a bullmarket and short positions during a bear market. Remember, the trend isyour friend!As you can see from Figure 3.7, the NASDAQ QQQQ moved higherfrom May to December. The trend, therefore, was positive, or bullish, because the fund had risen more than 20 percent from its lows. It is technically in a bull market. When it comes to making investment decisions,technical analysts will generally be buyers in bull markets and sellers inbear markets.Market QualiﬁersBull market: Advance of 20 percent or greater from a previous low.Bear market: Decline of 20 percent or more from a previous high.Correction: A move lower (5 to 20 percent) during a bull market or amove higher (5 to 20 percent) during a bear market.Pullback: A move of 5 percent or less to the downside during a bull market or a move 5 percent or less higher during a bear market.Retracements: A move counter to the prevailing trend. Technical analysts consider 23.6 percent, 38.2 percent, and 61.8 percent retracementsto be signiﬁcant.
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TRENDLINESTrendlines are one of the most basic ways to analyze specific markets, especially indexes. The lines are simply drawn on charts. When we startedtrading, we did this by hand with pencil, ruler, and paper. However, today,most charting software provides a variety of tools including the ability toaccurately draw trendlines.The goal in using these lines is to determine whether bulls or bearsare in control of the trend. The trend, in turn, is a prolonged period of timewhen the market or index is moving in one direction or another. If themarket is moving gradually higher and setting a series of higher highs andhigher lows, it is said to be in an uptrend. When an index is in an uptrend,the trendline is drawn on the chart along the bottom of the price. Figure3.8 shows an example of a healthy trend and the trendline that is drawnalong the series of higher lows.A downtrend, on the other hand, occurs when a index price falls overa period of time and sets a series of both lower lows and lower highs.When a stock or index is falling, the trendline will be drawn along the topof the price chart. The chart in Figure 3.9 shows an example of a nastybear trend and the accompanying trend line. As you can see, trendlinesare tools designed to capture the uptrends and downtrends relative to astock or index. Traders want to stay on the same side of these trends.Technicians often use the adages “The trend is your friend” and “Don’tfight the trend.”Drawing trendlines is relatively straightforward. Today, lines can be
FIGURE 3.8 Uptrend Chart Using QQQQ (Source: www.ProﬁtSource.com)
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FIGURE 3.9 Downtrend Chart (Source: www.ProﬁtSource.com)
created on index charts with most trading software programs and, in theabsence of software, charts can be printed from a website and the linescan be drawn the old-fashioned way, with a pencil and a ruler. For instance, in Figure 3.9 the downward-sloping trendline is drawn on sharesof the QQQQ from January 2001 until March 2003. The fund then reversedcourse and started an uptrend (the one shown in Figure 3.8), which hascontinued to the time of this writing.Trendlines can also be used to identify trading opportunities. The firstfactor to consider is the slope of the line. Again, an upward-sloping trendline is the sign of a healthy advance; a downward-sloping trendline suggests that the market is weak. Once the directional bias of the trend hasbeen identified, you can use a number of strategies to take advantage of it.Trendlines also serve as support and resistance. In the upward-slopingtrendline in Figure 3.8, each time the stock approached the line, itbounced off and made a move higher. This is considered “trendline support.” Once established, a trendline can, quite astonishingly, serve as afloor through which a stock price will not fall. On the other hand, in adownward-trending market, the trendline can prove to be a source of resistance, or a ceiling to higher prices. In Figure 3.9, the trendline clearlyidentifies areas of resistance.When a trendline is broken, it is sometimes known as trendline failure. For instance, the downward sloping trendline in Figure 3.9 was broken in early March and the trend shifted—from down to up. In otherwords, the trendline no longer served as resistance and once the stockbroke through it, shares made a significant move higher. Therefore, a
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trendline break can often signal a move in the opposite direction, which iscalled a reversal.The angle of a trendline is also significant. A very steep trendline suggests aggressive buying (in the case of an uptrend) or aggressive selling(in a downtrend). Therefore, when a steep trendline is broken, it hasgreater implications than when a relatively flat trendline is violated.When studying trendlines, time is the final consideration. In general,the longer the duration of the trendline, the better the trend. Hence, whena 12-month trendline is broken, it has more significant implications thanwhen a 3-week trendline is broken. The number of times a trendline is approached but not penetrated is significant as well. It is more meaningfulwhen a downward-sloping trendline that has served as resistance on adozen occasions is broken, as opposed to the one that has only beentested three times.Major trendlines: Lines drawn on charts along long-term uptrendsor downtrends that span many months or even years. Techniciansconsider these long-term trendlines extremely signiﬁcant, as they often serve as support or resistance to higher prices.Minor trendlines: Lines drawn on charts along short-term trendsthat last a few weeks or a couple of months. They are not consideredextremely important when studying the markets using technicalanalysis.
USING MOVING AVERAGESMoving averages (MA) can also help gauge the strength of trends. As thename implies, a moving average is simply the average, or mean, of a priceover a fixed number of days. Generally, the average is computed usingclosing prices, or the price of the last trade of the day. For instance, if atthe end of six trading days an exchange-traded fund closes for $40, $44,$50, $48, $50, and $52, the four-day MA at the end of the fifth day is $48[(44 + 50 + 48 + 50) ÷ 4]. As each new day is added, the last price is removed from the moving average. So, in this example, the four-day MA atthe end of the sixth day equals $50 [($50 + $48 + $50 + $52) ÷ 4]. Movingaverages generally cover a period of 20, 50, or 200 days. Most chartingsoftware packages include MAs, so there is no reason to compute themby hand.Moving averages will behave differently based on the number of daysused to compute the average. A 50-day MA, for example, will behave differently than a 200-day MA. The shorter the time frame, the more sensitive
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the moving average will be to price changes in the stock. Consider the chartin Figure 3.10, which shows the price action of the diamonds along with boththe 50-day MA and the 200-day MA. Notice that the 50-day moving average(which is above the 200-day) fluctuates more than the 200-day, because thelatter captures a longer-term time frame. Some technicians say that thelonger-term MA is “slower” or “smoother” and the shorter-term is “faster.”Some traders will use very short-term moving averages (e.g., nine days).The general rule is to use a moving average that corresponds with the timeframe of your trading strategy. For instance, in looking at a stock for potential trades for the next two years, a nine-day moving average will not beideal. It is too short-term, given that the strategy is long-term in nature.As with trendlines, traders need to consider the slope of the movingaverage. If a moving average is upward-sloping and moving higher, it suggests that the trend is healthy—a favorably bullish sign for the stock. Onthe other hand, a downward-sloping moving average suggests weaknessand is bearish for the stock. In Figure 3.10, notice how the 50-day movingaverage will change direction much faster than the longer-term (200-day)moving average. A simple moving average is created by adding up eachclosing price of the past number of days and dividing the total by thatnumber. Hence, a 50-day simple moving average would consist of the sumof the last 50 closing prices of the index divided by 50.A second way to study moving averages is to look for buy and sellsignals by considering when the stock price crosses over the MA. For instance, notice in Figure 3.10 when the price of the DIA fell below the 50day MA in late February, it triggered a “sell” signal. The fewer the number
FIGURE 3.10 Diamond Chart with 50- and 200-Day MAs (Source: www.ProﬁtSource.com)
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of days used to compute the moving averages, the greater the number(and the less the significance) of buy and sell signals. So a break of a 200day MA is considered much more significant than a break of a 9-day moving average.Moving averages can also serve as support and resistance zones.Figure 3.10 shows how the 50-day MA served as a support area for thediamond when it moved higher. Technical analysts watch the 200-dayMA closely in this respect. You may have heard news reports that theNASDAQ Composite Index ($COMPQ) recently moved above its 200-daymoving average. Many analysts view that as a powerful bullish technicalsignal because the penetration of the 200-day moving average symbolizesa break of a major resistance area for the index.The final way of using moving averages is to look at the crossovers between the two of them. When the short-term MA crosses over the longerterm MA, it triggers a “buy” signal. This occurred in Figure 3.10 during themonth of May 2003 and the DIA surged. Conversely, when the 50-day MAdrops below the 200-day MA, a “sell” signal is triggered.So far, our discussion of moving averages has used the simple movingaverage (SMA). Exponential moving averages (EMAs) are used in thesame way as SMAs, but are generally considered superior because themost recent data has a greater influence on the average when comparedto the older data. When computing the average, the most recent tradingday has a greater weighting. For example, in a nine-day moving average,the most recent trading day is given greater importance when comparedto the price nine days ago. As a result, the EMA will respond faster tochanges in the trend and is therefore a more reliable indicator. The exponential moving average is used for the remainder of this book.
Simple moving average: A series of successive averages that is deﬁned by a set of variables. As each new variable is added, the oldestor last variable is removed. Moving averages are often computed forstock prices to view trends over time. Fifty- and 200-day moving averages are among the most common time frames.Exponential moving average: A type of moving average that givesgreater weight to the latest data. For example, to compute the 10-dayexponential moving average, the analyst might take the closing priceof the 10th-day and multiply this number by 10, the 9th day by 9, the8th day by 8, and so on. As a result, it responds faster to new pricesand less to old data. For that reason, some trades prefer the exponential moving average over a simple moving average because it offersbetter information regarding the most recent trends or prices.
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Linearly weighted moving average: A type of moving averagethat gives greater weight to the latest data. For example, to computethe 10-day linearly weighted moving average, the analyst might takethe closing price of the 10th day and multiply this number by 10, the9th day by 9, the 8th day by 8, and so on, as with the exponentialmoving average. Then the products are divided by the total numberof multipliers. In this example, the total number of multipliers is 55(10 + 9 + 8 . . . + 1). The linearly weighted and exponential movingaverages are considered superior to simple moving averages becausethey assign more importance to new, rather than old data.
VOLUMEVolume is an important consideration when looking at the action in the index market. There is a saying among technicians that “Volume goes withthe trend.” Basically, during a true bull market, trading activity will expand during market advances and contract during periods of fallingprices. If a sharp drop in the Dow Jones Industrial Average is accompanied by light volume, analysts consider that to be a favorable sign. If, onthe other hand, volume expands during a market sell-off, it is interpretedas a negative or bearish sign for the overall market.The financial press reports volume daily. When discussing the performance of the Dow, the volume represents the day’s volume on theNew York Stock Exchange, which is not necessarily correct becausethe Dow currently includes two NASDAQ stocks. Nevertheless, a reporter might say something like, “the Dow fell 50 points on Tuesday, onvolume of 1.9 billion shares.” When discussing the performance of theNASDAQ, investors look at the total volume on the NASDAQ StockMarket.Investors can also track the trading volume of individual exchangetraded funds to determine whether there is more buying or selling pressure. For example, if the volume of the Qs is increasing while its pricemoves higher, it is a sign that the trend is healthy and on solid footing.However, if volume rises during the declines, a move to the downside isgathering momentum.Most charting software allows traders to place volume bar charts below the price data, like the chart shown in Figure 3.11. In this example,notice how volume is rising during the up days. The arrows point to examples of up days on high volume. This is a bullish sign. This is considered apositive indication that the trend has staying power. During a market advance, the strategist wants to see increasing volume on the up days and
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