this option was zero. So why did it cost anything—muchless 34 points—to buy this option? Because there was time left on the option contract, it had potential value. There was a chance that the S&P500 would start an upward move that carried it above 1,300, at whichpoint it would start having a real value. If the S&P 500 rose further, to aprice of 1,334, the option would have an intrinsic value of 34—exactly
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what it cost on July 13. If the S&P 500 continued to go up, the option would continue to gain in value. If the S&P 500 got to 1,368, theoption would be worth 64, at which point the option’s original buyerwould have doubled his or her investment.That’s partly why I called options bets. The buyer of an option whoseindex price is below the strike price is betting that over time the marketwill go up, eventually making the option worth something before expiration. The further one is from the strike price, the longer the odds. On theother hand, if the market rises, but much less than expected, the optionwill eventually go to zero as expiration nears. For example, the S&P 500might rise from 1,215 to exactly 1,300, a gain of 7%. If it then falls back,that option will end up worthless.On the other side of the contract, the seller of the call option that hasa time premium is getting money from the sale, with the idea that he orshe is selling something that has a long way to go before it actually willhave a value. The seller does this under the assumption that the indexwould never go much above the strike price over the life of the option,or if it did, it would at least fall back and have no value on expiration.Now let’s look at a put option. The buyer of a put option has purchased the right to sell the S&P 500 at a fixed price until expiration. Theseller of the put must buy it from him at that price until expiration. Let’slook at July 13, 2001 again. On that date, the put option to sell the S&P500 at a price of 1,100 for the next 5 months costs 24 S&P 500 points.The put option, like the call option in our previous example, has no intrinsic value, only time value. There was a chance, however, that theS&P 500 could start a large decline that carried it below 1,100, at whichtime the put would start having a real value. If the S&P 500 declined further, to a price of 1,076, the option would now have an intrinsic value of24, just what it cost on July 13. If the S&P 500 continued to decline, theoption would continue to gain in value.A combination write is a well-known option strategy that is designedspecifically for a trading range market. A combination write is the simultaneous selling of a put and a call with the same expiration date at twodifferent strike prices (Figure 8.13). The seller gets the money from thebuyer of these obligations. Suppose you expected that the S&P 500would never get above 1,300 or below 1,100 over the next 5 months; youthink the market will simply trade between these two extremes, goingback and forth in a sawtooth pattern. As long as the S&P 500 index staysbelow 1,300 and above 1,100, the two options are guaranteed to expire
200
TRADING RANGE INVESTMENT STATEGIES
TE
AMFLY
FIGURE 8.13 A combination write is an option strategy to use if you areexpecting prices to remain in a trading range. Ideally, the put and the call shouldbe sold when traders are putting unusually high time premiums into the options.This usually occurs when the VIX index (volatility index) is at a maximum. Theassumption is that this volatility will calm down over succeeding months, andmeanwhile one would have received a high price for selling the two options. Aslong as prices stayed within strike prices, the obligation assumed by selling theoptions would expire worthless.
worthless. You pocket the money and let the situation go to zero. It’s obvious why this is an option strategy designed for a trading range market.Combination writes do pose risks, however. If the market breaksabove or below either strike price and continues past what the sellerpocketed, the speculator has taken a position that can lead to increasinglosses. No one should establish a combination write without first determining a well-established stop-loss point. In other words, before thecombination write is established, clear exit prices should be establishedat which the combination writer buys back the options and gets out fromunderneath the obligation at a pre-established loss. Barring such an exitstrategy, if prices move above or below these strike prices and continueon that course, the buyer of a combination write could start losing on theinvestment, perhaps in a very big way.
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A FUND OF FUNDS FOR A TRADING RANGE MARKETIt would seem that if you were expecting a trading range stock market, afund of funds could be designed with a diversified set of hedge fundstrategies that do particularly well during this type of market. The tradingrange strategies should be those that produce investment results in trading range markets, for example, the fund could be composed of these fivehedge fund strategies.1. Market neutral—securities hedging2. Special situations3. Market timing:• Trend following• Price transition indicators4. Opportunistic5. Option strategiesOne of the advantages (or risks) of assuming that a trading range marketexists is that one can set aside certain strategies that wouldn’t work wellduring a sideways market. One of the reasons the investment results of afund of funds don’t always do so well is that the funds include every typeof hedge fund strategy there is, and some of these are contradictory (i.e.,they work against each other).There is always risk. By focusing on strategies for a trading rangemarket, if we do have a trading range market, a hedge fund should dovery well indeed. In truth, however, we have shifted the risk to the accuracy of our prediction of a trading range market. If it doesn’t materialize, the fund will not do as well as other funds. For example, if the greatbull market starts up again and continues on an unrelenting advance foranother six years, this strategy will probably not work as well as others.
Index
Abelson, Alan, 100–101Advance-decline line, 80, 81, 89, 168Art of Contrary Thinking, The (Neill),102BABES, 100–101Baby boomer misconception, 20–22Back-testing, 165, 193Bear market, 166Black, Fisher, 109Black book, 23Bollinger, John, 184Bollinger bands, 184–191strategy, 186–187Bond prices, stacking the money todetermine, 59–61Buffet, Warren, 123Bull market, 10, 25, 76, 126, 166, 181Buy and hold, 25application of, 15–17versus market timing, 12–14Call, 107Call option, 200, 201Chaos (Gluck), 31Chaos theory, 31, 34Chicago Board Option Exchange(CBOE), 107
Climax, 91Coincidental indicators, 3Combination write, 201–202Companies, and payment of dividends,70–72Computers, as traders, 97Conforming indicator, 83, 167–170Contracting volatility, 157–158Contrary opinion, theory of, 98–123BABES and O’BUCS, 100–101described, 99history of, 102–105measurement of investor expectations,105–113investor activity, 105–112polling services, 112–113in practice, 116–122as aid in navigating 1994–1999market, 119consensus opinion, 119–120correlations between group emotionsand market volume, 121–122using the theory, 117–119proof, 114–116examining results, 115–116gathering data, 114–115resistance to applying, 122–123why it works, 101–102203
204
Correction, in market trends, 150–164Current dividend yield and marketexpectation, 72–73Data, importance of, 19–20Divergence, 81–82Dividends, 7interest rates and, 66, 68–69companies that don’t pay, 70–72Dividend yield for stocks, 160–161Dow, Charles, 81, 125Dow Jones industrial average, 92, 166Dow Theory, The (Rhea), 126Drew, Daniel, 24Drew, Garfield A., 102Earnings, and prediction of stock prices,4–6, 7Economic information, 3Efficient market model, 28–31strengths of, 29–30weaknesses of, 30–31Elliott, R. N., 128–131, 155Elliott wave pattern, 153–159fourth wave, 155–157Elliott Wave Principle—Key to MarketBehavior (Prechter), 128Elliott wave variations, 134–137extensions, 134–135flat, 135horizontal triangle, 136–137irregular correction, 135–136Fair value (D/i), 44, 46, 48–51, 61Farrell, Robert, 101, 193Federal Reserve board, 65, 70Feedback loop, 31–35moving average and, 192–193Feynman, Richard, 50Fibonacci, 138Final stampede, 163–164Fisher, Irving, 62Fourier, Jean Baptiste Joseph, 173Fractalsand Elliott wave patterns, 138–147Koch curve, 141–142Mandelbrot curve, 142–145
INDEX
and stock price patterns, 139Fundamental analysis vs. technicalanalysis, 77–79Fund of funds, 198, 203Future dollar’s present value, 53–54Futures polling services, 112Fuzzy dividends, 66, 67Fuzzy numbers, 63–64Gann, W. D., 125, 135Golden mean, 138Granville, Joseph, 194Great Crash, 13, 151, 153Gross national product (GNP), 3Group Emotion and Market Volume,121–122Guru index, 112–113Hardy, Charles, 102Hedge fundsrise of, 194–199investment strategies, 197–199fund of funds, 198market neutral, 199market timing, 199opportunistic, 199special situations, 199Housing starts, 4How to Trade in Stocks (Livermore), 47,93Hurst, J. M., 173Index option, 200Indicators, 87coincidental, 3confirming, 83, 167–170oscillators as, 96predictive, 167–170Inflation, 52and theory of stacking the money, 70Insiders, and the market control, 23–25Interest rates, 7and dividends, 66–69importance of, to stock prices, 64–72response time to changes in, 69–70Internal market, 85Intrinsic value, 200
INDEX
Investing paradoxes, 7–9Investment opinion, developing, 17–25Investorexpectations, measurement of, 105–113as market timer, 14–15sophistication, 104–105time horizon of, 36Investor activity, 105–112put/call ratio, 107–108Rydex ratios, 111–112short-selling ratios, 105–107volatility index (VIX), 109–111Investor’s Intelligence, 112–113, 114, 119Irregular correction, 135–136, 149Koch curve, 141–142, 145–146Leading economic indicators, 3–4Lefevre, Edwin, 47, 102Livermore, Jesse, 46, 47, 93–94Long-term investing, 38Lump sum pension, calculating, 54–59interest rate effect, 57–59Major market tops, 10–11Malkiel, Gordon, 28Mandelbrot, Benoit, 125, 138, 139Mandelbrot curve, 141, 142–145Market bottoms, 83–86, 91–92Market breadth, 86Market news, effect of, 41–42Market paradigm, 10–17Market Patterns, 92–93Market predictability, 45–47Market signals, 168Market Technicians Association (MTA),80Market timers, 14–15Market timing, 25two approaches to, 166–172using moving averages, 170–172versus buy and hold, 12–14Market tops, 83–86, 88–89and fourth Elliott wave, 89–91Mathematics, 50–51Merton, Robert, 109Model, defined, 28
205
Money supply, 4Moving averagesand feedback loops, 192–193130-day, 179–180original study of, 172–182subsequent study of, 182–192used for defining trends, 172used for market timing, 170–172Mutual funds, 195–196NASDAQ, 92–93Neill, Humphrey, 102, 104New Methods for Profit in the StockMarket (Drew), 102New York Stock Exchange (NYSE), 102,1311987 crash, 38–41, 42Nixon, Richard, 2, 18“Normalized” thinking, 151–153Normal market cycle, 86–88O’BUCS, 100–101Odd lot theory, 102“Odd-Lot Trading on the New YorkExchange,” (Hardy), 102Option strategy, 200–202Oscillators as indicators, 96Overvalued stock, 162–163Paradoxes, investing, 7–9resolved, 73–75, 97Pivotal point, 93–95Polling services, 112–113futures polling services, 112guru index, 112–113Prechter, Robert, 128Predictive indicators, 167–170Present value, 52–53, 56Price patterns, 124–149R. N. Elliott and wave principle,128–131Dow-Gann pattern expanded,129–130patterns bigger than bull markets,131fractals, and Elliott wave patterns,138–145
206
Price patterns (cont.)original observations, 125–127Dow and Gann patterns combined,126–127Dow Theory of price movement,125–126W. D. Gann, 126predictability of real market’s fractalpattern, 145–149applying Elliott wave theory, 147search for predictability, 146–147search for underlying theory, 132–137wave theory vs. real market, 133–134labeling Elliott’s waves, 133–134wave variations, 134–137Probability, 54, 56Profit Magic of Stock TransactionsTiming, The (Hurst), 173Put, 107Put/call ratio, 107–108Put option, 200, 201QED (Quantum ElectroDynamics)(Feynman), 51Random Walk down Wall Street, A(Malkiel), 28Reminiscences of a Stock Operator(Lefevre), 47, 102Resonance, used to find time cycles inmarket, 174–175Response time to interest rate changes,69–70Rhea, Robert, 126Rydex ratios, 111–112Schaeffer, Bernie, 101Schaeffer, Bob, 194Scheinman, William X., 2Scholes, Myron, 109Securities and Exchange Commission(SEC), 102Sentiment, investor, 103Short selling, 98, 99Short-selling ratios, 105–107Short-term interest rates, 4
INDEX
Short-term trading, 38Sophistication, investor, 104–105Soros, George, 123Specialists, stock exchange, 23, 37–38Speculation, 17, 149Stable vs. unstable market, 34–35Stacking the money, 58–59and bond prices, 59–61resolution of two investing paradoxes,73–75and stock prices, 61–64Standard & Poor’s (S&P) 100 index,109–110Standard & Poor’s (S&P) 500 index, 4, 5,12, 86, 109–110, 152–153, 154,160, 170–171, 176–179, 182,186–189, 200–201Standard deviation, 184, 185Stealth bull markets, 194Stock market model, new, 27–47market predictability, 45–47modeldefined, 28feedback loop, 31–35old model, 28–31recommended model, 43–44solving the big theoretical problem,27–28time intention of trade, 36–43clarifying effects of, 42–43feedback loops and market news,41–42short-term trading, 38three feedback loops and 1987 crash,38–41Stock Market Profile, The—How to Investwith the Primary Trends (Jacobs),2Stock pricesearnings and 4–6movement, 12stacking the money to determine,61–64Strategic Guide to the Coming RollerCoaster Market (McDonald), 7,149Strike price, 200
INDEX
Technical analysis, 6–7, 76–97, 193–194basics of, 80–97changing market patterns, 92–93divergence, 81–82making bottom, 91–92making top, 88–89market tops vs. bottoms, 83–86normal market cycle, 86–88oscillators as indicators, 96pivotal point, 93–95principle of time invariance, 82–83topping, and fourth wave, 98–91two types of technical indicators, 83unstable markets, 95paradox three resolved, 97time limitations on, 79–80used in trading range investmentstrategies, 193–194versus fundamental analysis, 77–79Theory of Interest, The (Fisher), 62Theory of Investment Value, The(Williams), 62Time cycles in market, 173–174using resonance to find, 174–175Time intention of trade, 36–43Time invariance, principle of, 82–83, 193Time limitations on technical analysis,79–80Time scale of trading range period,158–159Trading price swings, 10–26developing an investment opinion,17–25baby boomer misconception, 20–22evaluating relative importance ofdata, 19–20insiders and market control, 23–25new market paradigm, 10–17application of buy and hold, 15–17investors as market timers, 14–15market timing versus buy and hold,12–14trading range market, 11–12Trading range investment strategies,165–203first moving-average study, 172–182factoring in whipsaw, 180–182
207
130-day moving average, 179–180original moving-average study,175–176results of study, 176–179study restrictions, 178–179time cycles in market, 173–174using resonance to find time cyclesin market, 174–175fund of funds for trading range market,203moving average and feedback loops,192–193new moving-average study, 182–192adding more dimension to movingaverages, 183–184Bollinger bands, 184–186Bollinger band strategy, 186–1871966 to 1982 period, 182–183results of study, 190–192study restrictions, 188summarizing trading ranges study,187–190option strategy for trading rangemarkets, 200–202rise of hedge funds, 194–199expected rising popularity of hedgefunds, 197hedge fund investment strategies,197–199hedge funds, 197–197limitations of mutual funds,195–196two approaches to market timing,166–172market timing using movingaverages, 170–172using standard technical analysis,193–194Trading range market, 11–12, 150–164correction, 150–153“normalized” thinking, 151–153past trading range markets, 150–151current Elliott wave pattern, 153–159contracting volatility, 157–158fourth wave, 155–157time scale of trading range period,158–159
208
Trading range market (cont.)economic “why,” 160–163overvalued, undervalued, 162–163final stampede, 163–164Transition indicator, 83Undervalued stock, 162–163Unstable market, 95Up and Down Wall Street (Abelson),100
INDEX
Volatility, 158Volatility index (VIX), 109–111Whipsaw, 180–182Why Most Investors Are Mostly WrongMost of the Time (Scheinman), 2Williams, John Burr, 62Works of R. N. Elliott, The, 163Zweig, Marty, 98, 99, 101, 107, 194
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