1976, 1979, 1980Bearish YearsDolphins: 1973, 1974Jets—1969Patriots—2002Raiders—1977, 1981, 1984Missed SignalsBroncos—1998, 1999Chiefs—197049ers—1990Cowboys—1978Rams—2000, 2001Patriots—2004
In 2002, however, the win on the part of the AFC Patriots foreshadowed the stock market’s dismal performance. In 2003, the Tampa BayBuccaneers squared off against the Oakland Raiders. A win by the NFCBuccaneers produced a positive signal for the stock market. From thatpoint forward, the stock market snapped a three-year losing streak andmoved sharply higher in 2003.In 2004, the NFC Carolina Panthers met the AFC New England Patriots. The Patriots won, which was a bearish sign for the stock market.However, the Dow rose 3 percent that year.In 2005, the New England Patriots defeated the Philadelphia Eagles inSuper Bowl XXXIX, which correctly predicted a down market. The DowJones Industrial Average finished the year down 0.8 percent. In 2006, a21–10 victory by the AFC Pittsburgh Steelers over the NFC Seattle Seahawks offered a bearish prediction for the market. As of this writing, theoutcome is not yet known.
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Wall Street LoreObviously, the Super Bowl indicator is not one we take seriously. We include it here simply because it’s already out there. In addition, it’s an example of Wall Street lore that can sometimes inﬂuence other investors.There are other examples. Some believe that if the New York Mets make itto the baseball World Series (which has happened four times in the last 40years), it has bearish implications for the stock market. Others believethat if a horse wins the Triple Crown—a feat accomplished only ﬁve timesin the past 55 years—stocks are in for a bear market.
Presidential ElectionUnlike the Super Bowl indicator and other Wall Street lore, the presidential cycle indicator has a bit more logic to it. According to thistruism, stocks will move higher in the year prior to a presidential election and continue moving higher during the election year. Since WorldWar II, the stock market has never had a down year in the year prior toan election, and it has suffered only three down years during an election year.Unlike the Super Bowl, where a fumble or incomplete pass can dictate the outcome, the presidential indicator reflects expectations aboutactual economic activity. After all, a newly elected president is morelikely to boost spending, cut taxes, or institute other measures to stimulate economic growth. In short, changes in economic policy associatedwith a change in administration can promote more economic growth andhigher stock prices. So the presidential cycle indicator urges us to buy atthe start of the year prior to the election and sell at the end of the election year.
January BarometerAccording to the January barometer, the stock market’s performance during the month of January will determine its performance throughout theremainder of the year. If stocks rise during the month of January, it bodeswell for the rest of the year. But if stocks fall during the first month of theyear, expect the major averages to finish in negative territory. As an example, in 2004, stocks rose during the month of January and also finishedhigher on the year. Then the Dow fell in January 2005 and also finished theyear in the red.
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In addition, according to the Dogs of the Dow web site (www.dogsofthedow.com), “The January Barometer does have a fairly successful trackrecord. For example, from 1950 to 2003, the S&P 500 was up in January 34times. In 30 of those 34 instances, the S&P 500 traded higher 11 monthslater. That equals a success rate of 88%.”
January EffectFor a long time now the market has experienced a peculiar yet verypopular seasonal impact from the end of December through January.It involves the tendency of small cap stocks to outperform largercap stocks. This phenomenon is commonly referred to as the Januaryeffect. Historical statistics going back to the mid-1920s indicate thatthis seasonal approach has been correct more than 70 percent ofthe time.However, there is also evidence that the effect is beginning to losesome of its predictive ability. According to research done by the StockTraders Almanac (New York: John Wiley & Sons, annually), many followers of the January effect are buying in November because of the incredible amount of publicity this seasonal approach has received. Thegoal is to get ahead of the crowd. As a result, the January effect is starting to see many doubters as they claim way too many people knowabout it, which could dramatically reduce its reliability as a market-timingmechanism.Yet the logic behind the effect makes sense, especially after a downyear for the stock market. The theory is that stocks—small cap stocks inparticular—are adversely impacted during the calendar year because ofinstitutional as well as small investors selling late in the year for tax purposes. This unloading of shares drives stock prices down toward the endof the year due to tax loss selling. However, it also leads to massive bargain hunting and repurchases the following year. Due to the “wash rule,”investors who record a tax loss on a stock are not allowed to repurchaseshares for 30 days. So after recording the tax loss, some investors returnto buy shares 30 days later.There seem to be two general approaches taken by traders when implementing the January effect. First, many strategists look to buy stocksthat have had the worst performance of the year. These are candidates fortax loss selling. Second, some traders look for a weak year for equities tosee further declines late in the year and then a rebound in January. Onlytime will tell if this particular seasonal strategy known as the January effect will continue to work. One thing is certain: It has become one of themost popular seasonal approaches of all.
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Ho, Ho, HoThe Santa Claus rally describes a seasonal strong period for stocks that includes the last ﬁve trading days of the year and the ﬁrst two trading daysof the New Year. According to the Stock Traders Almanac, since 1950, theS&P 500 Index has risen 1.5 percent during that period.
SEASONALITYThe January barometer, January effect, and Santa Claus rally are examples of seasonal trends. In fact, seasonality can play an important role inthe performance of the stock market throughout the entire year. Jay Kaeppel, author and Optionetics instructor, has done a lot of work identifyingthese seasonal patterns. Among his findings, Kaeppel has found four bullish tendencies:1. The two days immediately prior to an exchange holiday (New Year’s
Day, Presidents’ Day, Easter, Memorial Day, July 4th, Labor Day,Thanksgiving, and Christmas).2. The last trading day of the month and the first four trading days of thenext month.3. November 1 through the third trading day in May.4. The most favorable 14 months of the 48-month presidential electioncycle. This begins on October 1 two years prior to each presidentialelection, and ends on December 31 of the following year.Given these seasonal tendencies, strategists can create calendars and lookfor days when the bullish tendencies overlap and provide multiple signals.For instance, the most recent presidential election was held on November2, 2004. According to the presidential cycle indicator (or bullish tendencynumber 4), it is a good time to be in the market. In addition, the periodfrom November 1 to the third trading day in May is another bullish tendency pattern. Meanwhile, the last trading day of the month and the firstfour trading days of the month of next month are also bullish from a seasonal perspective. Therefore, November 2 during an election year is extremely bullish from a seasonal perspective because it satisfies three of thefour bullish tendencies. The calendar in Table 10.5 shows the seasonal pattern for the month of November of a midterm election year (2006). Whenthere are two or more tendencies working at the same time (i.e., a score of+2 or better) market performance over time is greatly enhanced.
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TABLE 10.5 Seasonality CalendarNOVEMBER 2006Mon
Tue
Wed
Thu
1
23
6
73
13
82
142
20
27
17
23
29
2
2
3
2
10
16
22
3
2
2
328
2
9
15
212
33
2
2
Fri
224
MKTCLOSED
2
302
3
MAXIMUM PAIN THEORYThe Maximum Pain Theory (MPT) is the last indicator we review in thischapter. According to MPT, the price of an underlying asset will gravitatetoward the point where the greatest number of options expire worthlessat expiration. This is the point where option holders feel the maximumamount of financial pain. Frederic Ruffy, a senior writer at Optionetics,has written a number of articles about the phenomenon, and the followingexample is borrowed from one of his articles.Whether some sort of market manipulation or mere chance causesthe price of an underlying asset to move toward the point where many options expire worthless is open to debate. Rather than examining thecause, we prefer to focus on the fact that there is sufficient evidence tosuggest this tendency does exist. It seems to occur more predictably whenthere are no major news stories or other market-moving events that canotherwise cause a sudden movement in the underlying asset.In order to compute the maximum pain price, or the price level thatwill see the greatest number of options expire worthless, the first step isto compute the dollar value of all open contracts. In this example, let’s usethe Semiconductor HOLDRs (SMH) and the December 2005 options. The
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open interest data is from Monday, December 12, and four days prior toexpiration. The first step is to look at the open interest across all December options (see Table 10.6).The next step is to compute the value of all the options contracts using the open interest for both the puts and the calls, calculated at variouspossible closing prices. To do this, we assume that the SMH closes at avalue equal to each of the nine strike prices listed in column 2 in Table10.7. For example, if the Semiconductor HOLDR closed Friday trading at30, all the calls with a strike price of 30 or higher would be out-of-themoney and would expire worthless. The value of all the in-the-money calloptions (top two lines in these tables) is computed as the difference between the price of the SMH ($30 in this example) and the strike price ofthe in-the-money option, times the open interest. In this example, thatvalue is $384,500 [(2.5 × 1402 × 100) + (5 × 68 × 100)]. This is the value ofthe options that will not expire worthless if the SMH is at $30 at expiration. From Table 10.7, we can see that the cumulative dollar value of thecalls increases as the SMH moves up in price, but the value of the putsdeclines at the same time.Next we add the total value of the open interest for both the puts andcalls across the various strike prices. Table 10.8 shows the total volume ofthe puts and calls in the second column. The maximum pain occurs wherethe total value is the lowest. In our example, $37.50 represents the price ofmaximum pain. At that level, the most puts and the most calls will expireworthless, causing the most pain to option owners. This is confirmed byreferring back to Table 10.6, which shows that at $37.50, more than117,000 put options and 57,000 call options expire worthless.
TABLE 10.6 SMH December Put and Call Open InterestCall Open Interest
Strike Price
Put Open Interest
68
25.00
0
1,402
27.50
768
638
30.00
2,062
6,659
32.50
12,677
25,005
35.00
51,981
57,011
37.50
117,350
21,974
40.00
10,206
3,174
42.50
265
0
45.00
12
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TABLE 10.7 Total $ Value of Puts and CallsTotal Value of Calls
0
SMH Price
Total Value of Puts
25.00
177,382,000
17,000
27.50
148,913,500
384,500
30.00
127,727,500
911,500
32.50
79,504,750
3,103,250
35.00
34,651,250
11,546,250
37.50
2,693,000
34,239,500
40.00
72,250
62,426,250
42.50
3,000
90,616,500
45.00
0
TABLE 10.8 Total Value of Puts and CallsSMH Price
Total Value of Puts and Calls
25.00
177,382,000
27.50
148,930,500
30.00
128,112,000
32.50
80,416,250
35.00
37,754,500
37.50
14,239,250
40.00
34,311,750
42.50
62,429,250
45.00
90,616,500
According to the maximum pain calculation, the SMH was expectedto see weakness heading into December option expiration and head toward the $37.50 per share level. At the time the numbers were run, thefund traded at $38.25 per share. At December expiration, it traded for$38.04 and finished at the low of the day. Therefore, in this case, it did drifttoward the MPT point. This appears to be the tendency with maximumpain—it seems to be the path of least resistance for the underlying asset.However, other factors will also affect the performance of the index,sometimes dramatically. As a result, MPT is not reliable or consistentenough to use as a stand-alone tool.
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CONCLUSIONWhew! This chapter conveyed a lot of information. At this point, thereader has learned about a significant number of new indicators. Do weneed to use them all? Absolutely not. There are some that you will find interesting and worth exploring further. It’s okay to narrow down the listand start with one or two indicators, or to use the information that seemsto fit most comfortably with your trading style.At the same time, there are some lessons that the reader should definitely take home from this chapter.• The market does not always behave in a rational manner.• Investors are emotional creatures.• There is a lot of money on the line in the financial markets, and as aresult, greed and fear—excessive buying and selling—will affect themarket over time.Sentiment analysis can help identify those periods of extreme greedor fear and open up opportunities for trades against the crowd. Wheneveryone else is bearish, it pays to get bullish and start putting a smallamount of capital to work with long calls, bull call spreads, or directionalstraddles. In addition, looking at market internals can help identify whenthe trends are resilient and likely to continue, or whether there is a risk ofa reversal. Finally, long-term strategies can be created using seasonal indicators and market anomalies. Often these involve taking a contrary approach to the market and doing things in relatively unconventional ways.
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Sector Trading
I
nvestors often move money throughout different areas of the market inanticipation of one sector outperforming another. This is called sectorrotation and it occurs because certain events can impact not just onecompany but an entire industry. For example, rising oil prices can boostthe profits of Exxon Mobil (XOM) and other major energy companies, butat the same time higher fuel prices hurt the profits of airline and transportation companies. So when oil prices rise, energy stocks will often perform well as transportation stocks suffer.Today, investors have a significant number of different exchangetraded funds and index options available to them to trade specific industrygroups or sectors. (A comprehensive list is provided in Chapter 2.) In thischapter, we look at some of the more actively traded index products anddemonstrate ways to combine fundamental and technical analysis to findwinning sector trades.Sectors can generate short-term profits for the trader while also allowing investors to more easily create a diversified portfolio and gaingreater control of their core financial situation. Strategies can be implemented to protect and build more wealth. Examples include the use of index puts to hedge against moves in specific sector or industry group,adding shares of a gold ETF to protect against inflation, or using calls on arate index to make profits when interest rates move higher. These andother strategies are taken up in greater detail in this chapter.
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UNDERSTANDING SECTOR ROTATIONSector rotation is sometimes shunned because it is a form of market timing. Also known as group rotation, it is the process of moving money todifferent areas of the market in anticipation of one sector performing better than the others. For example, if there are signs of an economic rebound on the horizon, an investor might choose to move into morecyclical sectors such as energy, autos, or retailers. At the same time the investor will move out of more defensive groups, such as health care, utilities, and consumer product stocks. This type of decision making isperformed by a variety of money managers—from small investors movingassets among ETFs to institutional investors that move massive amountsof capital among the different sectors of the market.So while sector rotation has its critics, it also has its followers,thanks in part to academic research papers from the 1980s. Notableamong these is a collaborative piece by Robert Grauer of Simon FraserUniversity, Nils Hakansson of the University of California, and FrederickShen of University of Waterloo entitled “Industry Group Rotation in theU.S. Stock Market” (Journal of Banking and Finance 14, 1990). In thepaper, the authors looked at the investment returns earned on a portfoliothat used active group rotation from 1934 to 1986. Similar to a number ofother academic papers during the 1980s, the results made a strong casefor the potential benefits of allocating money to different sectors of themarket. In sum, the academic work of the 1980s created growing interestin this type of market timing. Today, money flows readily from one sectorto the next.Sector rotation gains strength during periods of significant economicchange. For instance, in late 1999, financial-related stocks tumbled onconcerns of rising interest rates. Meanwhile, technology stocks surged.Then, following the great tech wreck of the year 2000, it became clear thatinterest rates were set to fall, and more interest-sensitive stocks such asbanks, pharmaceuticals, and consumer product stocks performed well.Interest-Sensitive StocksSome groups of stocks tend to react to changes in interest rates more thanothers. This has given rise to the term interest-sensitive to describe some sectors and industry groups. For instance, banks are very sensitive to interestrates. Much of their business comes in the form of borrowing at short-termrates and lending at longer-term rates. When short-term rates rise relative tolong-term rates, proﬁts can suffer. Therefore, when interest rates rise, investors sometimes sell bank shares. High-yield stocks such as utilities may
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Interest-Sensitive Stocks (Continued)fall because higher interest rates create competition for investor assets. Pharmaceuticals and consumer product stocks, which are more defensive investments, can also suffer when money moves to interest-bearing investments.
Figure 11.1 shows how expectations about changes in the economyoften benefit certain economic sectors or industry groups. Since the stockmarket is forward-looking, these groups tend to perform well six to ninemonths before the anticipated change in the economy. For instance, during the early and middle phases of an economic expansion, money will often move to cyclical stocks, transportation companies, and industrialstocks. Companies in these sectors will see their profits improve dramatically if the economy begins gathering momentum.In the later phases of an expansion, shares of energy and basic material companies can do well as the demand for their products remainsstrong and they can raise their prices to make more profits. A strong economy fuels demand for raw materials. As time progresses, however, theeconomy will begin to slow and investors might become more defensive.Groups like beverage companies, grocery chains, pharmaceuticals, andother groups that see steady business regardless of the economic outlookoften do well in a slower economic environment. If investors fear a recession and a stock market rout, they might begin turning to precious metals,biotechnology, or other areas of the market that are significantly lessimpacted by changes in the economy.Because money is constantly rotating across the various sectors ofthe market, there is almost always one group performing well. Even in the
Late ContractionBiotechnologyPrecious MetalsSpecial Situations
Early ExpansionTechnologyCyclicalsTransports
Middle ExpansionFinancialsCapital GoodsIndustrials
Early ContractionConsumer ProductsHealthcare
Late ExpansionBasic MaterialsEnergy
FIGURE 11.1 Economic Cycle and Sector Rotation
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nastiest bear markets, there are at least one or two groups moving higher.That’s why some traders like to say, “There is always a bull market somewhere.” The same is true on the flip side, of course—there is always a bearmarket somewhere, too. The idea behind sector rotation is to be in the hotsectors when they’re bullish, but out of them when the trend turns south.The result of all this group rotation is often sideways or range-boundtrading in the major averages. It can make it seem like the market is trading quietly and within a range. On the charts, the Dow Jones Industrial Average ($INDU), the S&P 100, and other market averages seem to gonowhere. For example, Figure 11.2 shows the performance of the Dowfrom mid-1999. It was flatter than a pancake.However, even when the market experiences minimal movement,some stocks and sectors could be trading more erratically with dramaticmoves higher or lower. For example, when the Dow was trading flat frommid-1999 to the middle of 2001, Internet stocks were in a bear market. Figure 11.3 shows the performance of the industrials along with theStreet.com Internet Index ($DOT). It lost more than two-thirds of its valuewhile the change in $INDU seemed negligible.During periods of strong group rotation, the market can trade flatwhile specific sectors trend higher or lower. The strength in the top performing sectors offsets weakness in the poor performing groups. The market as a whole seems to go nowhere. When the Dow was trading flat andInternet stocks were reeling in the period from mid-1999 to mid-2001, natural gas stocks were performing well. Figure 11.4 shows the performanceof the AMEX Natural Gas Index ($XNG) during that time.
FIGURE 11.2 Dow Industrial Average (Source: www.ProﬁtSource.com)
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FIGURE 11.3 Dow Jones Industrial Average and TheStreet.com Internet Index(Source: www.ProﬁtSource.com)
FIGURE 11.4 Dow Jones Industrial Average and the AMEX Natural Gas Index(Source: www.ProﬁtSource.com)
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Understanding group rotation can help the index trader in more thanone way. First, it allows a trader to see what is happening below the surfaceof the major averages. There will be times when the market trades flat butspecific sectors trend higher or lower. Second, understanding the nature ofsector rotation allows a trader to identify better opportunities via those market areas with volatility characteristics that benefit certain option strategies.
COMPARTMENTALIZE THE MARKETThe first step in seeking these types of focused trades is to slice the market into various sectors or industry groups. We want to compartmentalizethe market. The first place to start is with the Select Sector SPDRs. Thereader was introduced to these nine funds in Chapter 2. To recap, sharesof these exchange-traded funds are listed on the American Stock Exchange and can be bought and sold like stocks. Like the SPDRs, they represent ownership in a basket of stocks.However, rather than holding the stocks of the S&P 500 Index, SelectSector SPDRs are created around specific sectors—financials, technology,utilities, and so on. Collectively, the nine sector SPDRs hold all the S&P500 stocks. Table 11.1 lists the nine Select Sector SPDRs. Options arelisted on all nine funds. Therefore, options strategists seeking to participate in the rise and fall of specific sectors can implement strategies on thevarious Select Sector SPDR funds. We also use them to find areas of market strength or weakness.While it makes sense to track all nine sector funds, the strategist willsometimes want to dissect the market even further to find trends and trading opportunities within specific industry groups. Sometimes specific sectors can behave very differently than the market and even the general
TABLE 11.1 Select Sector FundsSelect Sector SPDR
Symbol
FinancialsInformation TechnologyHealth CareConsumer DiscretionaryIndustrialsConsumer StaplesEnergyBasic MaterialsUtilities
XLFXLKXLVXLYXLIXLPXLEXLBXLU
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sector. In fact, it is sometimes possible for a bull and bear market to occurwithin the same sector at the same time.One such example is the health care sector in 2005; biotechnology andpharmaceutical stocks performed very differently this particular year. Figure 11.5 shows the performance of the AMEX Pharmaceutical Index($DRG) and the iShares Biotechnology Fund (IBB) from February to December 2005. Beginning in late April, pharmaceutical stocks started trending lower and fell 10 percent during the next eight months. Meanwhile,biotechnology stocks reversed higher and IBB rose more than 20 percentduring that time. Both biotechnology and drug stocks are within thehealth care sector, but as seen in this chart, the two groups sometimesperform very differently.Today there are hundreds of exchange-traded funds and indexes thattrack specific industry groups. For example, traders interested in the chipsector can choose from options on the PHLX Semiconductor Index($SOX), the ISE Semiconductor Index ($BYT), the CBOE SemiconductorIndex ($PVU), the GSTI Semiconductor Index ($GSM), the iShares Goldman Sachs Semiconductor Fund (IGW), or the Semiconductor HOLDRs(SMH). Yes, there are six different ways to trade the chip stocks alone! Inaddition, the exchanges are continually rolling out new sector index products. (A comprehensive list of products appears in Chapter 2.)With so many sector index products available, how does one choosethe right one? It is impossible to track and trade them all. Instead, wewant to narrow the focus by looking only at those index products thathave actively traded contracts. Table 11.2 shows some of the sector products that currently see reasonable amounts of trading volume, which, ofcourse, can change over time. This list is not all-inclusive, but it provides a
FIGURE 11.5 Pharmaceutical Index and Biotech Fund (Source: www.ProﬁtSource.com)
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TABLE 11.2 Most Active Sector ETFs andIndexesSector Product
Ticker
PHLX Bank IndexBiotech HOLDRsPHLX Housing IndexInternet HOLDRsiShares Biotechnology FundMS Retail IndexOil Service HOLDRsPHLX Oil Service IndexPharmaceutical HOLDRsPHLX Semiconductor IndexRegional Bank HOLDRsRetail HOLDRsSemiconductor HOLDRsPHLX Gold and Silver Mining Index
BKXBBHHGXHHHIBBMVROIHOSX