the time. However, we are also using a strategy that won’t
FIGURE 11.13 BKX Daily Chart (Source: www.ProﬁtSource.com)
ccc_fontanills_221-256_ch11.qxd
Sector Trading
6/30/06
12:27 PM
Page 243
243
FIGURE 11.14 BKX June Put Ratio Backspread Risk Graph (Source: www.Optionetics.com Platinum)
kill us if the bank index moves higher rather than lower. In fact, we caneven earn a small profit if the BKX rallies and both sides of the trade expire worthless. The key to minimizing risk is to manage the position as expiration approaches. If the index has not made its move within a fewmonths, it is better to close the position rather than to run the risk of getting pinned to the strike price of the long option at expiration.
UTILITIESTraders often overlook the utility sector. These stocks were once knownfor their low volatility and stability because, historically, these companieshave delivered consistent earnings and hefty dividends. Therefore, the utility sector became the domain of predominantly conservative investors.That all changed when the industry was deregulated in the 1990s and after the California energy crisis of early January 2001. Since that time, the utility sector has become more volatile and, consequently, now offers as manytrading opportunities as any other sector of the market. In fact, it tends tosee better and longer trends than many other sectors (see Figure 11.15).Index strategists seeking to participate in future price changes in theutility sector have at least five vehicles to choose from. The Chicago Board
ccc_fontanills_221-256_ch11.qxd
244
6/30/06
12:27 PM
Page 244
THE INDEX TRADING COURSE
FIGURE 11.15 Dow Jones Utility Index Daily Chart (Source: ProﬁtSource.com)
Options Exchange lists options on the Dow Jones Utility Index ($DUX).This index consists of the same 15 stocks as the Dow Jones Utility Average.Meanwhile, the Philadelphia Stock Exchange lists options on the PHLXUtility Sector Index ($UTY), which consists of 20 utility-related stocks withoptions trading on the Philadelphia Stock Exchange. The iShares DowJones U.S. Utilities Sector Index Fund (IDU), the Utility HOLDRs (UTH),and the Select Sector Energy Fund (XLU) are three exchange-traded fundsthat hold utility stocks. Because of growing interest in the Select SectorSPDR funds, we consider the XLU to be the best trading vehicle from a liquidity standpoint. The UTH is a close second.
BONDSBonds are not really a sector, but they get consideration here becausethey fit nicely into this chapter. In recent years, the bond market has beenseeing a bit more volatility due to global events and the action of the Federal Reserve. The inversion of the yield curve in late 2005 has already beendiscussed. Index traders looking to participate in these trends have a fewinvestment vehicles from which to choose, including ETFs and cash indexes. Before discussing those, however, let’s first make clear what wemean by the bond market. There are several different kinds.• Zero coupon bonds: Unlike a regular bond, which pays interest eachyear, zero coupon bonds pays no interest prior to maturity. Since thereare no interest payments, zero coupon bonds trade at a deep discount
ccc_fontanills_221-256_ch11.qxd
Sector Trading
6/30/06
12:27 PM
Page 245
245
to their face value. Therefore, an investor can buy a zero coupon at adiscount and then receive the full principal payment when the bondmatures. In addition, because they pay no interest, zero coupon bondsare more sensitive to movements in interest rates than bonds that dopay interest because bonds at discount are multiyear.• Treasuries: There are three types of Treasuries: long-term,intermediate-term, and short-term. Short-term Treasuries are T-bills(held less than 1 year), intermediate-term are T-notes (held 1 to 10years), and longer-term are T-bonds (held 10 to 30 years). Since treasury bonds are backed by the full faith and credit of the U.S. government, there is essentially no credit risk. As a result, Treasury bondprice changes can be attributed to changes in interest rates.• GNMA bonds: Ginnie Mae bonds represent a pool of mortgages.They tend to offer a higher yield than Treasury bonds, but have ahigher credit quality than typical corporate bonds.• Corporate high-grade bonds: As the name implies, these arebonds issued by financially sound, creditworthy corporations. Highgrade bonds generally yield more than government bonds but lessthan junk bonds. In fact, long-term bonds issued by even the most financially sound company should pay a reasonably higher rate of interest than a Treasury bond of comparable maturity. This higher rate isrequired to compensate the investor for credit risk, which is negligiblewith a Treasury. One thing to remember when considering high-gradecorporate bonds is how quickly the financial condition of a corporation can change. One could easily compile a long list of companiesthat were financially sound 10 years ago, yet are either out of businessor hanging by a thread today.• Junk bonds: As the name implies, these are bonds of companieswith questionable finances. Since buying one junk bond can be risky,many investors prefer to buy a variety of individual bonds or a junkbond fund that holds a portfolio of bonds. The lure of junk bonds issimply that the yield on the bonds held that do not default will morethan compensate for any losses suffered by companies that default ontheir bonds.• Convertible bonds: Convertible bonds are called convertible because they can be converted into shares of the underlying stock. Eachconvertible bond has a conversion price associated with it. If the underlying stock reaches that price, then the holder of the bond canchoose to convert the bond into shares of stock.Table 11.6 summarizes the risk of the various types of bonds. Government bonds have virtually no credit risk, but high interest rate risk. Whenrates increase, the price of a bond decreases, so as the rate outlook
ccc_fontanills_221-256_ch11.qxd
6/30/06
12:27 PM
246
Page 246
THE INDEX TRADING COURSE
TABLE 11.6 Bond CategoriesBond Category
Credit Risk
Interest Rate Risk
Zero Coupon Bonds
Nil
High
Treasury Long-Term
Nil
High
Treasury Intermediate-Term
Nil
Medium
Treasury Short-Term
Nil
Low
GNMA
Low
Medium
Corporate High-Grade
Medium
Depends on length
Junk
High
Depends on length
Convertibles
High
Low
changes, government bonds can experience a lot of movement. Longerterm Treasury bonds generally see greater volatility associated withchanges in rate expectations.A final reminder about bonds (which we have already alluded to): Longterm bonds almost always yield more than short-term bonds. A case ofshorter-term bonds yielding more than longer-term bonds is referred to as aninverted yield curve and is usually a bad sign for the economy in general. Theinversion is the result of some near-term economic problem, which causesinvestors to be more concerned about the short term than the long term.
Tools to Trade BondsIn the index market, traders are primarily focused on Treasury notes andbonds. The government securities have a very active secondary market, andchanges in their yields can have an important effect on the economy by causing changes in other key rates (i.e., mortgage rates). However, rather thantrading actual bonds or bond futures, there are also a few ETFs and indexesfrom which to choose when looking for ways to play bonds and rates today.Computing the Yield on the Benchmark Ten Year NoteThe yield of the benchmark Ten Year Note is often quoted in the ﬁnancialnews. In addition, there is an index that tracks its changes—the CBOE TenYear Rate Index ($TNX). The current yield is based on the coupon and thecurrent price of the bond. For example, an 8 percent bond selling at$1,276 would have a current yield of $80/$1,276, or 6.27 percent. So,when “Treasuries rally,” the yield (and the $TNX) will fall.
ccc_fontanills_221-256_ch11.qxd
Sector Trading
6/30/06
12:27 PM
Page 247
247
In April 2003, the CBOE and AMEX both started listing options on theiShares Lehman 20+ Year Treasury Bond fund (TLT), the iShares Lehman1-3 Year Treasury Bond Fund (SHY), and the iShares Lehman 7-10 YearTreasury Bond Fund (IEF). All three funds hold government bonds, buteach is unique in terms of maturity. For instance, SHY holds short-termnotes that mature in 1 to 3 years, but TLT holds long-term bonds like the30-year Treasury bond.The Five Year Note Index ($FVX), the Ten Year Note Index ($TNX),and the Thirty Year Bond Index ($TYX) are vehicles some traders use tomonitor 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 benchmarkTen Year Treasury Note multiplied by a factor of 10. So if the current yieldon the Ten Year is 4.4 percent, the TNX will be trading at 44.00. In thesame manner, the FVX trades the Five Year Note and the TYX tracks theThirty Year Bond.Of the vehicles just mentioned, the iShares Long-Term Bond Fund(TLT) is the best way to play changes in the bond market today. For one, ithas the greatest trading volume and hence the best liquidity. In addition,since it holds longer-term bonds, it tends to see a bit more volatility thanthe other ETFs. Since the bond market tends to make gradual moves overtime based on the outlook for the economy, strategists might consider using strategies that work well in trending markets when using the TLT. Examples include bearish calendar or diagonal spreads when interest rateworries begin to surface, or collars and covered calls in a moderately bullish bond environment.
DOW THEORYTransportation stocks have thus far been excluded from our discussion ofsector trading. One problem with the group is that there are not very manyliquid indexes. The AMEX Airline Index ($XAL), for instance, can makefast moves and provide interesting trading opportunities, but the tradingvolume is almost nonexistent and the lack of liquidity makes the indexuninteresting.However, there is one index that is worth watching related to transportation stocks. In fact, it is the oldest market index—the Dow JonesTransportation Average ($TRAN). Charles Dow created the transports in1884. At that time, it was known as the Dow Jones Railroad Average. Today,index traders participate in the moves in the average via the Dow JonesTransportation Index (DTX). This index is simply a smaller version of the
ccc_fontanills_221-256_ch11.qxd
248
6/30/06
12:27 PM
Page 248
THE INDEX TRADING COURSE
120-year-old average. The DTX is equal to 1/10 of the value of the Transportation Average. So, if the transports are trading near 4,100, the DTX willequal 410.The transports are also worth watching because they form the foundation of a trading system known as Dow theory, which was briefly discussedin the early pages of this book. In the late 1800s, Mr. Dow, a pioneer in market analysis, wrote a series of essays describing the market’s actions andcharacteristics. These writings were later gathered and became known asDow theory. The transports and the industrials were central to his study.They are used along with six other key tenets of Dow Theory.1. The market discounts everything. The stock market has within its
universe so many people studying every bit of information and everylast detail, that the sum of all knowledge is quickly priced into themarket, and as such has anticipated the immediate future. This applies to the market as a whole, sectors, and individual stocks. Thereare seldom any surprises to the market; it knows all.2. The market has three major trends. According to Dow, the market has three types of trends. He compared them to the movement ofthe ocean, and they are the primary (tides), the secondary (thewaves), and the minor (ripples). The primary trend is observed bylooking at the tops of the waves. If each successive wave is higherthan the previous one, the “tide,” or trend, is rising. If each successivewave is lower than the previous one, the trend is lower. These primarytrends could last for as long as several years, or as short as one year.Traders want to focus on the primary trend, occasionally take actionduring the secondary, but ignore the minor ripples completely.3. Major trends have three phases.• Accumulation phase: This is when knowledgeable and astute investors begin accumulating shares, even if the trend initially isdown. They are the ones that are involved in various industries andsee bullish developments unfold.• Public participation phase: This is typically the point where thetrend up has formed and it attracts the attention of technicians andtraders. Prices are known to advance rapidly in this stage.• Distribution phase: The headlines are bullish, speculative volume is visible, and the crowd is bullish. It is here that the informedinvestors in the initial stage begin selling into the buying demand,locking in their profits.4. Volume must confirm the trend. We discussed this at length inChapter 10. A market that rises with decreasing volume is not consid-
ccc_fontanills_221-256_ch11.qxd
6/30/06
Sector Trading
12:27 PM
Page 249
249
ered to be a sustainable move. A market that is rising with increasingvolume that also had a drop in volume on pullbacks was consideredto be the most bullish of signals.5. A trend is considered to be intact until it shows definite signals that it has reversed. This is perhaps the most challenging partof investing: When has the trend changed? Many an investor has mistaken a serious correction for a temporary pullback. The opposite istrue for the end of a bear market. Misinterpreting whether a true reversal has begun or whether the recent rise in prices is just anotherbear trap is also a costly error.6. The averages must confirm each other. This is the tenet that relates to our discussion of sector trading and tracking a variety of market averages. According to Dow theorists, in order for a market trendto have staying power, the railroad (transports) and industrial averages must confirm each other’s rises and falls. During a bull market,both the Dow Jones Industrial Average and the Dow Jones Transportation Average must move to new highs together in order for theadvance to have staying power. However, if the industrial average setsa new high but the transportation average moves lower, it gives abearish signal.Charles Dow had only two averages to observe and he believed thatthey must move up or down together. Today, we have a myriad of indexesand ETFs to track. The industrials and the transports are still important.However, for Wall Street, it is also encouraging to see some of the othermore economically sensitive groups setting new highs along with the S&P500 Index. Examples include the AMEX Broker/Dealer Index ($XBD), theMS Cyclical Index ($CYC), and the NASDAQ Composite Index ($COMPQ).
SECTOR TRADING SYSTEMJay Kaeppel wrote an article for Technical Analysis of Stocks and Commodities magazine about a method used to trade Fidelity Select sectorfunds.* Dubbed “Pure Momentum,” it is simple, yet has significantly outperformed the market over the years. While he applies the analysis to theFidelity Select Sector Funds, the principle is relevant to our discussion of
*Jay Kaeppel, “Trade Sector Funds with Pure Momentum,” Technical Analysis ofStocks and Commodities 19, no. 11 (July 1999), 22–36.
ccc_fontanills_221-256_ch11.qxd
6/30/06
12:27 PM
Page 250
250
THE INDEX TRADING COURSE
index trading as well. Using the system we can find areas of potentialstrength or weakness. The buy rules to the system are as follows:1. At the end of each month, identify the five sector funds that have ad-
vanced the most in price over the previous 240 trading days.2. Buy and hold those five funds until minimally the end of the next
month.3. Repeat the process at the end of each month.There is nothing more to it. Table 11.7 lists the annual results for thePure Momentum system versus the S&P 500. It easily beat the market in10 of 14 years. In addition, when it didn’t top the S&P 500 Index, it produced positive returns during those four years. So, although it might bedifficult or scary to buy sectors that have already rallied, this evidencesuggests that it is worthwhile at times. An important factor to consider isdiversification.As Jay says, “It would be foolish to invest all of one’s capital in a single top-performing industry group, yet at the same time it would appear toTABLE 11.7 Pure Momentum System Annual ResultsYear
Pure Momentum
S&P 500
System vs. S&P
1990
(4.7)
(6.6)
1.9
1991
74.7
26.3
48.4
1992
17.4
4.5
12.9
1993
24.9
7.6
17.3
1994
8.1
(2.0)
10.1
1995
36.1
34.1
2.0
1996
17.9
20.3
(2.4)
1997
30.5
31.0
(0.5)
1998
23.1
26.7
(3.6)
1999
110.8
21.0
89.8
2000
18.2
(10.1)
28.4
2001
(6.4)
(13.0)
6.6
2002
(14.1)
(23.4)
9.3
2003
24.0
26.4
(2.4)
2004
1.1
2.7
(1.6)
Courtesy of Jay Kaeppel, Technical Analysis of Stocks andCommodities.
ccc_fontanills_221-256_ch11.qxd
6/30/06
12:27 PM
Page 251
251
Sector Trading
be very prudent to allocate a portion of one’s investment capital to a diversified group of top performing groups.”
GO INTERNATIONALJay Kaeppel went further and applied the Pure Momentum strategy to theinternational exchange-traded funds. These funds, included in Table 11.8,hold stocks from different countries. A complete discussion was presented in Chapter 2.The system setup was the same: After the last trading day of eachmonth, take the five country ETFs that have advanced the most over thelast 240 trading days. Buy and hold an equal dollar amount of shares of
TABLE 11.8 ETFs by CountryTicker
Country
EWA
Australia
EWC
Canada
EWD
Sweden
EWG
Germany
EWH
Hong Kong
EWI
Italy
EWJ
Japan
EWK
Belgium
EWL
Switzerland
EWM
Malaysia
EWN
Netherlands
EWO
Austria
EWP
Spain
EWQ
France
EWS
Singapore
EWT
Taiwan
EWU
United Kingdom
EWW
Mexico
EWY
South Korea
EWZ
Brazil
ccc_fontanills_221-256_ch11.qxd
6/30/06
12:27 PM
252
Page 252
THE INDEX TRADING COURSE
TABLE 11.9 Annual Pure Momentum System Results, 4/1/97 to 5/12/04Year
Top 5 Monthly
All ETFs
1997
17.2
1998
22.8
8.8
14.1
1999
10.5
24.9
(14.4)
2000
(14.7)
(19.8)
5.1
2001
(3.4)
(11.1)
7.6
2002
(8.3)
(13.2)
4.8
2003
34.6
45.2
(10.6)
2004
(4.5)
(2.4)
(2.1)
(0.2)
Top 5 Minus All ETFs
17.4
those five funds until the end of the next month. Then repeat this process.If fewer than five funds posted an advance over the past 240 trading days,then hold that portion of the portfolio in cash.Table 11.9 shows that the Pure Momentum system applied to countryfunds outperformed the others funds in five out of seven calendar years.Although it lost money all three years during the 2000–2002 bear market, itheld up much better than the other systems. Again, the results confirmthat it isn’t necessarily a bad idea to chase a hot sector.
PAIRS TRADING IN THE SAME SECTORThe last strategy that we want to consider related to sector analysis iscalled pairs trading. We already know that stocks within the same industry or sector tend to exhibit a certain amount of co-movement. A pairtrade is a market neutral strategy that attempts to profit from the factthat certain stocks tend to exhibit a high degree of co-movement over thelong term.In order to profit from pairs, traders want to find two highly correlatedstocks within the same sector that have been moving in a dissimilarmanner for a period of time. Then the pair trade is created by shortingone stock and buying the other in anticipation that the longer-term trendwill revert to its mean. It is a market and sector neutral strategy becauseit depends not on the movement of the overall sector or market, butis based on the idea that one stock will outperform the other in theshort term.The first step in setting up a pairs trade is to identify two stocks thatare highly correlated. For example, Ford (F) and General Motors (GM) are
ccc_fontanills_221-256_ch11.qxd
6/30/06
12:27 PM
Page 253
Sector Trading
253
two stocks that have been the subject of numerous pair trades. The twostocks tend to see similar price action because they are in the same industry. Their business activities are related to changes in consumer spendingand the economy.The key to a good pair trade is not just in the correlation, but also inthe stock picking. For instance, one might choose two companies that arerivals or competitors. Then, buy (or go long) shares of the company that isexpected to win the battle for market share and sell short the stock that isexpected to lose.Some traders have developed statistical tools for finding pair trades.Models that use historical data can scan stocks that have high levels ofcorrelation during the past few years but have diverged from that trendduring the past few weeks or months. For example, one might set up apairs trade when the price ratio (difference in price) between two highlycorrelated stocks diverges by one or two standard deviations.The Optionetics Platinum site has the ability to screen the stock universe to find highly correlated stocks. Or one could simply chart two stocksand look at relative performance over a period of time. Figure 11.16 showsthe performance of LSI Logic (LSI) and Intel (INTC) in a period when thetwo chip stocks had a high level of correlation (0.87). However, LSI was beginning to significantly outperform Intel by a large margin, which was atodds with the long-term correlation between these two stocks.To profit from the divergence between INTC and LSI, a strategistmight have set up a pair trade by shorting LSI and buying shares of Intel. Ifsemiconductor stocks remain strong, the trade can yield profits if Intelmoves higher faster than LSI. However, if the chip sector falters, the paircan generate profits if LSI falls faster than Intel. The trade is market neutral because it doesn’t depend on the direction of the overall market orsector. Figure 11.17 shows what eventually happened. Both stocks fell,
FIGURE 11.16 INTC and LSI Diverge (Source: www.ProﬁtSource.com)
ccc_fontanills_221-256_ch11.qxd
254
6/30/06
12:27 PM
Page 254
THE INDEX TRADING COURSE
FIGURE 11.17 LSI and INTC Revert (Source: www.ProﬁtSource.com)
but then INTC started to rally while LSI continued sliding. The gap closed,yielding a profit for the pair trade.To create a pair, the strategist will want the total value of the positionto be based on dollar value rather than number of shares. For example, ifthe underperforming stock is trading for $20 and the other for $40, then200 shares of the underperformer are purchased for every 100 sharesshorted in the other stock. This way a 10 percent move in one equals a 10percent move in the other.At the same time, there is a risk of loss if the two stocks move in theunanticipated direction and the divergence widens. In fact, the risk associated with a pair trade is greater than holding just one stock because thestrategist might be wrong twice. For instance, in our example, LSI mightcontinue moving higher while Intel falls. For that reason, as with moststrategies, stop-losses, adjustments, and exit plans are encouraged withthe pair trade.
CONCLUSIONSector analysis can improve the odds of finding good trades. A bit of research can help find high-probability situations, or synergies, when thefundamentals and the technicals are moving in the same direction. Fundamentals can provide a better idea regarding the long-term trends in thesector. The technicals can help with the timing. Finally, once an outlookbecomes clear, the strategist can initiate option trades on the appropriatesector fund or index.When looking for trades, use personal experience as a guide. Do youhave special skill or knowledge in technology, medicine, finance, or energy-
ccc_fontanills_221-256_ch11.qxd
Sector Trading
6/30/06
12:27 PM
Page 255
255
related fields? Look around you. Are the homes in your neighborhood selling? Are interest rates moving higher? Are gas prices increasing?In fact, through sector trading, it is possible to build a system aroundnot just the short-term outlook for the stock market, but around life goalsand objectives. Global economic events can and will affect all of us on apersonal level. Taken together, these strategies can help us to make profitsin good times and bad.
ccc_fontanills_221-256_ch11.qxd
6/30/06
12:27 PM
Page 256
ccc_fontanills_257-286_ch12.qxd
6/27/06
8:34 AM
Page 257
CHAPTER 12
Trackingand TradingVolatility
T
here are times when market volatility is high and other times whenvolatility is low. It tends to increase when important and relevantnew information arrives in the market. Sudden unexpected events,like a major terrorist attack, can immediately send the stock market into atailspin, and volatility shoots higher. In contrast, when events are unfolding in a predictable manner, volatility tends to fall or remain low.As a general rule of thumb, if new information causes investors to aggressively buy or sell, volatility increases. Human emotion can serve todrive volatility to extremes. During times of little or no new information,however, stock and index prices will exhibit low levels of volatility. In thatcase, human emotion will not have a major impact on volatility.While volatility is often associated with chaos, falling stock prices andloss of wealth, it is not to be feared by the index options trader. There arealways periods of high volatility and other times of low volatility. Thecrash of 1987 was an episode of high volatility, but it was followed by aprolonged period of gradually climbing stock prices and lower volatility.This chapter seeks to help the reader see the profit opportunities in bothmarket environments.
VOLATILITY DEFINEDVolatility is the speed of movement of an investment security. It is veryimportant to options traders because, as we will see, volatility has a257
ccc_fontanills_257-286_ch12.qxd
258
6/27/06
8:34 AM
Page 258
THE INDEX TRADING COURSE
direct impact on option prices. In fact, we wrote an entire book on thetopic. Readers who have enjoyed this book thus far are encouraged totake a look at our previous book, The Volatility Course, as well. It focuses on finding options trading strategies during periods of changingvolatility.Traders use a variety of different tools to view volatility. A simple baror open-high-low-close (OHLC) chart is one such tool. Since the lengthof each bar is determined by the high and low prices of the day, shortbars suggest that the stock is exhibiting low volatility. In that case, thetrading ranges between the daily high and low prices are small. In contrast, when the bars are longer, it means that there is a bigger differencebetween the highs and lows of the day. Therefore, longer bars reflecthigher volatility.Figure 12.1 features an OHLC chart of the PHLX Semiconductor Index($SOX). It shows a gradual move higher in early 2000 followed by a precipitous decline. During the advance, the bars were short and reflected aperiod of low volatility. Then, when the decline in March gathered momentum, the bars became longer, which was a sign that volatility was onthe rise in the semiconductor sector.However, volatility is not simply a development that occurs whenprices fall. Volatility can also be high when prices rise. Since volatility affects option premiums, this is an important concept to understand. Optionpremiums should be higher when the volatility of the underlying index isexpected to be high. This is true regardless of whether the price movement of the index is to the upside or the downside.
FIGURE 12.1 SOX Daily Bar Chart (Source: www.ProﬁtSource.com)
ccc_fontanills_257-286_ch12.qxd
6/27/06
8:34 AM
Tracking and Trading Volatility
Page 259
259
As an example, if the underlying index is trading for $102, a call option with a strike price of 120 will have a higher premium when the index has high rather than low volatility. Why? Because when volatility ishigh, there is a greater chance that the index