PPHSOXRKHRTHSMHXAU
good start. Focusing on those markets with consistent, reasonable volumewill reduce the universe of sector products to a much more manageablenumber. Combining this list with the nine Select Sector funds, the readernow has more than enough tools to work with for trading sectors and industry groups. Next, we want to focus on identifying situations that offerinteresting trading opportunities.
COMBINING FUNDAMENTAL AND TECHNICAL ANALYSISIn order to determine the sector into which money will flow next, investors can use different methods of analysis for research. Fundamentalanalysts will focus more on the economy, the industry, and the earningsprospects of the sector as whole. From there, the analyst might try toidentify the strongest stocks in the best sectors. As an example, if tradersexpect violence in the Middle East to trigger rising oil prices, they mightlook at the energy sector to find bullish option plays and at the airline sector for bearish trades.There are a number of different sources for fundamental research onspecific sectors. Brokerage firms produce regular research reports on industry groups. Independent research companies also do industry-specificfundamental research. Thomson Financial, Zacks, and Standard & Poor’sall provide earnings estimates for specific sectors.
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The technical trader will generally use a different approach to sectorrotation. The most common way is to study charts of the ETFs or indexes.The technical analyst will chart these like a stock and identify trading signals. This might include traditional trading tools such as support/resistance zones and trendlines or signals generated from other indicatorssuch as Volex and moving averages. Basically, the technical analyst is using a number of different industry indexes to see what is happening withinthe market as a whole. Then industry group and stock selection is madeaccordingly.Alternatively, the technical analyst can look at the chart patterns of individual stocks to gauge the strength of the industry group. Chartcraft inNew Rochelle, New York, has been doing this type of analysis for manyyears. In order to find the strongest and weakest industry groups, Chartcraft looks at the percentage of stocks giving buy signals verses the percentage of stocks giving sell signals using point and figure (PnF) charts.They then compute what are known as bullish percents.While Chartcraft uses PnF charts, a similar analysis can be done usingmoving averages or other technical indicators that give concrete buy andsell signals. When an industry group’s bullish percent falls to a low level (30percent or less of the stocks within the industry group are giving buy signals) and begins to rise, it suggests that the industry group was oversold, isnow becoming stronger, and is set to make a move higher. As the bullishpercent continues to rise, trades are placed to the upside. In contrast, whenthe bullish percent reaches a high level (70 percent or more of stocks in thesector are giving buy signals) and reverses down, it gives a sell signal. Atthat point, the strategist will look for bearish trades on the downside.Basically, to identify areas of strength or weakness, one approach isto look at the breadth within the sector. A trader may ask questions suchas, “What percentage of stocks within the index are above their 50-daymoving averages? What percent are above the 200-day? Are many of thesestocks holding support? Are they falling through resistance?” Table 11.3shows the components of the iShares Biotechnology Fund (IBB) in earlyJuly 2005. Many of these stocks were beginning to rise above their 50- and200-day moving averages. This was a sign that the sector was buildinglegitimate momentum that could continue.A final, less commonly used method of industry group analysis is quantitative in nature. Some firms use models to rank industry groups based onearnings prospects, ratios, price momentum, or other variables. The numbers are plugged into a formula and sectors are ranked based on the results. Perhaps the most well-known tool is the Value Line InvestmentSurvey ranking system discussed in Chapter 10. This widely used model isapplied to both stocks and industry groups. It can be ordered from ValueLine (www.valueline.com) but is also available in many libraries.
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TABLE 11.3 IBB Components and Moving AveragesIBB Component
Symbol
50-Day
200-Day
AmgenGenzymeMedimmuneGilead SciencesChironBiogenThe Medicines Co.Amylin PharmaceuticalsAffymetrix
AMGNGENZMEDIGILDCHIRBIIBMDCOAMLNAFFX
YesYesYesYesYesYesNoYesYes
YesYesYesYesYesNoNoYesYes
Many traders use a combination of fundamental, technical, and quantitative analysis to study specific groups or sectors. The idea is to find theareas of the market that are likely to see the greatest strength for bullishtrades and the greatest weakness for bearish ones. This type of analysiscan help considerably in stock selection. History has demonstrated thatthe price movement of an individual stock is often due to changesthroughout the broader sector or industry group—not just within the company. Let’s consider some examples that combine fundamental and technical analysis to find option trading strategies within specific sectors.
Example: Combining Fundamentaland Technical AnalysisSemiconductors often lead the technology sector and experience boomand bust cycles. The reason is that chip manufacturers adjust productionbased on demand (new orders). Good times lead chip makers to spendheavily on capital equipment and production. Then, when demand forsemiconductor chips slows, they are faced with overcapacity and inventory buildups. A glut of chips hits the market and semiconductor pricessink. This is a repetitive pattern that often leads to reductions in excesscapacity within the chip industry. Then, when demand picks up, chip makers are forced to ramp up production and increase capacity. The industrybooms once again.So good times in the chip sector often lead to a hangover, but the badtimes are always followed by something good. In early 2003, for example,the sector had suffered a relentless bear market. From March 2002 to February 2003, the Semiconductor HOLDRs (SMH) suffered a grueling 55 percent decline. Nobody wanted to trade the chip stocks.Yet in early 2003, some signs surfaced that improvement in the industry was under way. Moreover, expectations were building for a recovery.
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FIGURE 11.6 SMH Daily Chart (Source: ProﬁtSource.com)
On February 6, 2003, Semiconductor Industry Association (SIA) PresidentGeorge Scalise noted in a press release:The recovery that began in the final quarter of 2001 continuedthroughout 2002, producing 1.3% growth in this turnaround year.This is remarkable performance, in the face of lackluster demand inthe Information Technology market. We expect further improvementacross broad product sectors, positioning the industry for 19.8%growth in 2003, increasing revenues to $169.3 billion.*So expectations were building for a recovery in the sector. Other statistics confirmed the situation was improving. The semiconductor bookto-bill ratio was well off its 2002 low, indicating that demand forsemiconductor equipment was on the rise. Meanwhile, dynamic randomaccess-memory (DRAM) chip prices, which had plummeted in the previous two years, were beginning to hold steady. In sum, there was somefundamental evidence to suggest that the worst might be over for semiconductor companies early in 2003.On the technical side of the analysis, the trader notes that by March2003, the Semiconductor HOLDRs had moved off of their lows and onMarch 13, the ETF made a high-volume break of its 50-day moving average(see Figure 11.6). The selling had already abated and the SMH was drifting
*“Global Chip Sales Up 1.37% in Recovery Year,” Semiconductor Industry Association press release (www.sia-online.org), February 3, 2003.
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higher. The high-volume break of March 13 confirmed that chip stockswere gathering upside momentum.Faced with this bullish scenario, the strategist establishes a bull callspread in anticipation of a move higher in the Semiconductor HOLDRs during the next six months. On March 14, the strategist buys 10 August SMH25 calls for $2.75 a contract and sells 10 August 30 calls for $1.25. The totalcost of the trade is $1.50 per spread, or $1,500 total (10 contracts  $1.50 100) plus commissions.Ideally, the SMH will climb higher and the long call will increase invalue. The short call will increase in value as well, but not as quickly asthe long call because its delta is roughly half the delta of the long option.At the time of initiation, the SMH August 25 call option has a delta of 0.5,compared to 0.28 for the August 30 call.The risk graph of the trade appears in Figure 11.7. The total cost of thetrade is $1,500, which also represents the maximum risk. This would occurif SMH remained below $25 a share through expiration and the strategisttook no action—all of the calls would expire worthless. The maximumprofit for the position is equal to the difference between the two strikeprices minus the debit, or $3,500 [(5 – $1.50)  10  100]. The strategist isrisking $1,500 to make $3,500. The key to success is an SMH move higher.Shortly after the trade was initiated, many of the chip stocksstarted reporting earnings that topped expectations. Intel Corporation
FIGURE 11.7 SMH August Bull Call Spread (Source: www.Optionetics.comPlatinum)
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(INTC), the world’s largest chip maker, said in mid-April that first quarter earnings totaled 14 cents a share on revenues of $6.75 billion in thefirst quarter. Analysts were expecting INTC to earn only 12 cents ashare on sales of $6.7 billion. Other chip companies also beat expectations, which confirmed that fundamentals in the sector were improvingfaster than most investors believed, and validated the bullish sentimentof the trader.By early June, the Semiconductor HOLDRs were trading well abovethe strike price of the August 30 call and the objective had been met, a bitsooner than expected. On June 4, the SMH was trading for $30.92. Thelong call was bid for $6.40 and the short was offered at $2.95. The spreadcould therefore be closed out for $3.45 ($6.40 – $2.95) and well above the$1.50 paid at initiation. The result was a $1.95 profit per spread or $1,950for 10 contracts ($1.95  10  100).This example illustrates how traders can use a combination of fundamental and technical analysis to identify an anticipated direction for a sector and then use options to create a favorable risk/reward scenario basedon that outlook. Although we used fundamental factors related to semiconductor stocks, the same analysis can be done for other sectors including banks, biotechnology, Internet stocks, and so on. Readers shouldconsider what industries naturally interest them and where they mighthave special knowledge or experience. The goal is to understand the longterm fundamental trends that affect the sector, and then use technicalanalysis to aid in the timing of the entry and exit. The final step is to createattractive risk/reward situations using option strategies on the sectorindex or ETF.
TRADING OILEnergy prices surged to record highs in 2005. While some market watchers consider the recent rally in the black gold to be part of a great bigspeculative bubble, others believe it is justified and based on the forces ofsupply and demand. Regardless of what side you take in the bull/bear oildebate, there are ways to profit from the next move in oil without havingto trade crude or crude oil futures.There are several indexes that track groups of energy related stocks.For example, the AMEX Oil Index ($XOI) consists of a dozen major oilcompanies. The CBOE Oil Index ($OXI) includes 15 large and widely heldintegrated oil companies. The CBOE also lists options on the PowerPacksOil Index ($POY), which consists of 25 major oil companies.The PHLX Oil Service Index ($OSX) is among the more actively
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traded sector indexes. It consists of 15 oil drilling companies. Figure 11.8shows the close correlation between the OSX and crude oil spot prices.The CBOE also lists an oil drilling index—the PowerPacks Oil Service Index ($PVO)—which includes 25 different companies. The InternationalSecurities Exchange (ISE) launched options trading on a group of sectorindexes in 2005, which includes the ISE Oil and Gas Services Index($OOG). Investors can also trade options on the Morgan Stanley Oil Service Index ($MGO).Instead of trading options on cash indexes, exchange-traded fundscan be used to play trends in the oil markets. For example, the Oil Service HOLDRs (OIH) is a fund that includes a basket of oil drilling companies. It is similar to the PHLX Oil Service Index and will perform in a likemanner. However, since it is a fund, shares can be bought and sold in themarket like shares of stocks. In addition, the options settle for shares andnot cash like the OSX, MGO, and other indexes. The Select Sector EnergyFund (XLE) has also become a popular trading vehicle. This ETF holdsall of the energy-related stocks from within the S&P 500 Index ($SPX).Options on this fund are among the more actively traded energy-relatedsecurities.The Pengrowth Energy Trust (PGH) is another option for traders.This stock is actually a Canadian trust with shares listed on both theToronto Stock Exchange and the NYSE. It holds various oil and gas reserves and pays out regular distributions to shareholders based on revenues minus operation costs and expenses. The trust currently kicksout an annual dividend of almost 10 percent. Shares can be bought andsold like stock, and given the recent rise in oil and gas prices, PGH options
FIGURE 11.8 Oil Service Index and Spot Crude Oil Prices (Source: www.ProﬁtSource.com)
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have also been seeing a bit more volume lately. Traders need to understand both the characteristics of a trust and the impact high dividendshave on options prior to implementing such strategies on this type ofsecurity.Natural Gas PlaysNatural gas prices rose to record highs in 2005. Prices tend to rise alongwith crude oil prices. Historically, the conversion from oil to natural gas isroughly ﬁve to one. So if oil is around $50 a barrel, natural gas pricesshould be around $10 per million British Thermal Units (BTUs). Unfortunately, index strategists looking to play trends in the natural gas sectorhave few choices. The AMEX Natural Gas Index ($XNG) is one choice, butthe options see relatively little trading activity and volume—it’s not veryliquid. Instead, strategists will probably want to focus on the individualcompanies in the sector. Table 11.4 shows the components of the NaturalGas Index.
TABLE 11.4 XNG ComponentsCompany Name
Symbol
EOG Resources
EOG
Burlington Resources
BR
XTO Energy
XTO
Questar Corp.
STR
Anadarko Petroleum
APC
Williams Companies
WMB
Apache Corp.
APA
Noble Energy
NBL
Kinder Morgan
KMI
Natl Fuel Gas
NFG
El Paso Corp.
EP
Nicor Inc.
GAS
Pogo Producing
PPP
Devon Energy
DVN
Nisource Inc.
NI
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Overall, traders have many choices today when looking for tools forplaying trends related to oil. In addition to the indexes and ETFs, a newoil-related trading vehicle might soon be available to traders. Victoria BayAsset Management filed to launch an ETF that would track the price of oil.Called the U.S. Oil ETF LP (USO), it would hold futures contracts oncrude oil, the first fund of this kind. If approved, it would allow investors aunique trading vehicle for playing changes in crude oil prices. For now,however, index traders play the crude oil markets through ETFs and cashindexes that track a basket of energy-related stocks. From a liquiditystandpoint, the XLE, $OSX, and OIH are the three best choices.As an example, let’s assume that energy prices continue rising and webegin to feel the pinch from rising gasoline and natural gas prices. The situation is taking a toll on consumer spending and the economy, but theprofits of the oil drillers are surging. Meanwhile, the OSX has been rallyingand, after a brief pullback, broke above the upper Volex Band, signalingbullish momentum is building (see Figure 11.9).As a result, the strategist expects the OSX to rally and decides to sellsome premium on the index, in order to bring in some income and helpoffset the rising expense from filling up the Hummer with $2.25/gallongasoline. In late July the OSX is trading near 161.25 and the strategistsells 10 of the OSX September 165 puts for a credit of $8.20 per contract.To limit the risk, the strategist buys 10 of the OSX September 155 putsfor $3.50.What type of trade is this? It is a bull put spread. It will generateprofits if the OSX rises above the higher strike put and all the contracts
FIGURE 11.9 OSX Breaks Out (Source: ProﬁtSource.com)
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FIGURE 11.10 OSX Bull Put Spread Risk Graph (Source: www.Optionetics.comPlatinum)
expire worthless. Figure 11.10 shows the risk graph of the trade. In thiscase, the strategist would keep the premium or the credit from sellingthe spread, or $4.70 per contract. That is the maximum possible gain.The maximum risk is equal to the difference between the two strikeprices minus the credit, or $5.30 per spread. The biggest loss would occur if the OSX falls. For instance, at expiration, if the OSX September155 put is in-the-money, the strategist might get assigned and then usethe long put to cover. At that point, the cost to cover the spread wouldbe $10 per spread minus the credit received ($4.70), for a total cost of$5.30 a spread.However, the OSX was selected for this credit spread rather than theOil Service HOLDRs (OIH) or another ETF because of the European-styleexercise feature. Recall that early assignment is a risk only with Americanstyle options. In addition, if the position begins turning south, the strategist can exit the position prior to expiration and avoid suffering themaximum possible loss. In this case, however, the analysis was correctand the OSX did finish well above 165 at September option expiration (seeFigure 11.11).
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FIGURE 11.11 OSX Rally Following Volex Breakout (Source: ProﬁtSource.com)
THE YELLOW METALGold has been considered a safe haven during times of market volatility formany years. It is used to store value, and during inflationary periods, as investors turn to gold for safety, it has a tendency to increase in price. Forthat reason, during times of inflation, which can cause stocks and bonds tofall, gold and shares of gold mining companies often perform well.Other factors will also influence the price of gold. Since it is dollardenominated, the price of gold may decline when the dollar strengthens.Consumer demand for jewelry also affects the supply and demand forgold. Finally, the price of gold will also feel the effect from trends relatedto foreign central bank sales. In recent years, many banks have been bigsellers of gold. However, the pace of central bank selling is expected toslow. An August 17, 2005, report in the Wall Street Journal notes that:The dearth of central-bank gold sales in coming months is alsoboosting analysts’ predictions of higher short-term prices. According to UBS figures, total gold sales for the first year of the renewedEuropean Gold Sales Agreement total 494 metric tons (543 shorttons), leaving just six tons to sell in the six weeks before the September deadline. Under the 2004 agreement, 15 European central banksagreed to limit annual sales to 500 tons over a five-year period.*
*Emily Parkinson, “Gold May Extend Its Bull Run Amid Oil Rally, Few BankSales,” Wall Street Journal, August 17, 2005.
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FIGURE 11.12 XAU and Spot Gold Figure (Source: www.ProﬁtSource.com)
Gold and the DollarOne factor to consider when studying the performance of the gold and silver mining index is the U.S. dollar. There is an inverse relationship between the price of the precious metal and the US currency. Indeed, thechanges in the price of the yellow metal are often attributed to thechanges in the dollar. Consider this excerpt from a Dow Jones Newswiresreport: “Precious metals were trading mostly higher late Wednesday, withgold futures showing themselves to once again be slaves to currency ﬂuctuations, devotedly shadowing moves in the euro, traders said.”*
An entire book could be written on trading this precious metal. Wedon’t attempt to know and predict everything about the short-term swingsin the price of gold. Instead, we look to profit from the longer-term trendsand changes in volatility. With this goal in mind, one of the best ways totrade trends in the gold market is with the PHLX Gold and Silver MiningIndex ($XAU). This index tracks the performance of a basket of gold andsilver mining stocks.As a general rule, when the precious metal rallies, XAU climbs higher,but when gold falters, the index performs poorly. Figure 11.12 shows theclose correlation between the XAU and spot gold prices. Another thing wenotice about the XAU is that it tends to develop trends that last between sixand nine months. Chapter 7 provided examples of straddles and strangles*David Bogoslaw, “NY Precious Metals Mostly Up Late, Firmer USD Caps Gold,”Dow Jones Newswire, August 1, 2001.
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on the $XAU, which is a strategy that makes sense when gold prices areexpected to trend higher or lower for several months or years.
REAL ESTATE AND REITSThere are not too many ways to play trends in the real estate market, butstrategists looking to profit from potential movement might consider looking at the iShares Cohen & Steers Realty Majors Index Fund (ICF). Thisfund holds a basket of real estate investment trusts (REITs) and investorscan buy and sell shares throughout the trading day similar to stock. In addition, the options contract for this underlying security has become moreactively traded in recent years. Therefore, strategists can also place tradeson the real estate sector with ICF options.The ICF holds the same REITs as the Cohen & Steers Realty MajorsIndex ($RMB), which includes a diversified set of 30 different REITs. Realestate investment trusts are investment vehicles with shares listed fortrading on the U.S. stock exchanges, and each trust invests in a differenttype of real estate property.While some REITs hold mortgages, others focus on commercial properties such as shopping malls and office buildings. There are also REITsthat focus on apartments and other residential properties. Investors buyREIT shares when they expect real estate prices to remain strong. However, when investors expect the real estate market to face tough times,they are more inclined to sell REITs.The ICF allows investors to buy and sell a basket of REITS. Table 11.5
TABLE 11.5 ICF ComponentsREIT
Symbol
Real Estate Holdings
Percent of Fund
Simon Property Group
SPG
Regional mall
8.4
Equity Ofﬁce Properties Trust
EOP
Ofﬁce
8
Vornado Realty Trust
VNO
Ofﬁce
6.6
Equity Residential
EQR
Apartment
5.9
General Growth Properties
GGP
Regional mall
5.7
Public Storage
PSA
Self storage
5.2
Boston Properties
BXP
Ofﬁce
5
Archstone-Smith Trust
ASN
Apartment
4.4
Kimco Realty
KIM
Shopping center
4.4
ProLogis
PLD
Industrial
4.3
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shows the fund’s top 10 holdings in 2005. At that time, the largest trust, accounting for more than 8 percent of the value of the fund, was the SimonProperty Group (SPG), which holds mostly shopping malls (column 3).Other REITs hold office space, apartments, storage, or industrial buildings.In 2005 there was a lot of talk about a potential real estate bubble fueled by rock-bottom mortgage rates. Nevertheless, the ICF rose 11 percent on the year. However, for strategists looking for protection against apotential real estate debacle, this fund might be a suitable trading vehicle.For example, strategists expecting trouble in coming years might considershorting the fund or using options strategies like bear put spreads, strangles, or put ratio backspreads.
FINANCIALSAs of this writing, the financials account for the largest percentage of theS&P 500 Index—nearly 20 percent, or one-fifth of the value of the index. Itis therefore an important sector worth tracking. Movements in the financials can easily affect the market as whole, including the major averagestracked by various market participants. An easy way to track the sector iswith the Select Sector Financials (XLF), which holds all of the financialstocks from within the S&P 500 Index.In Chapter 7 we showed an example of a collar strategy on the XLF.Now suppose, however, we have turned bearish on financials. In particular,our outlook for commercial banks has turned a bit pessimistic because weare concerned about the interest rate environment (see the accompanyingbox regarding the inverted yield curve). As a result we are looking for bearish trades on the PHLX Bank Sector Index ($BKX). We could also use theXLF, but this ETF includes brokerage firms and insurance companies. Ourfocus is more clearly defined: We are betting against the banks.Inverted Yield CurveAn inverted yield curve occurs when the yield on short-term governmentsecurities exceeds the yield of long-term securities. In this environment,commercial banks can struggle because a lot of their business comes fromlending at long-term rates and borrowing at shorter-term rates. In late2005 the yield curve was inverting, and that did not bode well for bankstocks going into 2006.
Meanwhile, the technical action of the BKX suggests that the timing isright for a bearish trade. After a precipitous advance, the BKX hits resistance
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at the 106 level (see Figure 11.13) and then falls through trendline support.Volatility appears to be gathering momentum to the downside. Faced withbearish fundamentals and technicals, the strategist decides to set up a bearish trade on the BKX, but doesn’t want to risk too much capital in the eventthat the interest rate environment improves and the banks stage anotherrally. Consequently, the strategy of choice is a put ratio backspread.In late December 2005, the strategist has a price target of 90 for the BKXand expects the index to hit that level no later than March 2006. The index iscurrently trading near 104, so the expectation is for a first quarter decline ofapproximately 15 percent. In order to profit from the weakness in the banksector, the strategist sets up a one-by-two put ratio backspread (a positioncovered in more detail in Chapter 7). Specifically, one June 105 put is sold for$4 a contract and two June 97.50 puts are purchased for $1.50 each.Since the premium for the put sale is greater than that of the put purchases, the trade is established for a net credit of $100: [$4.00 – ($1.50  2)] 100. If the BKX rallies above 105, all of the puts expire worthless and thestrategist retains the credit. However, as we can see from Figure 11.14, bigger profits are possible if the bank index falls. The sooner the index falls,the sooner the trade will begin to see profits. The maximum profits aresizeable if the BKX really tanks. However, if it falls to only 97.50 at expiration, the strike price of the long puts, then the trade loses. At that point, thelong puts expire worthless and the short put has an intrinsic value of $7.50a contract and represents the maximum risk of $650 [($7.50 100) – $100initial credit] for the strategy.In the bank example we are betting against the market, which is always dangerous to do considering the stock market moves up roughlytwo-thirds of