track record.Just be mindful of the overall trend; and if the small-caps continueto dominate, factor that into your approach to the two portions ofthe January-effect spread.
Gold Stocks versus the Price of GoldThere are some stocks whose price is related to a raw material that isextremely important to the company’s financial fortunes. Among the
INTERMARKET SPREADS
409
raw materials that fall into this category are gold, oil, copper, and fertilizer. In certain cases, an intermarket spread strategy can be devisedwherein the stock(s) are traded against futures on the pertinent commodity. The intermarket strategy could be as simple as trading copper futures against Phelps Dodge stock (Phelps Dodge is a majorcopper producer); or it could be a little more complicated, such astrading an index of stocks—if a sector index, in fact, exists—againstthe futures contract. This latter strategy is a useful one; and since theindex provides some measure of diversification, it is probably a morereliable strategy than merely trading one stock against the futures.In order to trade the index, you could either buy the appropriatenumber of shares of each stock in the index or use options on theindex, if there are listed options trading. Usually, using options ismuch simpler because you can get “long” or “short” the index veryquickly and easily, as opposed to executing trades in all the stocksthat compose the sector index. Moreover, the capital required for theoption transaction would be much smaller than that required to buyall of the stocks in the index.Furthermore, when trading options on the index, there are twoapproaches that you could take as well. The first would be to use theequivalent strategy described at the beginning of Chapter 3. Forexample, if you wanted to be long the sector index, you could buy acall and sell a put—both with the same striking price and expirationdate—as a total substitute for owning the index. When using thisapproach, you have the full upside potential and downside risk of theindex. The second would be to merely buy a call on the index; thismeans that you would have limited downside risk, but you wouldhave risk of time value eroding your option.Now that we have discussed all those possibilities, it’s time tolook at one of these intermarket spreads. It is the one between theprice of gold (futures) and the price of the PHLX Gold and SilverIndex (symbol: $XAU). Figure 5.12 is an approximation of how thisspread has looked over a thirteen-year period, from 1991 through2003. The purpose of this chart is to demonstrate that the relationship between the price of gold stocks and the price of gold itself canchange dramatically over time. When you are actually trading theintermarket spread itself, you usually are interested in shorter-termmovements than those shown on this broad chart.
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TRADING SYSTEMS AND STRATEGIES
Nevertheless, the chart is useful. Note that, as the 1990s began,the price of gold stocks (XAU) was about 30 percent of the price ofDec gold futures (30 on the chart). At the time, that was historicallyexpensive. Then, both gold and gold stocks went into a prolongeddecline in 1990, and the ratio plunged. In fact, gold stocks wentdown farther than gold itself, as the XAU index dropped over 50percent from its early 1990 levels, while gold declined about 20 percent. This caused the ratio to eventually drop to levels near 20 on thechart in Figure 5.12.An opposite move occurred in 1993, as both gold and goldstocks blasted off to the upside, with the XAU doubling in price, butgold only gaining about 25 percent. Thus, the ratio moved higheronce again, peaking near 35 at the beginning of 1994. As you cansee, when major moves occur, XAU moves farther than gold becauseit is a more volatile item. So, when both the XAU Index and gold are
Figure 5.12$XAU DIVIDED BY DEC GOLD FUTURES
2
135
3
Ratio
30
(4)25
(B)20
a b
e
cd
1592
93
94
95
96
97
98
99
00
01
02
03
INTERMARKET SPREADS
411
moving together, we generally would not be looking to establish anintermarket spread. However, when one of them is moving and theother is not, we may have an interesting opportunity to establisha position.The 1993 –1995 period is a classic case in point. During thattime, gold itself was quite stable, remaining in a very narrow rangebetween about 375 and 410. However, gold stocks, which apparently are more subject to investors’ emotions, had some fairly bigmoves. This caused the action on the chart in Figure 5.12 wherebythe ratio peaked in the 33-to-35 area three times, only to declineeach time and bottom below 30. These ranges are tradeable via anintermarket spread.
Beginning in February 1995, many institutional investors, money managers, and advisors began to espouse gold stocks as an investment. As aresult, the XAU Index rose from just under 100 to over 130. During thatsame period, gold futures rose about $10, from 380 to 390. This causedthe ratio to move from about 24 to 33. Clearly, this was a sign that the twowere out of line, because there was not a real direction apparent in the priceof gold—the gold stocks were moving on their own. When this type ofaction occurs, the intermarket spread is attractive.Since it was the XAU that was “ahead” of gold, the proper intermarketspread was to buy gold futures and short the XAU (or buy puts on XAU).The strategy worked quite well, as gold remained quite stable; but goldstocks eventually gave up much of their gains, with the XAU falling backto below 110. The ratio simultaneously fell back toward 28, and the spreadproduced nice gains.
What made this situation an ideal one for establishing an intermarket spread was that only one of the two components was moving—the XAU, which was rising—while the other was relativelystable. When you see that situation in these related markets, thenyou have to figure that either (1) the gold stocks will fall back to getmore in line with the price of gold (and that’s what eventually happened in our example), or (2) the price of gold will rally to catch upwith the move in gold stocks.
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TRADING SYSTEMS AND STRATEGIES
As a means of describing the details behind setting up one ofthese types of intermarket spreads, we’ll use the same example.Before looking at specific prices, however, we must introduce theformula necessary for equalizing two different trading vehicles ontwo different markets. This formula gives us the ratio of contractsthat we need to trade to have a market neutral spread, one that willcapture the true movement of the two indices. It was not necessaryto use such a formula for the previously discussed intermarketspread (unleaded gas versus heating oil, and Value Line versus S&P500) because those markets were very closely related; in fact, theyare almost identical. However, when the relationship is looser, thenthe formula is necessary for determining how many contracts to buyand sell.Intermarket quotient =
Price1 Unit1 Volatility1 Delta1×××Price2 Unit 2 Volatility2 Delta 2
where Pricei = the price of the contractUniti = the trading unit of the contract (for example, $100per point, or $500 per point, etc.)Volatilityi = the actual (historical) volatility of the contractDeltai = the delta of the options being used in the spread, ifoptions are in fact being usedOnce you plug the various variables into this formula, the quotient will tell you quite simply how many of one contract to buy foreach one you sell. Thus, it is the basis for every intermarket spread.
Continuing with the situation in Figure 5.12, the following prices existed inmid-September 1995:XAU Index: 126.62Dec gold futures: 389.70In keeping with the overall philosophy of trying to use options in theseintermarket spreads, unless the options have too much time value premiumin them, the following option contracts looked attractive at the time:
INTERMARKET SPREADS
Option
Price
Delta
XAU Dec 135 put:Gold Dec 380 call:
1211.50
0.710.78
413
The time value premium of the put is 3.62, while the time value premium of the call is 1.80. Thus, the total time value expenditure is 5.42,somewhat hefty, but not unreasonable considering the rapidity with whichthis ratio can move. Also, remember that using the options gives you theextra chance to make money if prices move a great deal in one direction orthe other, even if the intermarket spread itself doesn’t converge.At the time (mid-September 1995) the 20-day historical volatility of theXAU Index was 27 percent and the same volatility for Dec gold futures was7 percent (that was an extremely low reading for gold, but it had been veryquiet for a long time). Finally, the trading units of both options were thesame: a one-point move was worth $100. So, we now have everything weneed in order to compute the quotient, using the previous formula.
Intermarket quotient =
126.62 100 27% 0.71×××= 1.14389.70 100 7% 0.78
This means that you should trade 1.14 Dec gold contracts for eachXAU contract that you trade. Ironically, this quotient is very nearly equal toone, when small quantities are involved, so most traders would just buy onegold Dec 380 call for each XAU Dec 135 put that they buy. However, iflarger quantities are involved, you should adhere to the ratio (for example,buy 114 Dec gold calls and buy 100 XAU puts).Finally, about five weeks later, the price of gold stocks had retreatedsubstantially, as there was no confirmation from the price of gold itself, andholders of those stocks were getting nervous. The price of gold had fallenslightly, but the price of the XAU had declined rather dramatically. Thus,the spread had performed as expected—the price of XAU had moved back“into line” with the price of gold:IndexXAU Index: 108.08Dec gold: 383.80
OptionDec 135 put: 27Dec 380 call: 5.00
The option combination was now worth a total of 32 points, as compared to the initial price of 23.50 points—a profit of $850 per combo.
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TRADING SYSTEMS AND STRATEGIES
In the preceding discussion, the prices of the underlying itemsbeing spread were not volatile during the time the position was held,yet the option strategy made money anyway when the prices converged. This demonstrates that by using the option strategy, you canprofit if the two markets converge, as long as the time value expenseof the options is reasonable when the spread is established. As forentry points, I would look for peaks or valleys in the ratio betweenthe XAU and the price of gold futures. The peaks are most significant above 30 percent and the valleys below 25 percent.These points can be seen in Figure 5.12. The numbers 1, 2, and3 are all areas where one would sell gold stocks and buy gold futures.Number 4 might be as well, since it is the highest point in recentyears, but it is quite a ways below the 1993–1997 peaks. This showsthe dynamic nature of the spread— once again, it’s not necessarilythe absolute level of the ratio that’s important, but where the ratiopeaks. Points A through E are local minima on the chart and aregood entry points for the opposite hedge: buying the XAU stocksand selling the gold futures. These all occurred below the 20 level onthe chart; but point B was a local minimum at a higher level, and itwas also a good entry point for such a spread.These examples demonstrate that the spread between the XAUIndex and the price of gold (futures) is a viable one to trade. The bestopportunities arise when one market is relatively stable and the othermarket makes a substantial move. I would avoid the spread whenboth markets are trending strongly, for that is when the movementsin XAU are more pronounced than those of gold.
Oil Stocks versus the Price of OilGiven that you can trade the gold stock index versus gold futures, itshould come as no surprise that a similar situation might arise withrespect to oil stocks and oil futures. The AMEX trades listed optionson the Oil and Gas Sector Index (symbol: $XOI), and, of course,there are futures that trade on crude oil. Once again, the relationshipbetween these two markets is not exact, and the best opportunities
INTERMARKET SPREADS
415
arise when one market makes a move that is not matched by theother one.In 1990, the ratio had dipped due to the price of oil skyrocketingduring Iraq’s occupation of Kuwait. Oil stocks did not follow suit atthat time. Actually, as it turned out, that was a tremendously goodtime to buy the oil stocks and short crude oil futures. Of course, hadIraq destroyed the Mideast oil fields and thereby sent the price of oilskyrocketing, I’m not sure that oil stocks would have followed.Figure 5.13 is the chart of the XOI Index divided by the price ofcrude oil futures over several years. It shows that oil stocks had generally been rising while the price of oil remained fairly constant—especially in 1993. If you had attempted to establish the intermarketspread during this time period, you would probably not have beensuccessful unless you used options. In 1994 and 1995, the spreadhad established a new trading range between 150 and 175 on thechart. Thus, at this time it was possible to trade the spread itself andmake a profit, without necessarily having to rely on price volatility.
Figure 5.13$XOI DIVIDED BY DEC CRUDE OIL FUTURES: 1992–1995
416
TRADING SYSTEMS AND STRATEGIES
In September 1993, there was a period when oil stocks advanced and crudeoil actually declined. On the chart in Figure 5.13, this is just a part of theoverall advance that you see in 1993. However, in Figure 5.14, you cansee how there was an upward “bubble” in September, even while the graphwas generally trending higher. At the time, it seemed like an illogical marketmove, so I established the intermarket spread at the following prices:XOI Index: 260XOI Oct 265 put: 8
Nov crude oil futures: 17.38Crude Nov 17 call: 0.84
The anomaly between the two markets was receiving some attention inthe press, and several analysts said that they felt that oil stocks were probably ahead of themselves and should be sold. Option traders might logicallytranslate that kind of statement into an opportunity to buy puts on the XOI.However, knowing that these things have a tendency to move in ways thatyou don’t read about in the newspaper, I felt the intermarket spread wasbetter. So I not only bought the XOI puts, but I also bought an equal number of the crude calls.
Figure 5.14$XOI DIVIDED BY DEC CRUDE OIL FUTURES: 1993
150
Ratio
140
130
120
93 F
M
A
M
J
J
A
S
O
N
D
INTERMARKET SPREADS
417
At first, oil stocks did decline. And to make matters even better, crudeoil began to rally as well. However, the rally by crude oil eventually causedthe oil stocks to rise as well, and they rallied even more than crude oil did.So, whatever factors had made investors buy oil stocks in the first placewere only exacerbated by the rally in crude oil.By early October, the following prices existed:XOI Index: 273XOI Oct 265 put: 2
Nov crude oil futures: 18.90Crude Nov 17 call: 2.13
Fortunately, the rallies in both markets were rather substantial, so thatthe crude oil Nov 17 calls rose quite a bit and made the whole position profitable, even though the XOI puts lost most of their value. The crude callsmade 1.19 ($1,190), while the XOI puts only lost six points ($600).
This example is a good illustration of how the use of options inthe spread can produce a profit where one would otherwise not haveexisted. Not only did the intermarket spread not converge (exceptfor the initial move), but the “conventional wisdom” of buying XOIputs was wrong also. Thus, while it is probably safer to trade thesespreads in nontrending markets (such as the 1994–1995 timeperiod as shown in Figure 5.13), it is still possible to trade them profitably if you use the option strategy as an integral part of your intermarket spreads.Now, consider Figure 5.15, which shows the ratio over a muchlonger period—12 years. What had appeared to be a strong upwardmove in the 1992–1995 time frame (Figure 5.13) was completelydwarfed by what happened from about 1996 through 2000—oilstocks (being stocks, and that time frame being one of the biggestbull markets of all time) drove to a spike peak on the chart at the 360level. Once again, had you tried to establish the spread between oilstocks and crude oil futures, you would have been best served byusing options, as shown in the previous example.From there, the ratio collapsed during the bear market as oilstocks fell into late 2002. Another rally on the chart ensued as stocksrallied, but then the ratio dropped back to the lows as crude oil ralliedduring the last half of 2003.The end result is that the 150 level appears to be a tradeable spoton the chart in Figure 5.15 (the trend line shows this). At those
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TRADING SYSTEMS AND STRATEGIES
Ratio
Figure 5.15$XOI DIVIDED BY DEC CRUDE OIL FUTURES: 1992–200336034032030028026024022020018016014012010092
93
94
95
96
97
98
99
00
01
02
03
times, you’d want to buy $XOI (oil stocks) and sell crude oil futures—or buy calls on $XOI and puts on crude oil. Furthermore, with theintroduction of ETFs in recent years, there are a couple of oil-relatedones that might be used instead of $XOI, for its options are ratherilliquid. One is the Oil Service HOLDRS (symbol: OIH), which isacceptable; but Oil Service stocks are not really the same stocks thatare in $XOI. However, there is also an iShares that does have oilsstocks in it—the iShares Dow Jones U.S. Energy (symbol: IYE).In late 2003, with the ratio near the low point seen on the chart in Figure5.15, we wanted to buy oil stocks, or the equivalent, and sell crude oilfutures. We decided to use the iShares for this trade since the options werecheap (in a low percentile of implied volatility). The following prices existed:XOI Index: 470.55
Dec crude oil: 29.17Ratio: 16.13
IYE: 44.7IYE Feb 40 calls: 5.00
Feb crude oil: 28.30Feb crude 30 puts: 3.54
INTERMARKET SPREADS
419
Since it is not intuitive as to what the ratio of IYE calls to crude oil putsshould be, it is necessary to use the formula stated earlier:IYE calls: 43.0 × 100 (shares per option) × 16.5 percent (volatility) × delta (0.80)Crude puts: 28.30 × 1000 (dollars per point) × 32 percent (volatility) × delta (0.75)
Multiplying the crude oil factors and dividing by the multiple of the IYEfactors, we compute a ratio of about 12—12 IYE calls should be bought forevery crude oil put purchased.As it turned out, both markets rallied to the point that the crude oil putsexpired worthless; but the IYE calls made 5.26 points, and the profit wasworthwhile:IYE calls: +5.26 × $12 = +$6,312Crude oil puts: –3.54 × $1000 = –$3,750
Note that, by mid-January (when the Feb crude oil puts expired), theratio between the XOI Index and December crude oil was 19.1. So, notonly did the ratio between the two markets expand, but the volatile, upwardprice movement helped as well. Both factors thus combined to produceabout a $2,500 profit on an initial investment of a little over $19,000 inabout three months—not a bad return at all for a hedged strategy.
Utility Stocks and 30-Year T-BondsTwo other markets that are related are the utility stocks and the longbond futures. Since the utility stocks generally pay rather large dividends, they are interest-rate-sensitive stocks. Obviously, bonds areinterest-rate sensitive also. Moreover, since buyers of the utilities aregenerally investors with a long-term view, these stocks are most sensitive to longer-term interest rates. The bellwether of long-term interest rates is the U.S. 30-year Treasury bond (T-bond). One of themost active futures contracts is the Chicago Board of Trade's(CBOT’s) 30-year bond future, typically called the “long bondfuture.”
420
TRADING SYSTEMS AND STRATEGIES
Figure 5.16 shows the relationship between these two marketsover the years. It is an interesting chart in that it trades in ranges forseveral years at a time, and then the range changes. This has beenparticularly true of the upside of the range, which moved three distinct times over the years (trend lines are drawn to show the ranges).But the bottom of the range was inviolate until 2002, when utilitystocks plunged (spurred by some concerns about the market makingin energy derivatives in which many companies were participating)coupled with a rising bond market because interest rates were falling.This combination of events plunged that ratio to depths never seenbefore. The ratio has since recovered somewhat, but only to barelyabove what used to be the bottom of the range—near the 2.7 level.In early 2004, the ratio stood at 2.83.Another thing that can be noted from Figure 5.16 is that thespread has behaved in a much more volatile pattern since late 1999.What has happened since then? Deflation reared its head, and therewas a general uncoupling of stocks and bonds—even betweeninterest-rate-related stocks and bonds, to some extent. So theratio has bounced back and forth in a much more violent mannersince then.Figure 5.16$UTY DIVIDED BY DEC T-BOND FUTURES
Ratio
35
30
25
2091
92
93
94
95
96
97
98
99
00
01
02
03
INTERMARKET SPREADS
421
But that’s okay, for the intermarket spread trader wants volatilityin the spread—especially if the markets are going to be volatile aswell. Hence, the best strategy seems to be to establish the spread atextremes in the ratio and capitalize when it lurches back in the otherdirection. Of course, if it blasts on through the old level, then youshould probably stop yourself out (unless the underlying prices aremoving very swiftly as well) and wait for a new extreme reading to beestablished.To that end, let’s look at how you might have treated a positionin late 2002, when the ratio smashed down through what had previously been the low end of the range for 10 years. By the way, thebehavior of this spread is an excellent reason why we establishthese positions with options when we can, and not with the underlying themselves—because we can still make money if the underlyings make violent moves, even if the spread itself does not move inour favor.Table 5.3 shows a snapshot of prices of both the Utility Indexand Dec T-bond futures (symbol: @USZ) during this volatile period.From the prices shown, one can see that the Utility Index was plummeting, due to the aforementioned problems, while the T-bondfutures were rallying strongly, both as a flight to quality from the bearmarket in stocks and as a response to the Fed’s continued loweringof interest rates (also a response to the bear market in stocks).About July 10 was the date when the ratio reached its old, historic lows near 2.6. The intermarket spreader might have boughtcalls on UTY and bought puts on USZ at that time, figuring thespread was about to go the other way. However, the ratio smashed
Table 5.3UTILITY INDEX (UTY) VS. DEC T-BONDFUTURES (@USZ)Date
UTY
@USZ
Ratio
7/1/027/10/027/20/028/25/0210/10/02
310270220295225
102.0103.5105.0107.0115.0
3.042.612.102.711.96
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TRADING SYSTEMS AND STRATEGIES
on down through that level, reaching a temporary low at 2.1—butjust 10 days later! In reality, a trader might have stopped himself outof the spread as soon as he saw it drop through the old lows—perhaps at 2.5 or 2.4. But in any case, both sides of the spread werelosers: the calls lost because UTY was falling, and the puts lostbecause USZ was rising. In other words, the relationship betweenthe two entities had become completely unhinged during this time.At least with options, the loss is limited; and assuming that thetrader had bought, say, three- or four-month options to begin with,the loss was not total. If he had established the spread with futuresand EFTs, the loss would have been just as bad as the widening ofthe spread—much worse in terms of points lost in comparison tothe option trade.The trader would probably not have entertained reentering aspread between these two entities until they resumed more normalconsistency—in early 2003. Look once again at the chart in Figure5.16. In early 2003, the ratio made a slightly higher low and thenbegan to rise. Hence, it appeared that as bonds continued to rise inprice, utility stocks were once again rising with them; and the spreadcould be established once again.Finally, it should be noted that the U.S. government intends tostop issuing 30-year bonds. But the 10-year note futures (base symbol: TY) will work equally as well. In fact, any strategy using the longbond futures can still be effectively implemented using the 10-yearnote futures, since the two contracts move very much in concert.In summary, this relationship is not as consistent as the ones previously shown using oil or gold, but it does have some tradeable periods and should be in the arsenal of the intermarket spread trader.
Similar-Sector Index versus FuturesIntermarket SpreadsThere are a few other sector indices that have correlation to thefutures markets. As such, they may be practical for intermarketspreads. One is the Natural Gas Sector Index (symbol: $NGX) andnatural gas futures. This one is a “natural”; but since the index wasonly listed in late 1994, there is not enough of a trading history toconclude what the range of the ratio between the two markets might
INTERMARKET SPREADS
423
be. Any strong move by one market that is not matched by the otherwould be an ideal situation for establishing an intermarket spreadbetween the XNG Index and natural gas futures.Since new sector index options are constantly being listed, youshould keep an eye out for ones that align rather well with listedfutures contracts. Intermarket spreads will probably be viablebetween such markets. This would include ETFs and their options.Many of the sectors covered by iShares or HOLDRS have relationships to futures markets and also have listed options.Moreover, you might watch for relationships between the priceof a commodity and the price of a major stock in that field, if there isnot a sector index or ETF available. For example, take copper. Thereare copper futures and Phelps Dodge (PD) is the major copperstock—a stock that often moves in relationship with the price of thecommodity. Consider Figure 5.17, which shows the relationshipbetween the two. Clearly, you could consider establishing a spread of“long PD calls, long copper futures puts” when the ratio was near theline drawn on the chart—near the 3.0 level. The last time priceswere near that level, in October 2002, PD ran from 26 to above 80,
Figure 5.17PD DIVIDED BY DEC COPPER FUTURES800700
Ratio
60050040030020092
93
94
95
96
97
98
99
00
01
02
03
424
TRADING SYSTEMS AND STRATEGIES
Table 5.4COMPONENTS OF THE MORGAN STANLEY COMMODITYRELATED EQUITY INDEX (CRX)Symbol
Name
Symbol
AAABXADMAHCALAPAAPCBHIBRCAG
Alcoa Inc.Barrick GoldArcher-DanielsAmerada HessAlcan Inc.Apache Corp.Anadarko PeteBaker Hughes Inc.Burlington Res.Conagra Foods
IPMRONEMPDPDGPOTSLBTSNWYX
NameInternational Paper Co.Marathon OilNewmont MiningPhelps Dodge CPPlacer Dome Inc.Potash Corp.Schlumberger Ltd.Tyson FoodsWeyerhaeuser Co.U.S. Steel Corp.
eventually. Meanwhile copper futures doubled in price, moving from65 to 130. This is what one likes to see—prices moving in the samedirection and the ratio widening. But even if the ratio hadn’twidened, an option trader would have still made money since pricesmoved strongly in the same direction. In this case, the calls on PDwould have kept making money, while the puts on copper wouldhave eventually gone to zero and thus stopped losing money. Overall, this spread would have been very successful.In fact, if a trader wanted a list of which stocks respond well toindividual commodity prices, he might look at the stocks comprisingthe CRX Index. This is an index designed by Morgan Stanley to be abasket of stocks that tracks commodity prices well. In fact, there iseven a spread between the CRX Index and CRB futures that can betraded