ollama-model-training-5060ti/training_data/relevant/text/facddbf8e72197a78edb90f0b6181f4f33874ed86f1d95dd746893457ee7e7c8.txt

A summary and concluding comments
We began our study of technical stock chart analysis in
Chapter 1
with a discussion of the
philosophy
underlying the technical approach to the problems of trading and investing. We could ask the reader to turn back now and review those few pages to recapture a perspective on the subject that must have been dimmed by the many pages of more or less arduous reading that have intervened. (For illustrations in this chapter, see Figures
17.1
through
17.4
.)
It is easy, in a detailed study of the many and fascinating phenomena that stock charts exhibit, to lose sight of the fact they are only the rather imperfect instruments by which we hope to gauge the relative strength of supply and demand, which, in turn, exclusively determines what way, how fast, and how far a stock will go.
Remember, in this work, it does not matter what creates the supply and the demand. The fact of their existence and the balance between them are all that count. No man, no organization (and we mean this
verbatim et literatim
) can hope to know and accurately appraise the infinity of factual data, mass moods, individual necessities, hopes, fears, estimates, and guesses that, with the subtle alterations ever proceeding in the general economic framework, combine to generate supply and demand. Nevertheless, the summation of all these factors is reflected virtually instantaneously in the market.
The technical analyst's task is to interpret the action of the market itself—to read the flux in supply and demand mirrored therein. For this task, charts are the most satisfactory tools thus far devised. Lest you become enrapt, however, with the mechanics of the chart— the minutiae of daily fluctuations—ask yourself constantly, “What does this action really mean in terms of supply and demand?”
Judgment, perspective, and a constant reversion to first principles is required. A chart, as we have said and should never forget, is not a perfect tool nor a robot; it does not give all the answers quickly, easily, or positively, in terms anyone can read and translate at once into certain profit.
We have examined and tested exhaustively many technical theories, systems, indexes, and devices that have not been discussed in this book (chiefly because they tend to shortcircuit judgment) to see the impossible by a purely mechanical approach to what is far from a purely mechanical problem. The methods of chart analysis that have been presented are those that have proved most useful because they are relatively simple and easily rationalized since they stick closely to first principles. Additionally, they are of a nature that does not lead us to expect too much of them and they supplement each other and work well together.
Let us review these methods briefly. They fall roughly into four categories:
1. The
Area Patterns
or formations of price fluctuation that, with their concomitant volume, indicate an important change in the supply-demand balance. They can signify Consolidation, a recuperation or gathering of strength for renewed drive in the
same direction
as the trend that preceded them. Or they can indicate Reversal, the playing out of the force formerly prevailing, and the victory of the opposing force, resulting in a new drive in the
reverse direction
. In either case, they may be described as periods during which energy is brewed or pressure is built up to propel prices in
Figure 17.1
Spiegel's Bear Market started in April 1946 from a Symmetrical Triangle that changed into a Descending Triangle. Note the Pullback in June and two Flags. This history is carried on in
Figure 17.2,
which overlaps Figure 17.1; this chart shows the move that ensued from the wide Descending Triangle of early 1947, culminating in a Reversal Day on May 19. Note various Minor and Intermediate Resistance Levels.
Technical Analysis of Stock Trends
Figure 17.2
Overlapping Figure 17.1, this chart shows the move that ensued from the wide Descending Triangle of early 1947, culminating in a Reversal Day on May 19. Note various Minor and Intermediate Resistance Levels.
Chapter seventeen: A summan/ and concluding comments
a move (up or down) that can be turned to profit. Some of them provide an indication as to how far their pressure will push prices. These chart formations, together with volume, furnish the technician with most of his “get-in” and many of his “get-out” signals.
Volume, which has not been discussed in this book as a feature apart from price action, and which cannot, in fact, be utilized as a technical guide by itself, deserves some further comment. Remember it is
relative
that it tends naturally to run higher near the top of a Bull Market than near the bottom of a Bear Market. Volume “follows the trend,” meaning it increases on rallies and decreases on reactions in an overall uptrend, and vice versa. But use this rule judiciously; do not place too much dependence on the showing of a few days and bear in mind that even in a Bear Market (except during Panic Moves), there is always a slight tendency for activity to pick up on rises. (“Prices can fall of their own weight, but it takes buying to put them up” as Edwards said.)
A notable increase in activity, as compared with previous days or weeks, may signify either the beginning (breakout) or the end (climax) of a move, temporary or final. (More rarely, it may signify a “shakeout.”) Its meaning, in any given case, can be determined by its relation to the price pattern.
2.
Trend and trendline
studies supplement Area Patterns as a means of determining the general direction in which prices are moving and of detecting changes in direction. Although lacking the nice definition of Area Formations, they may frequently be used for “get-in” and “get-out” purposes in short-term trading, as well as provide a defense against premature relinquishment of profitable long-term positions.
3.
Support and Resistance Levels
are created by the previous trading and investment commitments of others. They may indicate where it should pay to take a position, but their more important technical function is to show where a move is likely to slow down or end, and at what level it should encounter a sudden and important increase in supply or demand.
Before entering a trade, look both to the pattern of origin for an indication of the power behind the move and to the history of Support-Resistance for an indication as to whether it can proceed without difficulty for a profitable distance. SupportResistance studies are especially useful in providing “cash-in” or “switch” signals.
4.
Broad market background
, including the
Dow Theory
, should not be scorned. This time-tested device designates the (presumed) prevailing Major Trend of the market. Its signals are “late,” but with all its faults (like the greatly augmented following it has acquired in recent years resulting in a considerable artificial stimulation of activity at certain periods), it is still an invaluable adjunct to the technical trader's toolkit.
The general characteristics of the various stages in the stock market's great Primary Bull and Bear cycles, which were discussed in our Dow Theory chapters, should never be lost to view. This brings us back to the idea of
perspective
, which we emphasized as essential to successful technical analysis at the beginning of our summary. The stock that does not, to some degree, follow the Major Trend of the market as a whole is an extraordinary exception. More money has been lost by buying perfectly good stocks in the later and most exciting phases of a Bull Market, and then selling them, perhaps from necessity, in the discouraging conditions prevailing in a Bear Market, than from all other causes combined.
Hence, keep your perspective on the broad market picture. The basic economic tide is one of the most important elements in the supply-demand equation for each individual stock. It may pay to buck “the public,” but it does not ever pay to buck the real underlying trend.
Major Bull and Bear Markets have recurred in fairly regular patterns throughout all recorded economic history, and there is no reason to suppose they will not continue to recur for as long as our present system exists. It is well to keep in mind that caution is in order whenever stock prices are at historically high levels and that purchases will usually work out well eventually when they are at historically low levels.
If you make known your interest in your charts, you will be told the chart analyst (like the Dow theorist) is always late—buying after prices have already started up (maybe not until long after the “smart money” has completed its accumulation) and sells after the trend has unmistakably turned down. Partly true, as you have no doubt already discovered for yourself. The secret of success lies not in buying at the very lowest possible price and selling at the absolute top, but rather in the
avoidance of large losses
. (Small losses you will have to take, and as quickly as possible as warranted by the situation.)
One of the most successful “operators” Wall Street has ever seen, Bernard Baruch, a multimillionaire and a nationally respected citizen today, is reputed to have said never in his entire career had he succeeded in buying within 5 points of the bottom or selling within 5 points of the top! (
EN: For perspective, the 5 points mentioned constituted roughly 10% of the market at that time
.)
Before we leave this treatise on theory and proceed to the more practical matters of application and market tactics that are the province of Section II of this book, the reader will, we hope, forgive one more admonition. There is nothing in the science of technical analysis that requires one always to have a position in the market. There is nothing that dictates something must happen every day. There are periods—sometimes long months—when the conservative trader's best policy is to stay out entirely. What is more there is nothing in technical analysis to compel the market to go ahead and complete (in a few days) a move the charts have foretold; it will take its own good time. Patience is as much a virtue in stock trading as in any other human activity.
Technical analysis and technology in the 21st
century: the computer and the internet: tools of
the investment/information revolution
The purpose of this section is to put computer and information technology into proper context and perspective for chart-oriented technical analysts.
In John Magee's time, in his office in Springfield, Massachusetts, there was a chart room—a room filled with all-age chartists from teenagers to senior citizens. These people spent all their time keeping charts and assisting Magee in interpretation. These were wonderful and intelligent people who developed marvelous insights into the stocks they charted as well as created the manual charts that adorn this book.
Today, that room and all those technicians have been replaced by a beige (sometimes lime) box that sits crowded on our desktops and that is often worshipped as a fount of insight and wisdom: “Computer, analyze my stocks.”
Unfortunately, the computer does not have the discrimination and pattern recognition ability of the people in that chart room. Undeterred by this weakness in computer technology, traders and investors have poured incalculable money and effort into computer-aided research, attempting to discover the keys to market success. More money has been spent in this effort than was ever put into the search for the philosopher's stone. Much of it was wasted, but it has not all been spent in vain. In some areas, it has been quite productive. But no fail-safe algorithm, in spite of all this effort, has been found for investment success, and certainly not for stock trading. The research
has
demonstrated that even the algorithm of “buy low, sell high” has fatal flaws in it.
To fully understand the importance of the computer, the reader should appreciate some basic differences in participants' approach to the markets, or, we might say, schools of analysts and investors. We will not bother with fundamental analysts here, as they are of a different religious persuasion. Chart analysts, or Magee-type technical analysts, pretty much confine their analysis of the market to the interpretation of bar charts. (This does not mean their minds must be closed to other inputs. On the contrary—anything that works.) Another chart analyst school uses point and figure charts, and another candlestick charts. Another breed of technical analysts takes basic market data, price and volume, and uses them as the input to statistical routines that calculate everything from moving averages to mystically designated indicators like %R or Bollinger Bands (see Glossary); they are known as statistical or number-driven technical analysts. All these analysts attempt to invest or trade stocks and other financial instruments (not including options) using some form of what is called technical analysis—that is, they all take hard data that people cannot lie about, misrepresent, and manipulate, (unlike the data inputted to fundamental analysis like earnings, cash flow, sales, etc.) as input to their analysis.
Using number-driven or statistical technical analysis, these latter schools attempt, just as chart analysts do, to predict market trends and trading opportunities. This can be more than a little difficult because the stock and bond markets are behavioral markets driven by human emotion, perhaps the most important of many variables influencing price. Plus, human emotion and behavior dictates manic and depressive elements, which have not yet been quantified. Yet, some chart analysts believe they can recognize it when they see it on the charts.
In another area, the computer has yielded much more dramatic and profitable results, but that is in a model-driven market, namely the options markets. Quantitative analysts, those who investigate and trade the options markets, are a breed apart from technical analysts. In an interesting irony, emotion-driven markets, the stock markets, are used as the basis for derivatives, or options, whose price is determined largely by the operation of algorithms called “models;” for example, the Black Scholes model. Quantitative analysts believe, as does this editor, the options markets can be successfully gamed through quantitative analysis. Results of skilled practitioners indicate this belief is accurate.
Alas, life is not so simple for the simple stock trader. Stock prices having nothing to do with mathematics, except for being expressed as natural numbers, are not susceptible to easy prediction as to their future direction. Not even with Magee chart analysis or any other form of analysis—technical, fundamental, or psychic. (From a theoretical point of view, each trade made on the basis of a chart analysis should be looked at as an experiment made to confirm a probability. The experiment is ended quickly if the trend does not develop.) The fact chart analysis is not mechanizable is important. It is one reason chart analysis continues to be effective in the hands of a skilled practitioner. Not being susceptible to mechanization, counterstrategies cannot be brought against it, except in situations whose meaning is obvious to everyone, for instance, a large important Support or Resistance Level or a glaringly obvious chart formation. These days everyone looks at charts to trade even if they do not believe in their use. In these obvious cases, some market participants will attempt to push prices through these levels to profit from volatility and confusion. Indeed, human nature has not changed much since Jay Gould and Big Jim Fisk.
When these manipulations of price occur, they create false signals—Bull and Bear traps. Interestingly, the failure of these signals may constitute a reliable signal in itself—but in the direction opposite to the original signal.
The importance of computer technology
Of what use and importance then is this marvelous tool—the most interesting tool man (
homo
) has acquired since papyrus? (Numerous computer software packages available are capable of executing the functions described in the following discussion.) If the computer cannot definitively identify profitable opportunities, what good is it?
Probably the most important function the computer has for the Magee analyst is the automation of rote detail work. Data can be gathered by downloading from database servers. Charts can be called up in an instant. Portfolio accounting, maintenance, and tax preparation can be disposed of with one hand while drinking coffee with the other. All in all, this might make it sound as though the computer is a great tool, but with a pretty dull edge. Not strictly true. There is at least one great leap forward for Magee analysts with this tool, leaving aside the rote drudgery it saves. This great advantage is portfolio analysis. In
Appendix B
,
Resources
, a complex portfolio analysis of the kind used by professional traders (Blair Hull and Options Research Inc.) is illustrated. Even simpler portfolios of the average investor can benefit from the facilities afforded by most portfolio programs, either on the net or in commercial software packages (locations and software identified in
Appendix B, Resources
).
Another advantage is the ability to see basic data displayed in many different forms: point and figure charts, candlestick charts, close-only charts—these are prepared in the flick of an eyelash and may indeed contribute to understanding the particular situation under the magnifying glass. The effortless quantification of some aspects of analysis may be useful—volume studies, for instance, and given the popularity of moving averages, seeing the 50- and 200-day moving averages can be interesting. These moving averages are considered significant by many market participants—even fundamental analysts. The analysis of any of these should be considered in relation to the current state of the market as understood by the careful chart analyst.
But what about (the strangely named) stochastics, Bollinger Bands, %R, MACD, Moving Averages (plain vanilla, exponential, crossover, etc.), price/volume divergence, RSI (plain vanilla and Wilder), VP Trend, TCI, OBV, Upper/Lower Trading Bands, ESA Trading Bands, and AcmDis? Well, there is a certain whiff of alchemy to some of them, and some have some usefulness sometimes. What is more, all systems work beautifully at least twice in their lives: in research and in huge monumental Bull Markets. These number-driven indicators are also the times when trading genius is most likely to be discovered.
(EN9: It is also true, as I have said, that you can drive a nail with a screwdriver. And the inventor of a tool may be fabulously successful with it while its adopters lose their assets.)
It is also possible the excess of technical information created by these indicators may be like the excess of fundamental information—another shell to hide the pea under, another magician's trick to keep the investor from seeing what is truly important, and what is necessary and sufficient to know to trade well. Perhaps the investor would be better off with a behavioral model because the markets are behavioral. Number-driven technical analysis can do many things, some like Dr. Johnson's dog, which walked on its hind legs, but they cannot put the market in perspective—only the human mind can do that. Number-driven models after all do not consider skirt lengths, moon cycles, sun spots, the length of the economic cycle, or the Bullish or Bearish state of the market (if Bear Markets still exist) (
EN9: A wry ironical comment written before the market crash of the 2000s
.) In the end, the human brain is still the only organ capable of synthesizing all this quantitative and qualitative information and assessing those elements that cannot be reduced to ones and zeros. The educated mind is still the best discriminator of patterns and their contexts.
Summary 1
The computer is a tool, a powerful tool, but a tool nonetheless. It is not an intelligent problem solver or decision maker. We use a mechanical ditch digger to dig a ditch, but not to figure out where the ditch should be.
The multitude of indicators and systems should be viewed with a skeptical eye and evaluated within the context of informed chart analysis. Sometimes an indicator or technique will work for one user or its inventor but strangely mislead the chart analyst who tries to use it—or buys it, even based on a verified track record.
Therefore, the experienced investor keeps his methods and analysis simple until he has definitive knowledge of any technique, method, or indicator he would like to add to his repertoire. Most of all, he depends on his own observations and experience to evaluate his and others' trading techniques.
Other technological developments of importance to
the technical Magee analyst and all investors
The computer is not the only technological development of interest to the technical investor. A number of information revolution technologies need to be put in perspective. These are, in broad categories, the internet and all its facilities, developments in electronic markets, and advances in finance and investment theory and practice. This last is treated in the final section of this chapter.
Owing to the enormous body of material on these subjects, no attempt will be made to explore these subjects exhaustively, but the general investor will be given the information he needs to know to put these subjects in their proper perspective. Resources will point the analyst to avenues for further investigation if the need is felt.
First of all, are there any technological developments of whatever sort that have made charting obsolete? No. Are there any developments that have made trading a guaranteed success? No. The only sure thing is some huckster will claim to have a sure thing. Those who believe such claims are the victims of their own naivete.
The Internet: the eighth wonder of the modern world (EN9: Appendix
B, Resources, for the ninth edition has been enormously expanded
and is of paramount importance to modern investors.)
The internet has been called the most complex project ever built by man, which is probably true. Complex, sprawling, and idiosyncratic, it has something for everyone, especially the investor. Every form of investment creature known to man has set up a site on the internet and waits like the hungry arachnid for the casual surfer: brokers and advisors—technical and fundamental; newspapers, news magazines, newsgroups, and touts; mutual funds, mutual fund advisories, critics and evaluators of all the above; database vendors, chat rooms, electronic marketplaces and exchanges, and Exchange Traded Notes (ECNs)—the only unfilled niche that seems to exist is investment pornography. Perhaps naked options will be able to satisfy this need.
This is a bewildering array of resources. How does one sort them out? The implications of all this for the electronic or cyber investor may be further expanded to indicate the services and facilities available: quotes and data; portfolio management and accounting; online interactive charting; automatic alerts to PBDAs (personal body digital assistants or gizmos carried on the body, for example, cell phones and handheld computers, and so on); analysis and advice; electronic boardrooms; and electronic exchanges where trading takes place without intermediaries.
Appendix B, Resources
, supplies the specifics on these categories while this chapter supplies perspective. It is one thing to contemplate this cornucopia of facilities and another thing to appreciate the importance and priority of its elements. What good are real-time quotes if you are only interested in reviewing your portfolio once a week, except for special occasions? What good are satellite alerts and virtual reality glasses to a long-term investor? It is easy for the investor with no philosophy or method to be drawn into the maelstrom of electronic wonders and stagger out of it a little wiser and much poorer.
Observe then the goods and services of all of this are of importance to the levelheaded investor with his feet on the ground and his head out of the clouds (or
Cloud
). This, hopefully not, abstract investor, the object of our attention here, needs what? He needs
data
,
charts
, and
a connection to a trading place
. Data are available at the click of a mouse. A chart occupies the screen in another click. Another click and a trade is placed. In the Internet Age, it would be tautological to attempt to describe this process in prose when live demonstrations are as close as the desktop computer and an internet connection. A demonstration of this rather simple process (easy to say when one does it without thinking) may be seen at locations linked in
Appendix B, Resources
. The trade will be made, of necessity, through a broker of some sort, perhaps an electronic broker or even a non-virtual broker who communicates via telephone. This will occur shortly, if not already, an electronic pit where one matches wits with a computer instead of a market maker or specialist.
How long brokers will be necessary is a question that is up in the air in the new century. (The broker who earns his keep will always be with us, and welcome, too.) Electronic marketplaces where investors meet without the necessity of a broker or specialist are already proliferating (see
Appendix B, Resources
) and will continue to gain the advantage for the investor over the trading pit, which is one of the last remaining edges the professionals hold over off-floor traders. Suffice it to say, their initial phases will undoubtedly be periods of dislocation, risk, and opportunity as their glitches are ironed out.
Placing electronic orders, whether to an electronic exchange or to the New York Stock Exchange, has certain inherent advantages over oral orders. No one can quarrel about a trade registered electronically as opposed to orally where the potential for disagreement exists. In addition, the trader has only handled the data once—rather than making an analysis, calling a broker, recording the trade, and passing it to the portfolio. If he just hits the trade button and the transaction is routed through his software package, no one will have any doubt as to where an error might lie. The manual method presents an opportunity for error at each step. Rest assured, errors occur and can be disastrous to trading.
The efficiency and ease of the process with a computer have much to recommend it— automation of trade processing, elimination of confusion and ambiguities, audit tracks, automation of portfolio maintenance, and, perhaps most important of all, automatic mark-to-market of the portfolio (the practice of valuing a portfolio at its present market value whether trades are open or closed).
Marking-to-market
This book might have been entitled
Zen and the Art of Technical Analysis
if that title were not so hackneyed and threadbare. It conveys, nonetheless, the message of Zen in the art of archery, that of direct attachment to reality and the importance of the present moment. In his seminal book
The General Semantics of Wall Street
(now
Winning the Mental Game on Wall Street
), John Magee inveighed at some length against the very human tendency to keep two sets of books in the head—one recording profits, open and closed, and another recording losses, but only closed losses. Open losses were not losses until booked. Having an electronic portfolio accountant that refuses to participate in such self-deception has much to recommend it. If the portfolio is always marked to the market when the computer communicates with the data vendor, or the trade broker, it is difficult not to see red ink, and to see the equity of the account reflects all trades, open and closed.
Separating the wheat from the chaff
It requires a gimlet-eyed investor to pick his way through the minefield of temptations in electronic investing and number-driven technical analysis. Playing with the toys, seeing what the pundits have to say, and fiddling with “research” can subtly replace profitable trading as the activity. Actually, almost all the research the Magee analyst
must
do is addressed in this book.
Chaff
Chat rooms, touts, news, predictions, punditry, brokerage house buy, sell, hold, strong hold, weak buy, strong buy, and any other species of brokerage house recommendation should be taken at face value. Remember, brokerage firms survive by selling securities and make their money in general on activity. Actually, much of their money is made servicing their institutional clients and distributing their clients' shares to their retail clientele—a blatant conflict of interest that blew up in their faces in the early 2000s, resulting in many fines and some jail terms
(plus ga change ... ).
In the surging Clinton-Gore Bull Markets of the 1990s, all of these worked. In a serious Bear Market, none of them will work.
(EN9: A serious Bear Market started in earnest in 2000 and was correctly identified with Magee chart analysis as may be seen from the John Magee Letters at the
http://www.edwards-magee.com
.)
Summary 2
Never in the history of the markets have so many facilities for private investors been available. The computer is necessary to take advantage of those facilities.
Data may be acquired automatically via internet or dial-up sites at little or no cost. A (as they say) plethora of websites offer cyber investors everything from portfolio accounting to alerts sent to their personal body-carried devices (cell phones, pagers, handheld PDAs, and so on). Some of these even offer real-time data, which is a way for the unsophisticated trader to go broke in real time. Many of these sites offer every kind of analysis from respectable technical analysis (usually too complicated) to extraterrestrial channeling.
Internet chat rooms will provide real-time touting and numerous rumors to send the lemmings and impressionable scurrying hither and yon. But, one expects, not the readers of this book.
Of more importance, the information revolution and the computer will:
1. Relieve the analyst of manual drudgery, accelerate all the steps of analysis: data gathering, chart preparation, portfolio accounting, and analysis and tax preparation.
2. Give the analyst virtually effortless portfolio accounting and mark-to-market prices—a valuable device to have to keep the investor from mixing his cash and accrual accounting, as Magee says.
3. Enable processing of a hitherto unimaginable degree. An unlimited number of stocks may be analyzed. Choosing those to trade with a computer will be dealt with in
Chapter 21
,
Selection of Stocks to Chart
.
4. Allow the investor to trade on ECNs or in electronic marketplaces where there are no pit traders or locals to fiddle with prices.
Advancements in investment technology, part 1:
developments in finance theory and practice
Numerous pernicious and useless inventions, services, and products litter the internet and the financial industry marketplace; but modern finance theory and technology are important and must be taken into consideration by the general investor. This chapter will explore the minimum the moderately advanced investor needs to know about advances in theory and practice. And it will point the reader to further resources if he desires to continue more advanced study.
Instruments of limited (or non) availability during the time of Edwards and Magee included exchange traded options on stocks, futures on averages and indexes, options on futures and indexes, and securitized indexes and averages, as a partial list of only the most important instruments. Undoubtedly, one of the most important developments of the modern era is the creation of trading instruments that allow the investor to trade and hedge the major indexes. Of these, the instruments created by the Chicago Board of Trade (CBOT
®
) are of singular importance. These are the CBOT
®
DJIA
SM
Futures and the CBOT
®
DJIA
SM
Futures Options, which are discussed in greater detail at the end of this chapter.
(EN9: Not so singular, perhaps. Probably of greater importance to readers of this book are the AMEX iShares, particularly DIA, SPY, and QQQ, which are instruments (ETFs) that offer the investor direct participation in the major indexes as though they were stocks.)
General developments of great importance in finance theory and practice are found in the following sections.
Options
From the pivotal moment in 1973 when Fischer Black (friend and college classmate) and his partner, Myron Scholes, published their—excuse the usage—paradigm-setting Model, the options and derivatives markets have grown from negligible to trillions of dollars a year. The investor who is not informed about options is playing with half a deck. The subject, however, is beyond the scope of this book, which hopes only to offer some perspective on the subject and guides to the further study necessary for most traders and many investors.
Something in the neighborhood of 30% or more of options expire worthless. This is probably the most important fact to know about options. (There is a rule of thumb about options called the 60-30-10 rule: 60% are closed out before expiration, 30% are “long at expiration,” meaning they are worthless, and 10% are exercised.) Another fact to know about options occurred in the Reagan Crash of 1987; the money puts bought at $0.625 on October 16 were worth hundreds of dollars on October 19—if you could get the broker to pick up the telephone and trade them. (The editor had a client at Options Research, Inc. during that time who lost $57 million in three days and almost brought down a major Chicago bank; he had sold too many naked puts.)
The most sophisticated and skilled traders in the world make their livings (quite sumptuous livings, thank you) trading options. Educated estimates have been made that as many as 90% of retail options traders lose money. That combined with the fact that by far it is the general public that buys (rather than sells) options should suggest some syllogistic reasoning to the reader.
With these facts firmly fixed in mind, let us put options in their proper perspective for the general investor. Options have a number of useful functions, such as offering the trader powerful leverage. With an option, he can control much more stock than by the direct purchase of stock—his capital stretches much further. So options are an ideal speculative instrument (Exaggerated leverage is almost always a characteristic of speculative instruments.), but they can also be used in a most conservative way—as an insurance policy. For example, a position on the long security side may be hedged by the purchase of a put on the option side. (This is not a specific recommendation to do this. Every specific situation should be evaluated by the prudent investor with professional assistance as to its monetary consequences.)
The experienced investor may also use options to increase yield on his portfolio of securities. He may write covered calls or naked puts on a stock to acquire it at a lower cost (e.g., he sells out of the money put options. This is a way of being long the stock; if the stock comes back to the exercise price, he acquires the stock. If not, he pockets the premium.)
There are numerous tactics of this sort that may be
played
with options. Played because, for the general investor, the options game can be disastrous, as professionals are not playing. They are seriously practicing skills the amateur can never hope to master. Many floor traders, indeed, would qualify as idiot savants—they can compute the “fair value” of options in their heads and make money on price anomalies of 1/16, or, as they call it, a “teenie.” For perspective, the reader may contemplate a conversation the editor had with one of the most important options traders in the world who remarked casually that his fortune was built on teenies. The reader may imagine at some length what would be necessary for the general investor to make a profit on anomalies of 1/16.
(EN10: The advent of digital pricing has given market makers and specialists even more flexibility to beat the investor by shaving spreads, theoretically, to $0.01.)
This does not mean the general investor should never touch options; it just means he should be thoroughly prepared before he goes down to play that game. In options trading, traders speak of bull spreads, bear spreads, and alligator spreads. The alligator spread is an options strategy that eats the customer's capital
in toto
.
Among these strategies is covered call writing. This strategy is touted as being an income producer on a stock portfolio. There is no purpose in writing a call on a stock in which the investor is long—unless that stock is stuck in a clear congestion phase that is not due to expire before the option expires. Besides, if the stock is in a downtrend, it should be liquidated, but to write a call on a stock in a clear uptrend is to make oneself beloved of the broker, whose good humor improves markedly with account activity and commission income. The outcome of a covered call on an ascending stock is that the writer (you, dear reader) has the stock called at the exercise price, losing his position and future appreciation, not to mention costs. The income is actually small consolation, a sort of booby prize—a way of cutting your profits while increasing your costs. Nevertheless, covered writes are justified and profitable in some cases.
Quantitative analysis
The investor should be aware of another area of computer and investment technology that has yielded much more dramatic and profitable results, but that is in a model-driven market—namely, the options markets. Quantitative analysts, those who investigate and trade the options markets, are a breed apart from technical analysts. In an interesting irony, behavioral markets, the stock markets, are used as the basis for derivatives, or options whose price is determined largely by the operation of algorithms called “models.” The original model that created the modern world of options trading was the Black-Scholes options analysis model, which assumed the “fair value” of an option could be determined by entering five parameters into the formula: the strike price of the option, the price of the stock, the “risk-free” interest rate, the time to expiration, and the volatility of the stock.
The eventual universal acceptance of this model resulted in the derivatives industry we have today. To list all the forms of derivatives available for trading today would be to expand this book by many pages, and it is not the purpose of this book anyway. The purpose of this paragraph is to sternly warn general investors who are thinking of “beating the derivatives markets” to undergo rigorous training first. The alternative could be extremely expensive.
At first, the traders who saw the importance of this model and used it to price options virtually skinned older options traders and the public, who traded pretty much by the seat of the pants or the strength of their convictions, meaning human emotion. But professional losers learn fast and now all competent options traders use some sort of model or anti-model, or anti-antimodel to trade. True to form, options sellers, who are largely professionals, take most of the public's (the buyers) money. This is the way of the world.
Options pricing models and their importance
After the introduction of the Black-Scholes model, numerous other models followed, among them the Cox-Ross-Rubinstein, the Black Futures, and others. For the general investor, the message is this: he must be acquainted with these models and what their functions are if he intends to use options. Recall, the model computes the “fair value” of the option. One way professionals make money off amateurs is by selling overpriced options and buying underpriced options to create a relatively lower risk spread (for themselves). Not knowing what these values are for the private investor is like not knowing where the present price is for a stock; it is a piece of ignorance for which the professional will charge him a premium to be educated about. Unfortunately, many private options traders never get educated, in spite of paying tuition over and over again. But ignorance is not bliss—it is expensive.
Technology and knowledge works its way from innovators and creative geniuses through the ranks of professionals and sooner or later is disseminated to the general public. By that time, the innovators have developed new technology. Nonetheless, even assuming that professionals have superior tools and technology, the general investor must thoroughly educate himself before using options. As it is not the province of this book to dissect options trading, though the reader may find references in
Appendix B, Resources
.
Here it would not be untoward to mention one of the better books on options as a starting point for the moderately advanced and motivated trader. Lawrence McMillan's
Options as a Strategic Investment
is necessary reading. In addition, the newcomer may contact the Chicago Board Options Exchange (the CBOE) at
http://www.cboe.com
, which has tutorial software.
Futures on indexes
Futures, like options, offer the speculator intense leverage—the ability to control a comparatively large position with much less capital than the purchase of the underlying commodity or index. Futures salesmen are fond of pointing out the fact that, if you are margined at 5% or 10% of the contract value, a similar move in the price of the index will double your money. They are often not so conscientious about pointing out a similar move against your position will wipe out your margin (actually earnest money). Unlike (long) options, a mishap in the market can result in more than the loss of margin; it can become a deficit account and debts to the broker—in other words, losses of more than 100%. For this, among other reasons, it is wise not to plunge into futures without considerable preparation. This preparation might well begin, for the adroit investor, with the reading of Schwager's
Technical Analysis, Schwager on Futures
, currently one of the better books on the subject.
Let us say that, instead of using futures to speculate, we want to use them as a hedge for our portfolio of Dow-Jones DIAMONDS (DIA) or portfolio of Dow-Jones stocks. Now we are purchasing insurance, rather than speculating. As an oversimplified example, the investor might see the failure of the DJIA to break through a top as the beginning of a congestion zone (a consolidation or reversal pattern). He could then hedge his position by shorting the Dow-Jones futures. Now he is both long and short—long the cash, short the futures. He would place a stop on the futures above his purchase price to close the trade if the market continued rising. If the market fell, he would maintain the futures position until he calculated that the reaction had passed its worst point, or until it were definitely analyzed to have reversed. He would then take his profits on the futures position (taxable), but his cash position would be intact, and presumably, the greater capital gains on those positions would be safe from taxation, and also safe from the costs, slippage, and difficulties of reestablishing the stock position.
Options on futures and indexes
Conservative as well as speculative use may be made of options. For example, the investor might, after a vigorous spike upwards, feel the Standard & Poor's (S&P) 500, or the SPYs which he is long, were overbought. He might then buy an index put on the S&P as a hedge against the expected decline. If it occurs, he collects his profit on the option and his cash position in the S&P is undisturbed. If the index continues to climb, he loses the option premium—an insurance policy he took out to protect his stock portfolio.
Note:
The tactics described here are for the reader's conceptual education. Before executing tactics of this kind, or any other unfamiliar procedure, the investor should thoroughly inform himself and rehearse the procedure, testing outcomes through paper trading before committing real capital.
He must, in short, figure out how you lose
. A number of websites offer facilities of this kind, and the investor may also build on his own computer a research or paper-trading portfolio segregated from his actual transactions.
The trader might also choose to buy an option on a future. At the CBOT
®
, the trader can trade both options and futures on the DJIA. These can be used as the above examples for speculating or hedging, except in this case, the successful option buyer might wind up owning a futures contract instead of the cash position. This could be disconcerting to one not accustomed to the futures market, especially if large price anomalies between futures and cash occurred, as happened in 1987 and 1989 when futures prices went to huge discounts to cash. A primary reason for employing the futures would be for leverage and the reason for using the options on futures would be the analysis that uncertainty was in store and the wish to only risk the amount of the options premium.
Obviously, a speculator can choose to forget the stock or futures part of the portfolio and trade only options. Before taking such a step, the trader should pass a postgraduate course. The proportion of successful amateur option traders to successful professional traders is extremely skewed. In fact, one might say all successful options traders are professionals.
Modern Portfolio Theory
Modern Portfolio Theory (MPT) is a procedure and process whereby a portfolio manager may classify and analyze the components of his portfolio in such a way as to, hopefully, be aware of and control risk and return. It attempts to quantify the relationship between risk and return. Rather than analyzing only the individual instruments within a portfolio, MPT attempts to determine the statistical relationships among the members of the portfolio and their relationships to the market.
The processes involved in MPT analysis are as follows (1)
portfolio valuation
, or describing the portfolio in terms of expected risk and expected return; (2)
asset allocation
, determining how capital is to be allocated among the classes of instruments (bonds, stocks, and so on); (3)
optimization
, or finding the trade-offs between risk and return in selecting the components of the portfolio; and (4)
performance measurement
, or the division of each stock's risk into systemic and security-related classes.
How important is this for the general investor? Not very and there is a large question among pragmatic analysts, such as the editor, as to its pragmatic usefulness for professionals, although they cling to it as to a life ring in a shipwreck. Mandelbrot observed in articles (“A Multifractal Walk Down Wall Street”) and letters in the
Scientific American
(February 1999 and June 1999) that MPT discards about 5% of statistical experience as if it did not exist (although it [the experience] does). He also observed the ignored experience includes 10-sigma market storms that are blamed for portfolio failures as though it were the fault of the data instead of the fault of the process.
The wonders and joys of investment technology
Are there any other innovations in finance and investment theory of which the general investor should be aware? (See
Chapter 42
for discussion of Value at Risk and Pragmatic Portfolio Theory.) Well, it never hurts to know everything, and the very best professionals not only are aware of everything, but also are in the constant process of finding new wrinkles and glitches and anomalies. Though, as Magee would ask, what is necessary and sufficient to know (see
Winning the Mental Game on Wall Street
)? Absolute certainty is the hallmark of religious extremists and the naive, who do not know what they do not know. So I will remark that
probably
this book contains either what is necessary and sufficient for the investor to know about these matters or guides the reader to further study.
Not to mention,
nota bene
, any number of little old ladies with a chart, a pencil, a ruler, and previous editions of this book have beaten the pants off professional stock pickers with supercomputers and MPT and Nobel Laureates and who knows what other resources. I personally know investment groups that have thrown enormous resources into the development of real-time systems that, in research, were 100% successful in beating the market. The only real glitch was the systems required so much computer power they could not be run quickly enough in real time to actually trade in the markets. Philosopher's stone
redux.
Advancements in investment technology, part 2:
futures and options on futures on the Dow-Jones
Industrial Index at the CBOT
(EN9: The general investor
must
be aware that the methods and techniques described in this chapter are for advanced practitioners. Careless use of the described instruments can be extremely damaging to a portfolio.)
Investment and hedging strategies using the CBOT
®
DJIA
SM
futures contract
A futures contract is the obligation to buy or sell a specific commodity on or by some specified date in the future. For example, if one went long corn futures, he would be obligated to accept delivery of corn on the delivery date, unless he sold the contract before the settlement date. Shorting the contract would obligate the seller to deliver corn unless he offset (by repurchase) the contract. The “commodity” in our present case is the basket of stocks represented by the DJIA futures index. All futures contracts specify the date by which the transaction must conclude, known as the “settlement date,” and how the transaction will be implemented, known as “delivery.” The DJIA futures contract price closely tracks the price of the Dow-Jones Industrials as computed from stock market values.
The value of the future is found by multiplying the index price of the futures contract by $10.00. For example, if the futures index price is 10,000, the value of the contract is 10,000 x $10.00 = $100,000. So the buyer or seller of the futures contract is trading approximately $100,000 worth of stocks at that Dow futures level. The value may be higher or lower owing to several factors, for example, cost of carry, which will be discussed below.
Settlement of futures contracts
All futures contracts must be “settled.” Some futures are settled by delivery, the famous nightmare of finding 5,000 bushels of soybeans delivered on your front lawn. Dow Index futures “settle” (are delivered) in cash. The short does not dump a basket of Dow stocks on the yard of the long. Thus, on the settlement date of the contract, the settlement price is $10.00 times a figure called the “Special Opening Quotation,” a value calculated from the opening prices of the member stocks of the Dow Future following the last day of trading in the futures contract. This value is compared with the price paid for the contract when the trade initiated. For example, if the Dow Future is 10,000 at expiration, a long who bought the contract at 9,000 receives $10,000 ($10.00 x 1000) from the short.
Marking-to-market
This $10,000, however, is paid daily over the life of the contract, rather than in one payment upon expiration of the contract. It is paid as successive daily “margin” payments. These payments are not really margin but are in effect “earnest money” or a performance bond. The practice of squaring up accounts at the end of every day's trading is called “marking-to-market.” These daily payments are determined based on the difference between the previous day's settlement price and the contract settlement price at the close of trading each day.
As a practical example, if the settlement price of June Dow Index futures increases from 9,800 to 9,840 from May 17 to May 18, the short pays $400 ($10.00 x 40) and the long's account is credited $400. If the futures settlement price decreases 10 points the following day, the long pays $100 to the short's account—and so on each day until expiration of the contract, when the futures price and the index price achieve parity.
At any time, the trader can close his position by offsetting the contract, that is, by selling to close an open long, or buying to close an open short. At the expiration date, open contracts are settled in cash at the final settlement price.
Fungibility
One of the great contributions of the great established exchanges like the CBOT
®
and the Chicago Mercantile Exchange is their institutionalization of contract terms and relationships is known as “fungibility.” Any one futures contract for corn, or an index, or any other commodity is substitutable for another of the same commodity. Similarly, the Exchange has negated counterparty risk by placing a Clearing Corporation between all parties to trades. Thus, even if the other party to a trade went broke, the Clearing Corporation would assume his liability and, using the mechanism of daily settlement, whereby losers pay winners daily, the danger of major default is avoided.
Futures “margins” (or “earnest money”) are deposited with the broker on opening a trade. The leverage obtainable is quite extreme for a stock trader. The initial margin is usually 3%-5% of the total value of the contract. Each day thereafter, margins vary according to the process described above of marking-to-market.
As the reader can see, the purchase or sale of a Dow Future is the equivalent of a fairly large portfolio transaction, with the understanding it is a transaction that will be closed in the future, unlike a stock purchase, which may be held indefinitely.
Differences between cash and futures
The main two differences between the cash and the futures transactions are as follows:
1. In cash, the value of the portfolio must be paid up front or financed in a stock margin account.
2. The owner of the cash portfolio receives cash dividends.
These are not the only differences. The leverage employed in the futures transaction is a two-edged sword. If the trader has no reserves, a minor move in the index wipes him out. Such a minor move would be barely noticed by the owner of a cash portfolio.
Dow Index futures
The price of the future and the price of the index are closely linked. Any price anomaly is quickly corrected by arbitragers. On any significant price difference, arbitragers will buy the underpriced and sell the overpriced, bringing the relationship back in line. Their prices are not exactly the same because the futures contract value must reflect the costs of short-term financing of stocks and the dividends paid by index stocks until futures expiration, known as the “cost of carry.” The “theoretical value” of the future should equal the price of the index plus the carrying cost, what is called the “fair” or “theoretical” value.
Using stock index futures to control exposure to the market
The owner of a cash portfolio in the Dow, or of DIAMONDS, can control his exposure, his risk, by using futures to hedge. If, for example, he is pessimistic about the market, or more to the point, a lot of uptrend lines have been broken and the technical situation seems to be deteriorating, he can sell a futures contract equivalent to his portfolio and be flat the market.
Readers will immediately recognize the advantages of this strategy. Tax consequences on the cash portfolio are avoided, as are the other negative consequences of trading— slippage, errors, and so on. Long-term positions are better left alone. By flattening his position, the investor has now insured the future value of his portfolio,
and
the capital involved is now earning the money market rate of return.
What happens if the forecast market decline occurs? The portfolio is protected from loss and the capital earns the market rate of return; however, the investor should monitor his hedge closely, lifting it when he calculates the correction has run its course. Taxes will then be due on the profits on the hedge.
In monitoring the hedge, the possibility the market rises instead of falls must be considered. In planning the hedge in the first place, the investor must plan for this eventuality and determine at which point he will lift the hedge on the losing side. At worst, the investor has surrendered portfolio appreciation. Not considering cash flow implications.
It is worth emphasizing, in fact
strongly
emphasizing, that these techniques require knowledge, expertise, and study. Careless use of techniques of this nature can bloody the amateur investor. Hence, it is probably best to have a professional guide for the first several of these expeditions and to execute first a number of paper transactions.
The canny investor can increase his exposure to the market and the risk to his capital by buying index futures. But the canny investor must be careful not to turn into a burned speculator. Futures trading, because of the extreme leverage, is an area for dedicated and experienced speculators.
A Dow futures transaction costs less than if you had to buy or sell a whole basket of stocks. Professional fund managers—as well as other professionals—regularly use futures for asset allocation and reallocation. In all likelihood, they are not using the extreme leverage afforded by futures. In other words, if they have a $1 million cash portfolio, they do not buy $10 million worth of futures. It is not the leverage in which they are interested, but rather it is the extreme convenience and agility offered by doing short-term allocations in futures. The ability to almost instantaneously move in and out of the market without disturbing the underlying portfolio is a powerful feature of these “proxy markets.”
Figure 17.3
Diamonds and Futures. The 2% plus break at the arrow of an 11-month trendline is an unmistakable invitation to hedge the DIAMONDS by shorting the futures. Profits on the short would have offset losses in the DIAMONDS. This convenient drill would have preserved liquidity, postponed capital gains taxes, and avoided loss of equity. Notice the return to the trendline after the break. More of the foolish virgin syndrome?
Investment uses of Dow Index futures
The following examples describe the basic mechanics of using Dow futures contracts. These can be used to adjust equity exposure in anticipation of volatile market cycles and to rebalance portfolios among different asset classes. The futures also may be used for other purposes not illustrated here. The following examples are not intended to be absolutely precise, but only to illustrate the mechanics involved. For the sake of simplicity, mark-to-market payments and cost of carry have been eliminated from the examples.
Situation 1: Portfolio protection
You are a long-term Magee-type investor and you have old and profitable positions with which you are satisfied. Yet, you have seen the broadening top of the Dow Jones (ca. 2000) and it is almost October, so you would not be surprised to see a little bloodshed. You have $400,000 in the Dow and $100,000 in money market instruments. You decide to reverse this ratio, but you do not want to liquidate the Dow portfolio, as there is no sign of a confirmed downtrend, only that of consolidation. You sell $300,000 of index futures, leaving yourself with a $100,000 kicker in case you are wrong about the market's declining. At the time, the market is 10,000 and the futures are 10,500, meaning the cost of carry is approximately 0.5% (10,500/10,000 - 1).
You sell three futures contracts [$300,000/($10 x 10,000)]. You now have reversed your position and are long $100,000 Dow stocks and long $400,000 money market equivalents.
Validating your technical analysis, the market has begun to swing in broad undulations and, at the expiration of the futures, the Dow is at 10,000. On your stocks, you have a return of -0.5%, and the money market position has a rate of return of 0.5%.
What would have been the situation had you not hedged?
Stock Portfolio $400,000 x 0.95
$380,000
Money Market + 100,000 x 1.005
$100,500
Total
$480,500
How the futures position affects the portfolio:
Short three futures 3 x $10.00 x (10,000-9,500)
+$15,000
Total
$495,000
Value of portfolio with reallocation of assets in cash market:
Stocks $100,000 x 0.95
$95,000
Money market + $400,000 x 1.005
$402,000
Total
$497,000
By hedging in the futures market, you now have the equivalent of a $100,000 investment in Dow futures stocks and a $400,000 investment in the money market instrument. The stock market decline now affects only $100,000 of your stock portfolio rather than $400,000; in addition, you earn a money market rate of return of 0.5% on the $300,000 difference.
Without the futures transaction, the portfolio is worth $480,500. The $15,000 profit on the short futures position offsets the loss on the $300,000 of the portfolio that was moved out of equities by the short futures position. In brief, by selling futures, you are able to protect $300,000 of your initial portfolio value from a stock price decline, nearly breaking even, an achievement given these market conditions. Had you been more confident of the market decline, you might have completely neutralized the equity risk on the portfolio by selling more futures contracts. This would have converted the entire stock position to a $400,000 investment in the money market. The amount of protection you should obtain depends on your assessment of the market and your tolerance for risk.
Situation 2: Increasing exposure with futures
Now let us look at the other side of the coin. The market has come off its highs in a predictable and controlled secondary reaction and your technical analysis is that the Bull Market will continue. At 10,000, it appears headed for 11,000, and you want to increase your commitment. Your portfolio is as previously described, split 80/20 between Dow stocks and money markets. It is time to go whole hog, you decide. You are acutely aware of the market maxim (bulls make money and bears make money and hogs wind up slaughtered), but there is also a market maxim that no market maxim is true 100% of the time, which is also true of this maxim.
Rather than liquidate your money market holdings, you buy one futures contract, which puts you long another $100,000 of stocks. The rate of return on the money markets in your portfolio is 0.5%. To get a $500,000 exposure in blue chips, you buy the following number of contracts: $100,000/($10 x 10,000) = 1 contract.
Results: Your technical analysis of the direction of the market is correct, and the Dow future rises to 11,000 at the September expiration, or by 10%.
Value of portfolio with passive management:
Stocks
$400,000 x 1.10
$440,000
Money market+
$100,000 x 1.005
$100,500
Total
$540,500
Value of portfolio with futures position:
Long DJIA futures 1 x $10.00 x (11,000 - 10,000)
$10,000
Total
$550,500
Value of portfolio with reallocation of assets in cash market:
Stocks $500,000 x 1.10
$550,000
Money market
$0
Total
$550,000
In buying Dow Index futures, you are able to “equitize” $100,000 of your money market investment, effectively increasing your return from the money market rate of 0.5%-10%. If you had not bought futures, the total value of your portfolio at the September expiration would have been $540,500 instead of $550,500. Not only do you have a $10,000 extra gain in your portfolio, but also you have taken advantage of the market's continuing upward climb without having to adjust your portfolio.
Situation 3: Using bond and index futures for asset allocation
Speculation in bonds can be quite profitable, notwithstanding David Dreman's assertion that long-term investments in bonds are net losers.
(EN9: An oversimplification of a sophisticated thesis by an important figure
.
)
Subsequently, it is not unusual for an investor to have both bonds and stocks in his portfolio. In this event, the portfolio can be managed with facility by using both Index futures and Treasury bond futures.
Many investors consider it prudent to reallocate their capital commitments based on inflation rates, interest rates, and the reported expression on Alan Greenspan's (or Bernanke's) face before congressional testimony.
An efficient and inexpensive way to reallocate assets between stocks and bonds is to put on spreads of Treasury bond futures and Dow Index futures.
Analysis of recent long- and medium-term trends in the market, however, has led you to consider increasing your equity portfolio and decreasing your bond portfolio. You have $200,000 invested in Dow stocks and $200,000 invested in Treasury bonds. You would like to take advantage of the sustained market rally by increasing your equities exposure to 75% and decreasing your bond holdings to 25%.
As for tactics, you can reallocate both sides of your portfolio—buying $100,000 of stocks and selling $100,000 of bonds—with the sale of Treasury bond futures and the purchase of Dow Index futures.
The Treasury bonds in your portfolio have a market price of 103-20. The price of September Treasury bond futures is 102-20 per $100 of face value, and $100,000 of face value must be delivered against each contract. The value of the Dow futures is 10,000, and the price of the Dow Index futures contract is 10,000 (ignoring the cost of carry).
The number of T-bond futures to sell is: short T-bond futures: $100,000/ (102 - 20 x $1,000) = 1 (number of futures is rounded to the nearest whole number). The number of stock index futures to buy is as follows: long stock index futures: $100,000/ ($10.00 x 10,000) = 1 (number of futures is rounded to the nearest whole number).
Results: at the September futures expiration, the value of the Dow future is 11,000, a rate of return of 10%, and the market value of the bonds is 101-08, a rate of return of -1%.
Portfolio value with no market action taken:
Stocks
$200,000 x 1.10
$220,000
Money market
$200,000 x 0.99
$198,000
Total
$418,000
Value of futures positions:
Long Dow futures
$10 x 1 x (11,000 - 10,000)
$10,000
Short bond futures
+$1000 x 1 x (102-20 - 101-08)
$1375
Total
$11,375
Grand total
$429,375
Value of portfolio had transaction been done in cash market:
Stocks
$300,000 x 1.10
$330,000
Bonds
+$100,000 x 0.99
$99,000
Total
$429,000
By this simple maneuver, you have quickly and easily changed your market posture to add an additional $100,000 exposure to stocks and subtract $100,000 exposure to bonds.
Figure 17.4
Dow-Jones Futures and Options. A put purchased at the arrow on the break would have protected patiently won gains over the previous 11 months. The increase in the value of the put can be seen as futures track declining Dow cash. A theoretical drill, but theoretical drills precede actual tactics in the market.
Having correctly analyzed market trends, your action results in an increase in portfolio value from $418,000 to $429,375. You could have accomplished the same result by buying and selling bonds and stocks, but not without tax consequences and the attendant transaction headaches. The use of futures to accomplish your goals allowed you to implement your