The whiplash from the prior week continued to cause grief from traders trying to determine market direction. Alternating moves took us from the highs to the lows and back again with the frequency of a yo-yo. This was the first week this year that produced a triple-triple. That is three days with triple digit moves in the same week. Unfortunately they were not all in the same direction. Monday +169, Thursday -101 and Friday +172. However, even after all that volatility we are still locked into the same trading range that has held us captive since October-5th. I think that range from 1170-1200 is about to break to the upside but we have been here three times before over the last two weeks with a failure each time.
Dow Chart - Daily
Nasdaq Chart - Daily
SPX Chart - Daily
Friday morning started off well with a better than expected Q3 GDP at +3.8%. This was also an improvement over the Q2 level of +3.3%. This was a nice confirmation that the Q2 slump rebounded in Q3 although we do expect to see some confusion appear in the future revisions due to hurricanes. The strong support for the GDP came from consumer spending rising +3.9% and an increase in federal spending at +7.7% also due to the hurricanes. Durable goods rose +10.8%, business investment +6% and equipment and software +8.9%. Residential real estate investment continued to grow at a torrid pace of +8.9% but slowed somewhat from the +10.9% in Q2. Auto sales added +0.5% to the overall GDP number due to the employee pricing program. With that program now over it remains to be seen how the lack of sales will hurt Q4 GDP. Inflation as tracked by the personal consumption expenditures was up +3.7% on an annualized rate. However, the core PCE minus food and energy is still a very tame +1.3% in Q3 and was actually lower than Q2. This gave the markets a boost with the thought that maybe the inflation risk was less than recently suggested.
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The Employment Cost Index rose +0.8% in Q3 and inline with expectations. Wage growth continues to lag price growth and suggests real inflation will remain under control. Price growth typically fails when wages are stagnant but accelerates once wage growth starts to spike. Benefit costs accelerated at +1.3% and well over the +0.8% we saw in Q2. However, these rates are well below the +5% we saw in 2004. It is not that costs are slowing but employers are drawing the line against eating the increases and are passing it on to the workers in some form of benefit reduction. The unadjusted wage growth component has risen +2.3% for the 12 months ended in September and that is the lowest wage growth in 24 years.
Consumer Sentiment fell again to 74.2, -1.2 points from the initial October reading and a -2.7 point drop from September. The expectations component remained nearly flat with the biggest hit coming from a substantial drop in present conditions to 91.2 from 98.1. Consensus estimates had expected a gain in sentiment to something in the 76.5 range. Analysts feel the majority of the drop was due to the drop in the stock market. With gasoline prices falling we should see a rise in sentiment/confidence as the quarter progresses. Any impact from higher natural gas prices on utility bills should not be seen until Q1. The holiday spirit normally increases sentiment but post holiday depression is sure to appear if gas prices do rise as expected.
Monday closes out the quarter with Personal Income and Spending, Chicago PMI and the NAPM-NY reports. Tuesday has the very important ISM for October and Construction Spending. This will give the Fed their final look at the economic health of the country before the FOMC meeting on Tuesday. This meeting will not even be a blip on the radar screen for the markets unless there is a change in the statement to remove the measured pace language. Expectations are for a continued 25-point hike cycle into the January meeting with hikes in November and December. Once into 2006 rate speculation will again take center stage. For now the markets are comfortable with the low inflation numbers in the GDP and the potential for a Fed pause sooner than expected just last week. The flurry of Fedspeak had ratcheted up expectations for rates but today's reports cooled those fears to some extent.
Friday's spotlight on the Lewis Libby scandal sent bonds lower and yields higher with the 10-year yield hitting just over 4.60% intraday with a close at 4.57%. This was the highest yield since March 29th and well over last Friday's close at 4.39%. Strong drops in treasuries the first three days of the week sent yields higher but once resistance at 4.60% was hit the selling eased. As long as yields on the ten-year remain under 5% the market can move higher.
The talking heads on TV were obsessed with the Libby news but the real event taking place right under their noses was the end of October. Monday is technically the last day of the month but for most mutual funds with October year ends Friday was the last trading day. Many funds have October year-ends so tax consequences can be calculated and distributed to investors before the end of the year. This allows investors to plan for any tax bills and not be surprised in January. The last two weeks of volatility, led by the Refco liquidation, was likely due in some part to position rebalancing and tax selling by funds. Those with big gains in stocks like energy or health care may have elected to sell them along with any losers to offset the tax impact. Now that October is over those funds are free to reinvest that cash into other opportunities as November begins. At least that is the conventional wisdom way of thinking. We will see how that plays out.
December Crude Oil Chart - Daily
Like the market oil prices have been trapped in a range between $59 and $64 for nearly the entire month. While support at $59 is strong we are still in a two-month downtrend until conditions in the Gulf return to some semblance of normal. Natural gas prices have weakened to around $13 due to the substantial injection into reserves last week. This is only a temporary event due to the damage in the Gulf. Thirteen gas plants are still offline and 11% of U.S. total gas production is still offline. Even though Wilma did not veer into the Gulf oil patch there was still an evacuation cycle as a precaution. That requires another population cycle as those workers are ferried back out to the rigs. All of this complicates the eventual repair and return to production. The drop in gas prices to $13 is not a positive factor for winter energy bills. Nearly 500 billion cubic feet was injected into storage at this price level or even higher and that is the price homeowners are going to find on their bills. If it suddenly dropped to $10 tomorrow it will not help the winter bills to any great degree. The gas was bought at high numbers and it will heat our homes at those same high numbers. That will not help the stock prices of gas producers today. While $13 is still twice last year's rates and will produce massive profits for those companies the expectation of those rates and profits is already priced into the stocks. Until winter demand begins to draw down stockpiles I believe those stocks are stuck in limbo. It is a historical fact that the current production and pipeline system cannot support the rate of winter consumption. It is only by injecting massive amounts of gas into underground storage in advance of winter that shortages can be avoided. Storage of 3.2 trillion cubic feet is required at the start of November to provide a demand cushion. A prolonged cold snap can put pressure on those reserve levels and cause another spike in prices. Should that occur gas stocks would suddenly find new life. Oil stocks are also in limbo until oil prices break out of their down trend. This may turn out to be a major buying opportunity for both sectors but I would rather wait for the breakout before taking the next plunge. If you look at the chart from 2004 there was a two-month downtrend in Q4 before the explosive gains appeared.
It is only a matter of time before oil demand begins rising again. It was reported on Friday that China's growth for the first nine months of 2005 was +4%. This was on top of the +8% growth in 2004. Growth in China and India may ebb and flow but the trend is inevitably up. Growth around the globe stuttered in September as high oil prices produced sticker shock. Once that shock wears off growth will resume its prior pace. Commodity prices have eased since late September as buying trends slowed and that is good for U.S. manufacturers. Once global growth resumes that trend will reverse.
Oil earnings were the mixed bag we expected with hurricane damage and lost
production putting a crimp in the earnings
of many. Chevron, the largest
operator on the Gulf shelf, still reported a +12% rise in earnings and well
under estimates. CVX said Q4 would be even worse as expenses for recovery and
repair flow through to operations. Chevron was the poster child for the Gulf
disaster with refineries, pipelines, production platforms and drilling rigs all
suffering damage. Other companies reported earnings gains as much as +300% for
the quarter but most were in the +100% range excluding damage claims.
prompted a new round of calls for a reinstatement of the windfall profits tax.
With global production levels flat or falling now is not the time to tax those
profits. Those majors are not going to be spending $1.5 billion for a platform
like Thunder Horse unless it is commercially feasible. Taxing profits is the
same as lowering the price they receive for oil and oil needs to be high to
justify the frantic exploration for the few remaining fields. Oil at $60 will
more exploration effort than oil at $40 and limiting profits reduces the
cash available to pursue that exploration.
The fat lady is singing at Song Airways, the discount carrier created by Delta. The experiment appears not to be working and Delta announced on Friday it was closing Song. The routes and equipment will be folded back into Delta on those routes actually making money. JetBlue and AirTran Holdings rose on the news. Will Ted, the discount carrier spun off by United, be next?
The Jekyll and Hyde markets continue to produce volatility headaches. The close on Friday posted gains for the week on all the indexes except the SOX and NDX but the gain on the Russell was only a pitiful +2 points. Even worse the damage to the NDX was severe as was the lack of a material rebound. The SOX was knocked for a -30 point loss between Wednesdays high and Friday's close on disappointing numbers from numerous chip stocks. There was some dip buying in the SOX but it closed the day still in negative territory. The SOX would be the weakest link in my expectations for a market rebound. The lack of a rebound in the NDX is also troubling.
NDX Chart - 60 min
On Tuesday I suggested it might be time for the rally to start gaining traction as long as we managed to break and hold over the SPX 200-day average at 1200 and resistance at DWC 12000. Both those targets were hit on Wednesday morning but failed to hold more than a few minutes before bears piled on and pushed the markets back to their lows. We have had four major market reversals from the highs over the last ten days. This is NOT a good sign. We can blame it on the Refco liquidation and year end tax selling by funds but the fact remains the bulls were unable to hold the line. The bears performed a remarkable goal line stand at SPX 1200 while the clock ran down on October. I had hoped to be writing this weekend with the markets over that 1200 goal and the worst behind us. In life few things ever work out exactly as expected.
Wilshire 5000 Chart - Weekly
As I ponder next week I am retaining my bullish bias despite my feeling that the fundamentals are still weak. We have seen dozens of earnings misses and even more weak guidance announcements. Still the bulls continue to buy the dip. I don't know if it is just a seasonal thing where everyone just checks their brain at the door and buys October dips or an epidemic of mad cow disease affecting the bulls. I think it is calendar related event more than anything else. Traders are conditioned to believe stocks will go up in November as the only real guarantee in the market. Let's just hope our guarantee has not expired.
That brings me back to next week and the calendar. Since October is over for the funds they are free to put that cash back to work with a long time before they have to report on it again. If they don't go long now and miss a potential Q4 rally investors will jump ship. They are out of choices with the markets knocking on the 1200 door. They can't afford to miss the boat.
The obstacles the bulls have to climb are the October PMI on Monday and ISM on Tuesday. Consensus is for a drop in the PMI from 60.5 to 57.8 and the ISM from 59.4 to 58. While a bigger drop may cause some short-term volatility I believe it will be written off as hurricane damage and the dip bought. Better than expected numbers would of course be very market positive. With the FOMC meeting on Tuesday those numbers take on more of a rate perspective but again, I don't think the Fed is going to rock the boat. If anything I believe their statement will suggest the economy is gaining strength and that would also be market positive.
SPX Chart - 60 min
SPX Chart - 180 min
I am not going to go so far as suggesting we buy any dip on Mon/Tue but it might
be a good idea. I would rather buy a breakout or catch the next cross of 1185 to
the upside from any dip below that level. I don't want to try and call
under 1185 although numbers under 1180 have been doing a good job of attracting
buyers. At the risk of having my crystal ball taken away I think the worst is
over and a real rally is going to appear. That SOX drop back to the July lows
may have been just what we needed to flush some weak tech holders just in time
for the big money to step in. The same goes for the NDX. The complete erasure of
six days of strong gains took the NDX back to 1540 and decent support. Although
rebound was weak it was fund year-end. We have seen my SPX 1185 trigger
number see more traffic than Times Square at rush hour but I continue to honor
the moves. I am cautiously long again on Friday's rebound and will be looking to
add to those positions on a confirmation move over 200-day average at 1200. The
SPX has a strong pattern of higher highs since Oct 13th that places the next
resistance level just over 1210 but I believe the next break over 1200 will pass
easily with the calendar winding down. HOWEVER, the more I look
at the chart the more it looks like a bear flag so caution is still the key word
until a breakout is confirmed. We are running out of days in 2005 and the big
money has got to produce some returns or risk losing business and bonuses. A
break of that 1210 resistance should be the last call before the train leaves
the station. Nobody I know wants to miss it. Enter cautiously on dips but be
ready to act quickly on any breakout.
Black Box - BBOX - close: 39.40 chg: +0.10 stop: n/a
We Like It:
BUY CALL DEC 45.00 QBX-LI open interest=207 current ask $0.75
Picked on October 30 at $ 39.40
Inamed Corp. - IMDC - close: 70.63 change: +0.73 stop: n/a
Why We Like It:
BUY CALL DEC 75.00 UZI-LO open interest= 11 current ask $1.60
Picked on October 30 at $ 70.63
Oshkosh Truck - OSK - close: 42.82 chg: +0.98 stop: n/a
Why We Like It:
BUY CALL DEC 45.00 OSK-LI open interest=154 current ask $0.95
Picked on October 30 at $ 42.82
Protein Design Labs - PDLI - cls: 27.70 chg: +0.18 stop: n/a
Why We Like It:
CALL DEC 30.00 PQI-LF open interest=565 current ask $1.00
Picked on October 30 at $ 27.70
Molson Coors Co - TAP - close: 60.90 chg: -0.00 stop: n/a
Why We Like It:
BUY CALL DEC 65.00 TAP-LM open interest= 79 current ask $0.75
Picked on October 30 at $ 60.90
Bard C.R.- BCR - close: 61.90 change: +0.54 stop: 64.25
Friday was a very tough day for the bears with almost every sector closing in the green and many with very hefty gains. Shares of BCR were not immune to the widespread bullishness and the stock rebounded from its intraday low. We would hesitate to launch any new put positions at this time. Look for a failed rally under the simple 10-dma currently near $63.00 as a potential entry point. Our target is the $58.00 level but more aggressive traders might want to target the $55 region. Currently the Point & Figure chart points to a $55.00 target. Our time frame is less than six weeks.
Picked on October 26 at $ 61.70
Broadcom - BRCM - close: 41.42 chg: +0.11 stop: 44.11
The semiconductor sector was one of two sectors that failed to close in the green during Friday's big rally. Yet it is important to note that chip stocks rebounded well off their lows. BRCM dipped to $39.57 before bouncing all the way back into the green. This pattern is typically a one-day bullish reversal pattern and doesn't bode well for us. The pattern is even more of a problem for us since BRCM has effectively "filled the gap" from July. We would expect BRCM to produce some follow through on Friday's bounce. The question is where will the stock encounter resistance. There is some resistance near $42.00 and its 100-dma. There is additional resistance in the $43.00-43.25 region. We are not going to suggest new plays at this time. If BRCM produces a failed rally under $43.00 then more aggressive traders might want to consider it. Should BRCM reverse course again our target is the $37.00 level. Currently the Point & Figure chart points to a $35 target.
Picked on October 24 at $ 41.95
Infosys Tech. - INFY - close: 67.14 chg: +1.62 stop: 70.51
Investors reacted favorably to MSFT's earnings report and the stock added 2.57% on strong volume, which lead the GSO software index to a 1.5% gain. INFY followed suit and paced MSFT with a 2.4% bounce from the $65 region. INFY's pattern remains bearish. The P&F chart points to a $57 target. We are not going to suggest new put positions in INFY at this time but more aggressive traders might want to watch for a failed rally under the 200-dma and the $70.00 level as a new entry point. Our target is the $62-60 range. November 11th might see some volatility as INFY hosts an analysts meeting.
Picked on October 26 at $ 67.95
(What is a strangle? It's when a trader buys an out-of-the-money (OTM) call and an OTM put on the same stock. The strategy is neutral. You do not care what direction the stock moves as long as the move is big enough to make your investment profitable.)
AmerisourceBergen - ABC - cls: 75.34 chg: +1.90 stop: n/a
The big rally on Friday pushed ABC to a 2.58% gain on strong volume. Shares are trading back near the pivotal $75.00 level and testing technical resistance at its simple 50-dma. As long as ABC trades inside the $74.50-75.50 range we would still consider launching new strangle positions but we want to do so before the company's earnings report. ABC is expected to report earnings on Thursday, November 3rd before the market's open. Wall Street is looking for profits of $0.93 a share. Our initial strangle involves the November strikes. We are also going to suggest December strikes for any new positions. See below.
BUY CALL NOV 80.00 ABC-KP open interest= 764 current ask $0.70
If you play December strikes current prices would cost about $2.80. Try to pay less than $3.00. We would target a rise to $5.00 or more.
BUY CALL DEC 80.00 ABC-LP open interest= 115 current ask $1.40
Picked on October 16 at $ 74.81
Abercrombie&Fitch - ANF - cls: 49.58 chg: +2.61 stop: n/a
Perfect! The big rally on Friday pushed ANF right back toward the $50.00 mark and into our suggested entry window of $49.50-50.50. The stock has been narrowing its consolidation with a pattern of higher lows and lower highs and the longer it coils like this the bigger the breakout. We do plan to hold over ANF's November 15th earnings report.
BUY CALL DEC 55.00 ANF-LK open interest= 464 current ask $1.40
Picked on October 28 at $ 49.50
Administaff - ASF - close: 41.29 change: +1.01 stop: n/a
Friday offered traders yet another chance to launch strangle positions on ASF.
The stock oscillated on either side of the $40.00 level before finally surging
higher in the afternoon. The stock looks poised to continue climbing but all
that could change. The company is due to report earnings on Tuesday, November
1st. Wall Street expects earnings of $0.23 a share. At this time we would not
strangle positions but if ASF pulled back to the $40 level again on
Monday that could be used as another entry point.
Picked on October 23 at $ 39.40
Genentech - DNA - close: 87.72 chg: +0.63 stop: n/a
We are currently in a wait-and-see mode with DNA. The recent breakout from its sideways consolidation suggests an upward bias. This is also reflected in the Point & Figure chart with its triple-top breakout buy signal and $107 price target. We're not suggesting new positions at this time. The options in our strangle are the December $95 call (DWN-LS) and the December $75 put (DWN-XO). We plan to exit if either option rises to $4.50-5.00 or more.
Picked on October 20
at $ 84.83
eBay Inc. - EBAY - close: 38.43 chg: +0.59 stop: n/a
EBAY continues to languish behind the rest of the market following its disappointing earnings report. Yet even EBAY could not escape the Friday rally and shares added 1.55%. We are not suggesting new plays at this time. The options in our suggested strangle are the November $45 call (XBA-KI) and the November $35 put (XBA-WG). Thus far EBAY has not been cooperating and this sideways churning is killing the option premiums. We are adjusting our price target for either side of the strangle from $2.00 to $1.65.
Picked on October
18 at $ 40.42
General Dynamics - GD - cls: 116.65 chg: +1.49 stop: n/a
The market rally on Friday helped GD rebound from support near $115 and its simple 100-dma. Short-term technicals are turning positive but the $118.00-118.50 region looks like new resistance. We are not suggesting new plays. Our strangle strategy involves the November $125 call (GD-KE) and the November $115 put (GD-WC). We plan to sell if either option rises to $4.00 or more.
Picked on October 09 at $119.59
Harman Intl - HAR - cls: 98.85 chg: -1.25 stop: n/a
Technicals have taken a turn for the worse and HAR is now trading under the $100 level and its simple 50-dma. We are not suggesting new strangle positions at this time. Our initial strangle is based on the November $110 call (HAR-KB) and the November $90 put (HAR-WR). Lack of follow through on the earnings move does not bode well. We are adjusting our target from $6.00 to $4.00. We'll try to get out at break even and may be a little bit more to cover commissions. Our hypothetical cost basis is $3.80.
Picked on October 18 at $100.80
Hutchinson Tech. - HTCH - cls: 24.36 chg: -0.14 stop: n/a
HTCH continues to display relative weakness. The stock lost more than half a percent on Friday while the rest of the market surged higher. The company is expected to report earnings on Tuesday, November 1st after the closing bell. Wall Street is looking for profits of 13-cents a share. That makes Monday and Tuesday our last chance to initiate any new strangle positions but only if HTCH moves back into our suggested entry window of $24.75-25.25. The options we were suggesting are the January $30 calls (UTQ-AF) and the January $20 puts (UTQ-MD). We would try and keep the costs around $1.75 or less. We'll target a rise to $3.00.
on October 26 at $ 24.89
Kos Pharma - KOSP - close: 60.79 chg: -0.86 stop: n/a
The relative weakness in KOSP on Friday pulled the stock back towards the $60.00 level. Traders might want to consider launching new strangle positions with shares under $61.00. However, our preferred entry window to initiate strangles would be the $60.50-59.50 range. Traders will want to create their positions ahead of KOSP's earnings report. The company is due to report earnings on November 3rd before the opening bell. Analysts are looking for 0.70 a share. The options for our previously suggested strangle are the November $65 call (KQW-KM) and the November $55 put (KQW-WK). We'll plan to exit if either option rises to $5.00 or more.
Picked on October 20 at $ 59.80
Legg Mason - LM - cls: 104.00 chg: +1.04 stop: n/a
LM traded in a relatively narrow range on Friday. It was as if both the bulls and bears were too tired to push any more after the extremely volatile week. We are not suggesting new strangle positions on the stock at this time. Furthermore we will have to consider the possibility that LM will continue to churn sideways inside its $100-$110 trading range, which would kill any remaining premiums for our options. We do still have three weeks before the November options expire but it may be time to adjust our target to breakeven at $2.40 or higher. Keep that possibility in mind. The options in our previously suggested strangle were the November $110 call (LM-KB) and the November $90 put (LM-WR).
October 12 at $102.59
Loews - LTR - close: 90.75 change: +1.95 close: n/a
Shares of LTR did not produce a very big reaction to its earnings report. Therefore we are not suggesting new strangle positions at this time although if LTR continues to narrow its consolidation around the $90.00 mark new strangles could certainly work. The options in our strategy are the December $95 calls (LTR-LS) and the December $85 puts (LTR-XQ). We'll plan to exit if either option rises to $5.00 or more.
Picked on October 23 at $ 89.94
Microsoft - MSFT - close: 25.53 change: +0.64 stop: n/a
Reaction to MSFT's earnings report on Thursday night went from mostly bearish after hours on Thursday to bullish on Friday. An upgrade from CSFB didn't hurt nor did a massive rally in the markets. The stock added 2.5% and is challenging resistance at its simple 200-dma. We are not suggesting new strangle positions at this time. Our strangle is based on the December $27.50 call (MSQ-LY) and the December $22.50 put (MSQ-XX). We are aiming for a rise to $0.80-0.90 for either side of the strangle.
Picked on October 25 at $ 25.03
O'Reilly Auto. - ORLY - close: 27.01 chg: -0.23 stop: n/a
ORLY did not produce a very big reaction to its earnings report. The sideways churning in the stock price is killing the option premiums. Therefore we're going to lower our target. We'll exit if either option in our strangle rises to $1.20. The options were the November $30 calls (OQR-KF) and the November $25 puts (OQR-WE). More conservative traders might want to consider just exiting at breakeven (0.75).
Picked on October 09 at $ 28.23
Verifone Holdings - PAY - cls: 21.86 chg: +0.02 stop: n/a
We are still in a wait-and-see mode with PAY. The stock is outside our suggested entry window to initiate strangles. It looks like the call side of the strangle might win out but there is still plenty of time for our January options. We also listed a more aggressive November strangle, which has three weeks left until expiration. The options in our suggested January strangle are the January $17.50 puts (PAY-MW) and the January $22.50 calls (PAY-AX). We plan to sell if either of these hits $4.50 or more. The options in the November strangle were the November $17.50 puts (PAY-WW) and the November $22.50 calls (PAY-KX). We would sell if either of these hits $2.00 or more.
Picked on October 12 at $ 19.98
Avid Tech. - AVID - close: 48.91 chg: +5.08 stop: n/a
Target achieved! Investor reaction to AVID's earnings after the bell on Thursday pushed the stock significantly higher on Friday. The stock gapped open at $49.40 and traded to $50.00. At least two analysts reiterated their "buy" ratings on the stock. The options in our strangle were the December $45 call (AQI-LI) and the December $35 put (AQI-XG). Our target was to sell if either side rose to $4.50 or more. The $45 call hit a high of $6.50 and is trading now at 5.30bid/5.70 ask.
Picked on October 25 at $ 39.56
Intl Rectifier - IRF - close: 27.86 chg: -6.19 stop: n/a
Target achieved. Friday's reaction to IRF's earnings (Thursday night) was pretty drastic. The stock lost more than 18 percent. The December $30 put (IRF-XF) in our strangle hit a high of $3.70 and is trading at $3.00bid/$3.10 ask. Our target was $2.40.
Picked on October 25 at $ 34.95
In September, the Chicago Board Options Exchange (CBOE) and the Nasdaq jointly announced the introduction of the CBOE Nasdaq-100 BuyWrite Index, the BXN. This index joined two other previously introduced BuyWrite indices, the CBOE S&P 500 BuyWrite Index (BXM) and the CBOE Dow Jones Industrials BuyWrite Index (BXD).
The CBOE intends these BuyWrite indices to track the performance of a buy-write strategy for the various indices. A buy-write strategy requires buying a stock or portfolio of stocks and writing covered calls on the stock or portfolio. This strategy comprises one of the two most used options strategies, the other being call buying. The CBOE believed that the development of the indices would induce "more long-term customer interest in, and use of, CBOE index options," according to the 2002 Annual Report. They had their reasons for creating them: investors have another reason. These indices allow a study of how such strategies perform in different markets, helping investors decide if the strategies are right for their investment styles.
Investors didn't necessarily need the indices because theory and market pundits tell them how buy-write strategies will perform. Lawrence G. McMillan devoted more than 50 pages to the buy-write strategy in OPTIONS AS A STRATEGY INVESTMENT, explaining it as a strategy that investors would employ if mildly bullish or neutral. The money received from the written call provides some cushion if stocks declined slightly. The seller or writer of the call would also retain the credit if the stock or portfolio rose only slightly.
It's not as easy as that, though, because there are of course drawbacks. The credit retained would not cushion against too big of a drop, so this would not be a strategy employed if investors believed that a stock or portfolio of stocks would likely take a big hit. In addition, the stock or portfolio would be called away if it had risen above the strike price of the sold call at expiration, so the strategy would also not be appropriate if one anticipated a strong rally rather than a gradual one. The buy-write practitioners' gains would be capped, and those investors would not fully benefit in a strong run that took the price above the sold strike. For all these reasons, McMillan would likely agree with the CBOE's characterization of the strategy as one that tends to outperform the underlying index in a bear market, but underperform in a bullish one, as depicted in the chart below.
P&L Diagram for a Buy-Write Strategy,
However, knowing theoretically how the strategy might perform differs from studying a chartable index. Most would choose the chartable index over theory. The CBOE revealed how it would create such indices. Establishing an index that tracks the performance of a buy-write strategy on a particular index involves buying an index portfolio and then writing the near-term covered call option, generally on the third Friday of each month. That would be held until cash-settled on the third Friday of the next month, and then the process would be repeated. The call chosen would be slightly out of the money, the CBOE description states. No adjustments are made on the positions: no stock picking, no puts purchased to offset declines and no rolling up into a higher strike call. The BXM would hold a portfolio of S&P 500 stocks; the BXD, DJIA stocks and the new BXN, NDX 100 stocks. Because no adjustments are made, these indices allow investors to gauge how well such strategies work in each type of market.
The CBOE chose the BXM as the first of the BuyWrite indices to be introduced, so that index has the most accumulated history of the three. Before the index's introduction, the CBOE commissioned Duke University's Professor Robert Whaley to compile data showing how the BXM would have performed from June 1988 through December 2001, a period that encompassed the bull market of the late 90's in addition to the bulk of the bear-market decline that ended in 2002. In addition, Ibbotson Associates performed a study in 2004 that researched the performance of the BXM. The Ibbotson case study followed BXM values from June 1988 through June 2003 and found that the compounded annual return of the BXM Index was 12.39 percent as compared to a 12.20 percent return for the S&P without the covered-call strategy. A further benefit, the study found, was that this index had only two-thirds of the volatility of the SPX and that the risk-adjusted performance was favorable as compared to the SPX, too. Ibbotson researchers concluded that the BXM "has had the best risk-adjusted performance of the major domestic and international equity-based indexes over the past 16 years, and that the index enhances the risk-return tradeoff when added to a portfolio."
Before investors log on to their online brokers' sites to start buying stock and selling calls on them, some cautions are needed. The CBOE's FAQ's on the BXM warn that it might be difficult to reproduce the BXM's returns in real life. Real-life investors are paying commissions, taxes and other transaction costs. This warning is in addition to the one that echoes McMillan's, that traders employing this strategy cannot benefit in any rally beyond the strike price plus the credit received, and that the cushion provided by the credit received will not protect traders from a deep downdraft in the owned stock or portfolio. Of course, the CBOE also cautions that traders employing any options strategy must read and understand the CBOE's "Characteristics and Risks of Standardized Options" and that past performances to not guarantee future results.
What if investors were still interested in employing such a strategy on an index, despite its shortcomings, but not in doing all the work and, more to the point, not in spending all the money to buy the components of an index? The three BuyWrite Indices are not investable indices. Investors can't just buy the BXM, BXD or BXN, so those indices are not going to provide the easy solution.
It's theoretically possible to use a combination of SPY purchases and sold SPX call options to mimic a buy write position on the S&P 500, but most brokerages would not deem this a covered-call position. Most would require hefty capital as margin for that sold call position. Most ETF's have options based on the underlying security, and the QQQQ certainly does, so it would theoretically be possible to replicate the results of the CBOE BXN, the CBOE Nasdaq-100 BuyWrite Index, by purchasing QQQQ's and writing covered calls. The same could be done with the Diamonds (DIA). However, some ETF's are settled with a delivery of shares rather than being cash-settled, so would differ in this manner from the CBOE BuyWrite indices. Besides, this still requires selling calls each month, so it's not the sought-after easy solution.
Some covered-call funds exist, but many allow managers to use discretion to adjust positions, so those funds may not replicate the results of those BuyWrite indices. In 2003, the CBOE licensed Rampart Investment Management to market Rampart BXM, established as an investment vehicle that is meant to replicate the index. The Ibbotson study concluded that the fund did produce results that closely matched the CBOE's BXM. However, at least initially, Rampart intended to market its product to institutional investors and not retail investors.
Two closed-end funds, Madison Claymore's and First Trust's, have since been introduced, both benchmarked to the CBOE BMX. An article by Steven Smith of The Street noted that stakes in their publicly traded shares could be bought and sold, but that their fees were higher than those of most traditional mutual funds. Traders should do their homework if interested in the strategy, Smith advised. The costs of implementing the strategy, through the selling of options twelve times a year against an ETF such as the QQQQ, might actually exceed that of the mutual fund's fees.
Smith proposed that an ETF-type product that replicated the covered-call strategy of the CBOE BuyWrite indices would be eventually be introduced, and he was right. The BEP (XBEPX on the Nasdaq), offered by Nuveen Investments, intends to do just that. The BEP's investment objective is to approximate the performance of the CBOE BXM minus fees and expenses, using a covered call strategy. It was established March 31, 2005, and has varied in price from a high of $20.45 to a low of $18.30. It obviously has little history and almost no information was available. Average daily volume appears low, at about 45,000 on the NYSE. Perhaps other such ETF-type products exist, but a search on Yahoo, Morningstar and other sources for ETF's linked to the BXM turned up no results, although mutual funds and stocks were found.
For now, there may be few good solutions for those who want to employ a buy-write strategy on an index but don't want to do the work. The current environment of much uncertainty in the markets may not be the best to employ such a strategy anyway, as it requires a bullish to neutral outlook to perform well, and it's difficult to settle on an outlook with the current uncertainty.
Suggesting a new investment vehicle was not the purpose of this article, anyway. Suggesting a new tool to be used in considerations about options strategies was the purpose. Anyone considering adopting a covered call strategy might do well to look at charts on the BXM, BXD or the new BXN, studying how they perform in various types of markets. A daily closing price for each is calculated after the close of trading, with that price found at the CBOE website. Quick reference guides to each BuyWrite index can be found there, too.
If considering buy-write strategies, spend some time with the new kid on the
block, the BXN, and devote some time to
his siblings, the BXM and BXD, too.
Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Linda
Piazza and all other plays and content by the Option Investor staff.
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