For several months now I've concentrated on writing a series on all things 'technical', such as chart patterns, indicators, patterns in conjunction with certain indicator extremes and so on. This, for the purpose of building up our current Trader's Corner archive so that you can peruse various topics in this knowledge base. I have more of these articles to write but first a word this week from our 'sponsor' so to speak, as I've gone to my Mailbox for some OIN Subscriber comments and questions.

MY TRADER'S CORNER MAILBOX:

SUBSCRIBER MAIL:

"I trade Dow index futures on cbot/cme. I noticed in August that the market had become inverted and it was cheaper to buy the future than the cash. For a stock indice I am not sure I know what this means or is predicting.

For agriculture goods this may mean a shortage. Does an inversion in a stock market futures indicate a cash shortage? If so does this mean stock market drop or stock market up??? Any advice would be welcome.

REPLY:

An 'inverted' market structure is, as you say, where the futures are cheaper than the current spot or 'cash' price. Why would a futures curve invert? This situation has long been known in the futures markets as backwardation. In the case of physical commodity futures, backwardation suggests possible benefit to owning the asset (i.e., 'the convenience yield'). With a financial asset such as stock index futures, ownership of the actual stocks brings a dividend(s) to the owner for stocks that pay dividends, making the stock basket worth more than the nearby futures. Normally, futures trade ABOVE the spot index as relates to the concept of 'fair value'.

FAIR VALUE: This could also be thought of as equivalent value. The theoretical cost of owning the stocks in the Dow Index futures (or the S&P 500, etc.) will always be different than the cost of owning the futures contract, which has no cost beyond its face value. This difference comes from two factors:

1.) If you bought all 30 of the stocks in the Dow 30 (INDU) you'd have to fully finance the purchase (or have your money tied up), which involves an interest rate cost; i.e., the cost of carry to borrow money, also equal to the 'opportunity' cost of having money tied up in stocks. Those that calculate fair-value, especially the big investment banks and brokerages, factor in a constantly changing borrowing cost. Remember that short-term interest rates that 'carries' stock purchases are near ZERO. So, in this uncommon situation, futures will trade at almost NO premium to the actual index.

2.) If you owned the stocks comprising INDU (or SPX), you'd receive some dividends. To varying degrees, many big companies pay dividends, but of course futures don't distribute earnings to shareholders as the contract doesn’t involve the rights of shareholders. Of the 30 stocks in the Dow, there were at the time you observed an inverted market, a few stocks that hadn't yet gone ex-dividend, so holding the stocks for the dividend payments makes owning the stocks more valuable than the nearby futures contract. In this instance, a nearby contract that's trading at a discount to the actual index is EQUIVALENT to owning the stocks, some of which pay dividends.

Normally, once all the stocks in the Dow 30 (or SPX) that pay dividends have gone ex-dividend for the quarter we're in, the futures would revert to trading above the spot price. However, this WON'T be the case with short-term interest rates near zero. Yesterday (12/14/10), the December Dow Jones futures contract closed at 11484, a discount to the INDU close at 11476.5; the March DJ futures closed at 11421. The December S&P 500 futures closed at 1241.8, versus the spot/cash close of 1241.6, showing a slight premium. However, the March SPX contract closed at 1236.8, a discount to spot.

The most common cash/futures price structure is where the futures trade above the spot price and is labeled 'normal' in the graph below. Sometimes there is an inverted curve when futures prices trade below the spot market value. Both types are seen below.

It's also true that once in a while, stock index futures (as will physical commodities at times) will trade BELOW the spot/cash market in the midst of a panic type sell off. Traders assume that stocks will keep falling and are willing to short a futures contract at prices below the current cash price, either as a speculation or for hedging purposes, looking to cover short positions when futures' premiums come back into a more normal alignment; i.e., when prices hit 'rock bottom' or a level where buyers start to come in again. However, the current situation is not the 'panic' selling type situation and relates to dividend payments and interest rates combining to produce our current inverted stock index futures curve.

A FURTHER NOTE FROM THE SAME SUBSCRIBER:

... "when I asked you that question in August I wanted to short a DOW futures contract at that time, but when I noticed that the the DOW contracts were inverted on barchart.com and the CME/CBOT website I became hesitant to short, even though September is a month that has a great historical record of going down, so I swallowed hard and took a long DOW contract around september 13 and September 2010 ended up being the best UP September since 1939! I offset my long around the first week of November, in hindsight I should have held on. Interestingly the DOW futures contracts are still inverted (cash shortage?). Personally I have never seen an inversion in a stock index before, so I am not sure of its significance, but it is interesting to observe and make money off of if you can. I appreciate you getting back with me."

MY REPLY:

There is NO "cash shortage" and in fact the Fed continues to pump money into the economy. We're awash in cash. (There is a 'shortage' of lenders and borrowers.) The significance of WHY futures are generally trading at a discount to cash is 1.) Owning the stocks has value from dividends and 2.) cost of borrowing to buy the stocks is very low, so to maintain EQUIVALENT value futures are near to under cash.

Your profitable trade was a result of making the right decision to buy into an uptrend. The Dow had broken out above its down trendline on 9/1 and by the close on 9/2 was trading above its 21-day moving average (see chart) demonstrating upside momentum. You bought into a breakout move and you were rewarded with a profitable trade. Making your trading decision based on stock index futures trading UNDER cash wasn't especially relevant as to why it was a smart trade to make. It was smart in the sense that you wouldn't 'lose' a premium (of futures to cash) when futures converge on the spot price by expiration.

SUBSCRIBER MAIL:

The following Subscriber e-mail related to my Trader's Corner article on the Bollinger Band (9/15/10) indicator.

"Touching the upper or lower band with couple days sideway could signal a reversal so long it is in a confined up and down band, but if the band widening up it can has complete different meaning. Yes. it can be a consolidation and correct (reverse) a bit for a very short period of time and never meant to touch the other side of the band. After that it could continue rising along the upper band. So the examples you use in that chart only because they were in a sideway up and down fixed band width BB. What happen now is a widening band."

REPLY: I'd normally reply to a Subscriber e-mail even if there wasn't a question mark in there; in this case, thanking you for adding your observations, especially as a CMT (Chartered Market Technician) to my 9/15/10 Trader's Corner column.

As you say, if volatility increases and the Bollinger Bands expand accordingly, this could be another leg and prices just continue in the same trend direction, only probably accelerating. I recall using an example of a trading range market where the bands would tend to define upper resistance and lower support. This is the middle period seen on the daily chart of the Nasdaq 100 (NDX) below. These kind of periods (a trading range) This is where I find Bollinger bands to be moderately useful. Moreover, having some upper and lower price parameters, as the Bolli Bands (set at two standard deviations above and below a 20-day moving average) typically will 'contain' 95% of all price action. This is another useful aspect, especially when combined with an overbought/oversold indicator like the RSI (Relative Strength Index). I'll explain.

You see the section below in the middle of the chart where NDX was bouncing back and forth between 1950 or so on the upside and the 1750 area on the downside. The Bollinger Band levels were useful in terms of 'acting as' resistance on one hand and support on the other. When prices are just running up along the upper line, this does not signal 'resistance' and isn't in itself useful for calling a top, interim or otherwise.

However, with my 'rule of 3', as highlighted above showing RSI overbought extremes, it's often the case that the 14-day RSI will hit overbought (at 75/75+) levels approximately 3 times before coming down; this is my rule of thumb in a bull market. This worked well in this market to suggest a top at the upper Bollinger Band as seen with my RSI 1-2-3 highlights.

Sell offs can get extreme relative to the Bollinger Band indicator, as seen above with the first (May, 2010) dip well under the lower Bollinger Band. If you were watching this price action, that first dip to 1750 was a screaming buy. In general, during the past months trading shown above, dips to the lower Bollinger Band accompanied by a 14-day RSI reading at or below 35 (this is the lower extreme in a bull market), NDX calls were a buy.

When price swings get wider in periods of greater volatility, the Bollinger Bands also widen of course. Again, Bollinger Bands are set at two standard deviations relative to a 20-day moving average that's unseen on the chart.

In terms of trading strategy involving aspects of volatility, I've benefited at times from studying a chart set up using the CBOE Volatility Index (VIX) for the S&P 500. What seems to 'work' is to buy calls (and equivalent bullish strategies) in a bullish trend when the daily VIX is at least 5% above the 10-day VIX moving average, as seen below. Buying puts may also pay off when the daily VIX is 5% or more below VIX's 10-day average AND the 13 or 14-day RSI is at an overbought extreme at 75 or above.

The following mail might also fall into the 'shameless promotion' category, except that I will never get future royalties on sales of this book due to a large advance given to me by Publisher J. Willey & Sons to write it. Sales of these type market-related books took a dive after the 2000-2003 bear market and have never recovered.

SUBSCRIBER MAIL:

"Hi. I bought your book (Essential Technical Analysis), last week. It is really an awesome book. Although, I am into P&F Charting big time, and the portion you have covered about this charting method, is really useful.

I don't know much about Options. I was wondering if you write a newsletter about Equities, which I could subscribe, please let me know?"

REPLY:

I'm glad you're finding my book useful. I just downloaded the Kindle version from Amazon. My Essential Technical Analysis book is out of print, although new and used copies by the resellers are still available via Amazon and elsewhere. I myself don't write about individual equities as much as the main stock indexes. My orientation is toward options traders in terms of a somewhat shorter-term market timing approach. Some use my take on the market to also trade some key stocks, but I have a 'trading' approach more than having an 'investment' (buy and hold) time horizon.

In our 'family' of market letters, Premier Investor is the one devoted to those more actively managing an equities portfolio. Premier Investor stock recommendations tend toward both short and intermediate-term horizons; e.g., a 2-3 month or longer time outlook. The goal is to guide Premier Investor Subscribers toward achieving profits that are greater than a more passive buy and hold strategy; one that simply hopes to match the historical (e.g., 9-10%) return from equities.


GOOD TRADING SUCCESS!