The pattern trader wants volatility -- one-sided
volatility, that is. Buying off breakouts and pullbacks, we want
price to spike upward.
When we short, we want downward price volatility. But what if you play
exchange-traded funds?
Exchange-traded funds that track broad indexes don't produce the explosive price
moves of high relative strength stocks. But you don't have to give up on all exchange-traded funds.
Merrill Lynch's
HOLDRs expose your dollars to specific sectors or industries rather than broad indexes.
That kind of concentrated exposure means HOLDRs can produce explosive price moves, to the downside as well as the upside.
Holding Company Depository Receipts,
or HOLDRs, represent holdings in a fixed basket of stocks. This separates
HOLDRs from another class of exchange-traded funds called index shares. True to their name, index shares track different
stock indexes and so change their holdings to follow those indexes. If
you're new to exchange-traded funds, check out my introduction
to these securities.
Price volatility poses a special
problem for short-sellers of stocks, a problem that doesn't crop up when you
short HOLDRs. Under a rule of the Securities &
Exchange Commission, you can only short on the uptick. Most short-selling
signals occur on price declines. So the short-seller of stocks is forced to
wait, allowing the share price to move further from his or her entry point until
an uptick occurs. This problem is even worse in highly volatile stocks.
Fortunately, HOLDR products, like all
exchange-traded funds, are not subject to the uptick rule. You are able to short
in the direction of downtrend. Assuming
you're accurate on your setup, you often enter the trade much closer to your
optimum entry point than you do with individual stocks. This reduces the risk of getting stopped out
and boosts returns on winning trades, since you're getting in earlier on the
favorable move.
For more on short-selling these
instruments, read my tutorial,
Tactics
For Tradable Funds, Part III: Short-Selling Base Failures.
The movement of an index, of course, reflects the collective net price change
of dozens or hundreds of component stocks. Its laggards will partially
offset the effect of its pacesetters. This diversification reduces the risk to trading index shares,
but it can dull returns as well.
The best-known index shares include the Diamonds (DIA | Quote | Chart | News | PowerRating), Nasdaq 100
Tracking Stock (QQQ | Quote | Chart | News | PowerRating) and the S&P Depository Receipts (SPY | Quote | Chart | News | PowerRating). These
funds, which trade on the American Stock Exchange, follow the Dow Jones
industrial (INDU | Quote | Chart | News | PowerRating), S&P 500 (SPX | Quote | Chart | News | PowerRating) and Nasdaq 100 (NDX | Quote | Chart | News | PowerRating),
respectively. These tradable funds are popularly referred to as the Diamonds,
Spiders and Cubes (or Qubes).
On the other hand, each HOLDR starts out with a basket of only 20 stocks.
Fewer stocks means more concentration, which means more price volatility. In
addition, each industrial HOLDR zeroes in on its own industrial niche. That increases volatility
further, assuming a lively industry. (Merrill Lynch also has plans to roll out other
HOLDRs that track investing styles, such as growth and value, rather than
concentrating in specific industries.)
For instance, let's say
semiconductor stocks break out for an advance or sell off. The
Semiconductor HOLDR (SMH | Quote | Chart | News | PowerRating) will reflect the collective action of its
components, which include Intel (INTC | Quote | Chart | News | PowerRating), Texas Instruments (TXN | Quote | Chart | News | PowerRating), Applied Materials
(AMAT | Quote | Chart | News | PowerRating),
Broadcom (BRCM | Quote | Chart | News | PowerRating), Micron Technology (MU | Quote | Chart | News | PowerRating), Analog Devices (ADI | Quote | Chart | News | PowerRating),
Xilinx (XLNX | Quote | Chart | News | PowerRating), Maxim Integrated Products (MXIM | Quote | Chart | News | PowerRating), LSI Logic Group (LSI | Quote | Chart | News | PowerRating)
and Teradyne (TER | Quote | Chart | News | PowerRating).
A big move by semiconductors will only
partly impact the Cubes and the Spiders as their indexes include stocks from
other industries. The Dow, tracked by the Diamonds, hosts just one semiconductor stock: Intel.
Some HOLDRs track even narrower niches. For instance, the Internet HOLDR (HHH | Quote | Chart | News | PowerRating),
which incorporates such diverse companies as Web portal Yahoo! (YHOO | Quote | Chart | News | PowerRating),
online brokers E*Trade Group (EGRP | Quote | Chart | News | PowerRating) and Ameritrade Holding (AMTD | Quote | Chart | News | PowerRating),
service providers America Online (AOL | Quote | Chart | News | PowerRating) and EarthLink Network (ELNK | Quote | Chart | News | PowerRating),
Web retailer Amazon.com (AMZN | Quote | Chart | News | PowerRating), online auctioneer eBay (EBAY | Quote | Chart | News | PowerRating), dotcom
incubator Internet Capital Group (CMGI | Quote | Chart | News | PowerRating) and Inktomi (INKT | Quote | Chart | News | PowerRating), a
developer of search-engine software.
Merrill Lynch slices and dices the Internet arena into more specialized
portions with three other HOLDRs: B2B Internet (BHH | Quote | Chart | News | PowerRating), Internet Architecture
(IAH | Quote | Chart | News | PowerRating) and Internet Infrastructure (IIH | Quote | Chart | News | PowerRating).
This kind of concentration often translates into far great price movement
than in the index shares.
Take the Biotech HOLDR. The basket ran
up 136% from its first day of trade on Nov. 23 to March 6 peak. Over the same
time frame, the Nasdaq 100 Tracking Stockm popularly referred to as the Cubes or
Qubes, appreciated 52%.
Of course, HOLDRs can run to extremes
on the downside as well. Take the bear market of Spring 2000.
The Nasdaq 100 Tracking Stock shed 40% of its value from its March 24
intraday high of 120 1/2 to its May 25 intraday low 72 1/4. A severe markdown by
any standard. But the carnage was worse in many of the HOLDRs. The Internet
HOLDR, which peaked and bottomed over the same period, shed 49% in price.
The Internet Infrastructure HOLDR plunged 59% during the same time frame. The
tradable basket actually peaked two weeks earlier. The entire decline --
measured from March 10 top to May 24 bottom -- represented a 66% loss. The B2B
Internet HOLDR suffered a 76% haircut from March 10 peak to May 26 bottom. The
Biotech HOLDR tumbled 54% from March 6 peak to May 24 bottom.
A more sophisticated measure of how
much a security changes in price over time is Historical
Volatility. HV is the standard deviation of day-to-day price change
expressed as an annual percentage. Suppose a stock is trading at $100 and has an
HV of 20%. The stock has a 66% probability of trading somewhere between $120 or
$80 in a year's time. My measure of HV is based on stock prices over the past 50
days.
The higher the HV, the more
opportunity and the greater the risk. Lower HV securities pose less risk but
offer the trader less opportunity to exploit an explosive price move.
As of the June 28, 2000 market close,
the Cubes closed at 94 a share and scored a Historical Volatility of 61%. So
under the HV formula, there's a 66% chance that the Cubes will trade between 151
and 37. By comparison, the S&P Depository Receipts (SPY | Quote | Chart | News | PowerRating) look mild. The
Spiders, as they're called, closed the same day at 145.563 (I'll decimalize
prices to keep things simple.) With an HV of 23%, the Spiders have a 66%
probability of trading between 179 and 112 a year down the road.
Yet Cube volatility pales beside
the HV scores of some HOLDRs. Biotech HOLDR closed June 28 at 180 with an HV of
69%. Buy the basket and forget about it for a year. There's a two-thirds chance
that you'll have a security worth somewhere between 304 and 56. The B2B Internet
HOLDR had an HV of 76, Internet and Internet Architecture HOLDRs, both 72%.
On the low end, the Telecom HOLDR (TTH | Quote | Chart | News | PowerRating)
had an HV of 33%, the Pharmaceutical HOLDR, 24%. This make sense. These are
broad sectors with more established companies.
For more information on this
indicator, check out Dave Landry's lesson on Historical
Volatility in the TradingMarkets' education section.
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