Spiders: Where Are the Bugs?

One of the clearest trends in asset management is the rapid increase in the amount of individual and institutional money invested in indexed products. By far the most popular index which investors want to replicate is the S&P 500 index. While many academic studies have examined the characteristics of two instruments frequently used to replicate the S&P, index funds and futures, very little has been written about the newest way to replicate the S&P 500 index: Standard and Poors Depository Receipts (SDPR) commonly referred to as Spiders. The importance of Spiders can be seen by the fact that at the end of 1999 there were 19.8 billion dollars invested in Spiders and that in 1998 daily shares traded in Spiders exceeded any other stock except Compaq and daily dollar volume was the highest of any share traded. This is all the more surprising given the fact that Spiders have not been around very long.
There are three major reasons why this analysis is useful. First, the principal advantage of Spiders versus index funds is that they can be purchased and sold at prices which exist at any time during the trading day. As we will show, low-cost index funds produce higher returns than Spiders. Given that investors can use either vehicle, the difference in return gives a measure of the value of immediacy. The value of immediacy is an important issue in the literature on market microstructure. Second, since Spiders have become an important investment vehicle in terms of both trading volume and dollar value outstanding, their performance and characteristics are of interest by themselves. Third, the organizational form of Spiders is seen
as the prototype for index funds of the future, and thus it is important to understand both their performance and the affect of the organizational structure on that performance.
Before analyzing Spiders, we will briefly review their history and important characteristics. Each Spider represents an ownership interest in the SPDR Trust. The Trust as stated in the prospectus holds all of the common stocks in the S&P 500 composite stock price index and is intended to provide investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index. Spiders are traded on the American Stock Exchange and can be bought and sold like any stock at any time during the day. One Spider has a price equal to approximately 1/10 of the price of the S&P Index. The initial deposit creating Spiders was made on January 22, 1993. The Spider was organized as an investment trust and has a mandatory termination date of January 22, 22183. Any trust is governed by a trust agreement and there are certain aspects of the trust agreement governing Spiders which are important to understand. First, Spiders charge an expense ratio to holders of the Spider. This has historically been 18.45 basis points per annum. Second, a specific mechanism exists
for changing the number of Spiders outstanding. Investors can create or delete Spiders in minimum units of 50,000 shares by engaging in transactions in kind plus getting or receiving certain sums of cash. For example, investors can turn in a bundle of stock matching the S&P Index plus cash equal to the accumulated dividends less management expenses and receive Spiders in return. Investors can do so for a payment of $3,000 (regardless of the size of the transaction).
There is another peculiar aspect of Spiders that arises from their organizational form. Spiders pay out the dividends the trust receives on the stocks that it holds quarterly; on the last business days of April, July, October and January (though the ex-dividend day of the trust occurs in the previous month). What is unusual is that the dividends the trust receives from the
underlying stock is held in a non-earning account between the time it is received and the time it is paid out.
Having provided background on Spiders, we turn to the purpose of this article: to study the performance of Spiders and to compare Spiders with other methods of indexing. This paper proceeds as follows: In the first section we examine the performance of Spiders as an investment vehicle. We start by examining the return from holding Spiders compared with the return from holding the S&P Index. In this section we first examine Spider returns as if Spiders could be bought and sold at their net asset value. We then examine the magnitude and time path of the differences between Spider price and NAV. Since Spiders are not the only way of holding an index, we next compare the return on Spiders with the return on other methods of indexing, index funds and futures. One of the unique aspects of Spiders is the ability of investors to create and delete them by turning in or receiving bundles of securities.

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THE SINGLE CURRENCY

In January 2002, euro notes and coins were actually being circulated in the different countries and by the end of the first quarter, national notes and coins no longer existed. This change had an impact on everyone, from manufacturers, importers and exporters with trade flows to hedge, central banks with reserve asset and debt management concerns, to financial institutions and pension funds with international portfolios. In fact, even though this event was specific to Europe, the impact affected the world’s currency market community from American to Japan. The single currency in Europe formed one corner of the new triangular world of the dollar, the yen and the euro.
The conversion of national legacy currencies meant that organisations had to have the ability to accept both forms of transaction. It has been quite complicated because, for instance, to convert sterling to francs you had to have a conversion via the euro. This is because the national legacy currency no longer existed in its own right but was a denomination of the euro, fixed by the conversion rate. The European currencies have always fluctuated against the dollar, even as the debate about the euro raged. This can be shown by:
Birth of European Monetary System – it was the economic crisis of the 1970s that led to the first plans for a single currency. The system of fixed exchange rates pegged to the dollar was abandoned. European leaders agreed to create a “currency snake”, tying together European currencies. However, the system immediately came under pressure from the dollar, causing problems for some of the weaker European currencies.
Kuwait crisis – on 2 August 1990 Iraq invaded Kuwait. On the same day, the UN Security Council passed a resolution condemning the invasion.
Maastricht Treaty – in 1991, the 15 members of the European Union, meeting in the Dutch town of Maastricht, agreed to set up a single currency as part of a drive towards economic and monetary union. There were strict criteria for joining, including targets for inflation, interest rates and budget deficits. A European Central Bank was established to set interest rates. Britain
and Denmark, however, opted out of these plans.
ERM crisis – the exchange rate mechanism was established in 1979 and was used to keep the value of European currencies stable. However, fears that voters might reject the Maastricht Treaty led currency speculators to target the weaker currencies. In September 1992, Britain and a few of the other EU countries were forced to devalue. Only the French franc was successfully defended against the speculators.
Asian crisis – the turbulence in the Asian currency markets began in July 1997 in Thailand and quickly spread throughout the Asian economies, eventually reaching Russia and Brazil. Foreign lenders withdrew their funds amid fears of a global financial meltdown and the dollar strengthened. ManyEUcountries were struggling to cut their budget deficits to meet the criteria
for euro membership.
Euro launch – the euro, of course, was launched on 1 January 1999 as an electronic currency used by banks, foreign exchange dealers and stock markets. The new European Central Bank set interest rates across the euro zone. However, uncertainty about its policy and public disagreements among member governments weakened the value of the euro on the foreign exchange markets.

Central bank intervention – after just 20 months, the euro had lost nearly 30% in value against the dollar. The European Central Bank and other central banks finally joined forces to boost its value. The move helped put a floor under the euro, but it has still not recovered its value. A weak euro has helped European exports, but it has also undermined the credibility of the currency and has fuelled inflationary pressures.

Terrorist attack on New York and Washington – this attack in New York severely tested the currency markets. Money flowed out of the dollar into safe havens like the Swiss franc and, for the first time, into the euro. The central banks tried to calm the markets and interest rates were cut across the globe. Many observers believe it may have marked the coming of age of the euro as an international currency.
Euro becomes cash currency – on 1 January 2002, the euro became a reality for approximately
300 million citizens of the 12 countries in the euro zone. The arrival of the euro as a cash currency may foster closer integration and greater price competition within the euro zone. It may also help boost its international role, as doubts grow over the strength of the dollar, especially as American economy continues to slow.

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Short-Term Reversal Systems

Reversal systems are among the most effective systems that you can find for trading the stock index futures contracts. One of the most pronounced tendencies of the stock market is for the indices such as the S&P 500 to travel from a relative low to a relative high and from a relative high to a relative low. By this we mean that the market will often swing from the lowest close in x number of days to the highest closing price in x number of days.
The focus of my reversal system is a short-term move that reverses a recent extreme in price. You await the onset of a reversal from a relative high or low before trading in the direction of this counter-swing. The historical results of our system are high enough to warrant the use of such vehicles as OEX put and call options. We do not recommend futures positions leveraged far .beyond your cash. Rather, the safety net provided by slightly out of the money hedging options against futures positions can be crucial to your survival when the unexpected strikes.
In the S&P 500 futures market, many traders employ stochastics, RSI and other trading oscillators. Normally these traders will buy at the close when the oscillators move from oversold to overbought and sell when the reverse occurs. I refer you to my chapter on the "Market Wizard" method for more detail on this type of strategy. The prevalence of oscillator trading strategies can provide an edge in using intraday reversal systems. Indeed, I will show you how oscillator traders will actually push our reversal system trades in the direction we want.

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THE IMPORTANCE OF TIMING

A few thoughts about timing are important before we move forward. We would like to think that we can profit from the news if we act faster than others. It’s not true.

• The market moves on anticipation. “Buy the rumor, sell the fact.” If you bought on every piece of good news published in the Wall Street Journal, you would be broke.
• The market responds to the difference between the actual news and what was expected. The unemployment rate could have dropped 0.2 percent, and the market falls because it expected a drop of 0.4 percent.
• Action does not always mean immediate reaction. When did the Fed start lowering interest rates? When did the market start to respond? In the case of interest rates, it always takes more than one move by the Fed before you see a reaction in the economy.

Can You Apply the Same Buy-Sell Principles to All Stocks?

• Can you write down the rules you’ve used to buy and sell a stock, any stock? Can you write down the rules for when you would have exited the long positions in the previous stock charts? If so, you’re a systematic trader.
• When you look at a chart, do you see it in terms of continuous price moves? Do you look at the highs and lows of price swings? Do you draw conclusions, make up rules, and imagine that you can capture large profits?
  

Looking at a historic chart is frustrating and deceiving. It makes you think that you could have profited from the price moves. It’s much harder when you can’t see the future. However, high-tech display equipment lets you see the past price movement of any stock. It has brought many new traders to the table who think they can profit from future price moves because they can see the past.

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STRIKE PRICE AND STRIKE SELECTION

The preset price is called the strike price or the exercise price, which is the predetermined rate of exchange at which exercise takes place. The strike is usually chosen at a level close to the current foreign exchange spot of forward rate but may be at any reasonable level. The premium (price) of an option is very sensitive to the relationship of the strike to the current spot foreign exchange rate. However, in general, both buyers and sellers of options will select a strike based on several factors, including their forecast or expectations of the value of the underlying currency during the lifetime of the option and the option’s payoff (profit/loss) profile.
The strike price is the exchange rate at which the option may be exercised.
For example, a market participant with a bullish view for the dollar against the Swiss franc may choose to purchase the dollar in the forward foreign exchange market because there is a belief that the value of the dollar will appreciate against the Swiss franc. A long position in the underlying (dollar) represents the most bullish view of the underlying. However, a long dollar forward foreign exchange position has a payoff profile of unlimited gains if the dollar increases in value and unlimited losses if the dollar decreases in value. If the market participant wishes to eliminate the potential loss while keeping the potential gains, this participant may purchase a dollar call/Swiss franc put instead of purchasing the dollars in the forward foreign exchange market. Thus, a long dollar call represents a bullish view of the dollar but with protection. The cost of the protection is the upfront premium, thus there is a trade-off between the premium payment and the payoff profile.
The market participant now needs to select a strike rate. Should it be in-, at- or out-of-themoney?. In order to make this decision, the market participant will need to consider the upfront premium payment, the breakeven point (the point where the gains begin), and the leverage of the given risk. If the market participant has limited funds to spend on the premium, then an out-of-the-money strike, which is relatively inexpensive, reflecting less protection and higher leverage will be chosen. Thus, the purchaser is willing to accept less protection because of a strong view that the dollar value will increase. The breakeven point will not be as favourable as a strike that is further in-the-money because it will represent the premium and the difference between the forward rate and the strike.

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Applications of Currency Options

The users of the option market are widespread and varied, but the main users are organisations
whose business involves foreign exchange risk. Options may be a suitable means of removing that risk and are an alternative to forward foreign exchange transactions. In general, the exchange traded options markets will be accessed by the professional market makers and currency risk managers, where the standardisation of options contracts promotes tradability, but this is at the expense of flexibility.
In spite of the fact that options are becoming more and more popular with corporate clients, funds and private individuals, there is still some client resistance to using options as a means to managing currency exposures. Some clients consider options to be expensive and/or speculative. When you buy an option, the most you can lose is the premium (price paid for the option). In some cases, options can help minimise downside risk, while allowing participation in the upside potential. One of the reasons a client may choose to use an option, instead of a forward to manage their downside risk, is this opportunity to participate in the upside profit potential which is given up with a forward contract. Clients who buy currency options enjoy protection from any unfavourable exchange rate movements.
Companies use currency options to hedge contingent/economic exposures, hedge an existing currency exposure, and possibly profit from currency fluctuations, while funds may use options to enhance yield.
Sometimes a strategy may involve more than one option and some option strategies employ multiple and complex combinations. Certain combinations can yield a low or no-cost option strategy by trading off the premium spent on buying an option with the premium earned by selling an option.
Hence, in buying a currency option, it may help the purchaser by:

Limiting downside currency fluctuation risk while retaining upside potential;

Providing unlimited potential for gain;

Providing a hedge for a contingent risk; and

Enable planning with more certainty.
Selling currency options may assist the writer (seller) by:

Providing immediate income from the premium received; and

Providing flexibility when used with other tools as part of an exchange rate strategy.
For a hedger, in terms of exchange rate risk management, currency options can be used to guarantee a budget rate for a transaction. By buying a call (the right to buy) the maximum cost can be fixed for a purchase and by purchasing a put (the right to sell) the minimum size of a receipt can be fixed. The purchase of the option involves paying a premium but gives the buyer the full protection against unfavourable moves while retaining full potential to profit should rates subsequently move beneficially. This contrasts with a forward contract, which locks the hedger into a fixed exchange rate, where no premium is payable but no benefit can be taken from subsequent favourable moves.
In the case of trading, to assume risk in order to make a profit, traders use options to benefit from both directional views and/or changes in volatility. (This allows profit to be made from expecting volatility either to increase or decrease over a period of time.) For example, in order to take a directional view, an options trader might feel strongly that the dollar will strengthen against the Swiss franc in the next three months from its current level of $/sfr 1.66. The trader buys a dollar call (right to buy), Swiss franc put (right to sell) option with a strike price of 1.6835, with expiry in three months’ time.
The trader has two choices:

• 
  To hold the option to expiry and if the spot rate has risen to, for example, $/sfr 1.73, the trader would exercise his right to buy dollars and sell Swiss francs at 1.6835, and hence, make money. If the spot rate is below $/sfr 1.6835 at expiry, then the maximum loss is limited to the premium paid for the option.
• Alternatively, if the spot rate rises, say one month after the trader has purchased the option,the trader could choose to sell the option back. By doing this, the trader will recoup both the time value and intrinsic value of the option.

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CURRENCY OPTIONS

The essential characteristics of a currency option for its owner are those of risk limitation and unlimited profit potential. It is similar to an insurance policy, whereby instead of a householder paying a premium for insuring the house against fire risk, a company pays a premium to insure itself against adverse foreign exchange risk movement. This premium is paid upfront and is the company’s maximum cost. Exchange of currencies in the future may take place at the strike price or, if it is more beneficial, at the prevailing exchange rate.
Options can be obtained directly from banks, known as over-the-counter (OTC) options, or via brokers from an exchange (exchange traded options). The essential characteristics of over-the-counter options are their flexibility. The buyer can choose the currencies, time period, strike price and the contract size, in order to match the particular exposure requirements at the time. Against this, exchange traded options have standardised time periods and strike prices and only a certain number of currencies are traded, thus limiting choice. This standardisation of option contracts promotes tradability, but this is at the expense of flexibility.
The main users of options are organisations whose business involves foreign exchange risk and may be a suitable means of removing that foreign exchange risk instead of using forward foreign exchange. Against this, in general, the exchange traded options markets will be accessed by the professional market makers and currency risk managers. The over-the-counter option market has as its market makers banks, who sometimes use the exchanges to offset risk.
Options can be and are used in many different circumstances, but essentially in times of uncertainty. For example, a British company wanting to make an acquisition in Japan is faced with a possible uncertainty in the timing of a foreign exchange cash flow. The British company does not know exactly when the acquisition will take place as there are so many factors to be put in place, but it does know that at some stage the company will have to buy Japanese yen and sell sterling. The foreign exchange risk is obviously key to a successful acquisition. By using a currency option, the treasurer would know exactly the maximum cost of the acquisition but would also have the potential for greater profit if the Japanese yen weakened.
Another example would be in a tender-to-contract situation, where a company is uncertain as to whether there will be an exposure at all. By using options, the company will know with certainty the worst rate at which it can exchange one currency for another should the company win the contract. If the exchange rate moves in its favour, the company can deal at the better prevailing rate. If, however, the company loses the contract, it will either have lost the premium, which is a known cost paid upfront, or it may have the potential for gain if the prevailing exchange rate is better than the rate agreed under the option.
Thus, normal foreign exchange transaction risk obviously gives rise to uncertainty. Using options as an insurance policy can result in peace of mind for the user. The cost, the premium, is
known and paid upfront. The treasurer then knows what the worst rate would be and can budget accordingly knowing that there may be a windfall gain. Translation risk is always a difficult problem for a company. If an unrealised exposure is hedged using an option, the maximum cost is known upfront. If it is hedged using a foreign exchange forward, then there is potential for a realised loss when the foreword contract is rolled.

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Reactive Day Trading of the S&P 500

By using daily pattern analysis to determine our short- term trades, we accomplish several worthwhile goals. First of all, we insure that our performance as traders reflects the quality of our statistical research and not just the trend of the market. Second of all, we create a diversified portfolio of trading methods, which when united, create a lower risk profile than any one method can yield. To trade one method alone is to base our results on certain random factors and certain elements beyond our control. Finally, by entering and exiting our positions rapidly, we create an environment that will tolerate our missing a move.
As a trend follower, I cannot make an error or take time off from trading. If a signal occurs and I am not watching, I may not be able to get back into the market at the system entry price. Short term pattern trading helps solve this problem. Many of the greatest money managers trade exclusively in this fashion but will never reveal to you the basis of their success. Every statistical trader has a bunch of pet patterns that are used each time certain conditions take place. I am giving you a sample library of pet patterns, but you must have experience in other areas to make money trading this way.
One great secret of many professional traders will really shock you. They almost never use stop orders to exit losing positions. Contrary to the advice of most trading manuals, the dozen or so large fund traders that I have worked with do not use intraday protective protective stops end up degrading their systems. The stops tend to get triggered at the extreme price levels of the day, thus giving up positions at the very worst possible moments. A large trader with a protective stop in the market becomes extremely vulnerable to manipulative strategies. We will hang onto our trades until time runs out on our patterns. We will not use leverage that will force us out of the market upon adverse price movements. If we do use leverage, then we will buy out of the money hedging options to trade against repeatedly without requiring our using protective stops.
Without further comment, let me present you with a collection of S&P daily trading patterns that I found through extensive computerized searches of historical price behavior. So that this chapter did not turn into a mindless exercise in data mining, I have only included patterns that contain common sense reasons for their effectiveness.
The patterns are presented in a way that a professional computer based trader might use them. They need to be entered into a real time system monitoring machine such as Tradestation™ by Omega Research. When Tradestation signals that one of these patterns has fired, the code will tell you what signal has occurred and what orders you must place. Response time must be fast and furious. In cases in which entries or exits are based upon the closing price, you must know your systems' rules and not depend upon the computer alerts. A bell ringing at the close and telling you to enter your position tells you too late what you should have done. I have provided the Tradestation™ code for each pattern so that there will be no ambiguity caused by my written descriptions.>/span>

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Trading the Options Expiration Method

As you may know, on option expiration day each month in the stock market, volume and volatility have a tendency to swell. Very small moves in the stock indices may determine whether or not vast sums are won or lost in the options markets. Indeed, there is an overwhelmingly powerful motive for large traders to act to make their positions profitable at expiration. In this chapter, you will learn how market makers and large traders act in ways that create profit opportunity for savvy professionals.
Specifically, I will teach you how and when professionals have been taking positions to profit from the expiration shenanigans. The mechanical entry into the S&P 500 futures contract provided has made approximately $115,000 with 76% accuracy trading a single contract. I encourage you not to fear to trade the expirations, but to study them instead.
Predatory trading tactics at expiration
One tactic that can sometimes be seen on expiration day in stock indices is nicknamed the "Paris March" by top hedge fund traders. The nickname comes from the famous pictures of the Nazis marching by the Arc de Triomphe in Paris during WWII. In the photo, heavily armed bullies storm the city while the residents stand by defenselessly.
Similarly, in the stock market, major players will buy large positions in individual stock call options before expiration day. Traders are happy to sell these short-term options to the big players because the time decay is so extensively close to expiration that the sale looks like a good bet. However, the trick that follows can end up putting the seller out of business.
To carry out the Paris March, the large house that bought the calls buys the underlying stock(s) just an hour or so before expiration to force the calls into the money. Call options that were slightly out of the money suddenly go into the money and force the brokerage houses to scramble to buy stock to meet the exercises. This strategy creates a short-term buying surge and the buying looks to be coming from many sources—a powerful psychological driver in the market. The trading house profits on its long cash position and its calls or short puts at expiration. Naturally, the market has a tendency to go down the morning following expiration as the artificial demand for stocks disappears.
I have created a historical calendar for you of options expirations from 1981-1997 so that you may conduct your own research into expiration phenomena. But now, I will give you my best trading strategy for exploiting the upward bias of many pre-expiration periods.

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Crash Filters For The Stock Market

Though the topic may seem a bit unusual, it may end up being the most important chapter in the book for many of you. The information contained is crucial. Indeed, recognizing the pattern I will show you may very well end up saving your career as a trader. It may also make your career as a trader if the pattern unfolds, and you take aggressive positions for a smash. In fact, in 1994, this model gave a signal that I relayed to my fund manager. He took immediate action in the OEX Put market and saved the fund millions of dollars over the next month. The subject of this report is panic liquidation of the stock market, when it has happened, how to predict it, and how to profit from it.
My crash filter pattern does not get tripped too often. Usually the market goes up. In fact, on only 235 days has the trade called for a short position in the market since 1986. Even when the pattern does occur, there have been times when no panic liquidation has taken place. Do not panic yourself when the pattern appears imminent. No market move can be called inevitable. However, taking protective measures with your money and making a speculation in put options seem warranted.
Many commentators have theorized that drops in the price of Treasury instruments such as bonds, notes or bills can be very negative for stocks. Similarly, other researchers have found a link between the U.S. dollar's price momentum and stock prices. A falling dollar normally is negative for stocks while a rising dollar is positive.
What this report will show you is a completely mechanical method for gauging the weakness of Treasury notes and the trade-weighted U.S. dollar for use in S&P trading. My studies show conclusively that panic liquidation of stocks occurs most readily when a simultaneous deterioration of intermediate/long term government bonds and the tradeweighted dollar is taking place. Sometimes just one of these conditions can be met and stocks drop, but the combined meltdown has carried more dire consequences.

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Our Winning Expiration Trading Method

I look for an unusual disturbance in volatility patterns 4-5 days prior to options expiration to tip me off that a tradable expiration move is on the way. This system takes positions at the close of the "tip-off day and holds until the close of the expiration day.

Rules:

• If the range of the day five trading days before expiration day is less than 70% of the average range of the previous three days or is greater than 140% of the average range of the previous three days then an unusual volatility disturbance has taken place.
• Given an unusual volatility disturbance five days before expiration, buy the S&P 500 futures on the close of the unusual disturbance day.
• Hold the long futures position until the close of options expiration day.

We have tested results of trading on a volatility disturbance four days before expiration with very similar results. However, for the record, we will use five days as our model pattern. The expiration system has traded 66 times since 1982. Total net profit of $122,530 has been achieved trading only one lot. Profitability for this model has increased sharply in recent years as the phenomenon has become more pronounced.
The system has also tallied up an extraordinary win/loss ratio of 2.43 and an impressive profit factor of 7.30. You would have been in the market for only 340 days using this model. Therefore, being long less than 10% of the time since the inception of the S&P contract, this model has captured approximately 51 % of the total index points of buy and hold. This statistical
phenomenon is very powerful. If you think likewise, maybe you will conduct your own research into this type of trading.

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