You would think an index would know better than to create a pattern. Especially if the index is the benchmark every Fund manager, investor, compares his performance to. ( A fund manager has to beat the S&P otherwise why would an investor ever invest into a Mutual Fund and not in the S&P index fund). Well here it is:
Check out this obvious trade. It was Broadcom (BRCM). Why? BRCM was being added to the S&P 500. Which means that it made a BIG move north (up). Standards and Poors (S&P) usually adds companies which go above the 500 threshold of evaluation. Usually as soon as a company has a higher market capitalization than the lowest one in the index it will replace that one, well that is supposed to be the concept, but: Among the criteria is that a company is financially viable," says David Blitzer, a managing director at Standard & Poor's and the chairman of the index selection committee. "We have a strong preference for companies that have earnings. A year ago, I got several calls a month asking why we didn't have Amazon AMZN in the index. I'm not upset we didn't add that one. S&P does not like volatility and therefore waits on certain issues to add them, that is why JDS Uniphase (JDSU) is not added yet either. Furthermore, some companies get held back in the mid-cap index, while companies like Bethlehem Steel, the company with the lowest market cap in the S&P 500 have been members of the S&P 500 forever." That is why Broadcom wasn't put in sooner. It had a market cap around $32 billion when Standard & Poor's made the addition announcement, enough to put it among the top 100 stocks in the index. At number 60 to be exact. The short answer is that the S&P 500 is a qualitative index, not a quantitative one. In order to avoid rapid turnover, Standard & Poors only adds companies with solid fundamentals.
But BRCM with a market capitalization of $40 billion started a ranking at around 60 of the 500 stocks. As soon as we saw that Friday afternoon coming, we saw a huge spike in BRCM as index funds, and other mutual funds had to sell a lot of stocks within the S&P and buy a lot of BRCM. There's about $800 billion indexed to the S&P, and indexers had to buy around $2.5 billion worth of Broadcom, according to Merrill Lynch. "The S&P will be under price pressure that day," adds Murali Ramaswami, Lehman Brothers' global head of equity derivatives research. "It's almost like Yahoo!." Yahoo! was added to the S&P on Dec. 7, 1999. Because it had such a big market cap -- around $94.5 billion -- indexers had to raise something like $4.5 billion to $5 billion, according to Ramaswami. That helped to send the S&P down 1% on the day. (Lehman estimates indexers will need to buy $3.2 billion to $3.3 billion worth of Broadcom.).
As a result, when something like Yahoo! or Broadcom comes in, index managers need to buy a ton of stock. This creates tremendous demand, which feeds on itself. Traders can quite rationally run a stock higher, because they know that as it goes up, so will its capitalization, its rank in the S&P 500, and the amount of stock indexers must buy. By waiting so long to add big stocks to the index, Standard & Poor's has inadvertently created a trading game where, seemingly, there is very little downside risk.
So what happens after the addition: Stocks joining the Standard & Poor's 500 have performed worse than the index in the month following their inclusion, a study by Merrill Lynch found. In the 30 days following their addition, though, the same stocks gave up more than that, falling an average 7.9 percent more than the index.
How one should trade: Purchase the company and some calls the day the addition is announced. I suggest to short the index with index futures the day the company gets added, preferably the e-mini. Then buy more calls on the underlying security, two or three months away from expiration and barely out of the money, (for more information on options trading click: here). As soon as the company is added, sell the calls and if your want to be really risky buy some puts and bet on the downward trend for the company the month after it got added.
A forecast on companies that are likely to be added within a year for which this pattern would right to make money.
JDS Uniphase JDSU; Doubleclick DCLK; more coming soon!
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