Author: Clinton Lee.
Clinging
on to Fundamental Analysis and stock picking software, only keeps you stuck in
trading equities. Trading this way, compounds concentration risk in one asset
class and fails to adequately diversify risks across Equities, Bonds,
Currencies and Commodities.
There’s much more to stock option trading, than stock itself.
I
cite Benjamin F. King’s study, quoted repeatedly since 1966, because it remains
valid and has yet to be disproved to the point of dismissing its logic.
Market
and Industry Factors, Journal of Business, January 1966: “ Of a stock’s move ...
❑ 31% can be attributed to the general
stock market,
❑ 3% to industry influence,
❑ 36% to influence of other groupings,
and the remaining
❑ 20% is peculiar to the one stock.”
There
must be a more compelling reason for you to trade stock other than just for the
movement, if only 20% is unique to the underlying equity in question. Consider this, in context of the
Fundamental Analysis or stock picking software that you bought on a per $1
basis. For each $1 dollar you
spend, you “outsourced” the analysis at a cost of 80 cents, only to receive
back 20 cents worth of work. Shouldn’t the 80:20 rule of “outsourcing” be the
other way round? The problem is that you are still stuck with 80% of the work,
to analyze price movement! Plus,
the more you use FA techniques/stock picking software, the more trading capital
is stuck in equities alone.
Now,
you can say “special” research papers help you pick stocks. Let’s have a look at some of the more
common fundamental metrics in these research subscriptions:
1.
Dividend Yield: the problem is in the variability of yields as firms are in
different stages of their business development. A Mature company that dominates in a well established
sub-segment/sector is going to being able to afford a different dividend yield;
versus, a Young company in a growth-oriented field; versus, a Small firm in a
growing area that may not be able to afford a dividend payout. Bear in mind there is nothing special
about firms that pay a dividend.
A
company that gives away a portion of it’s retained earnings - which is what a
dividend is - effectively gives away part of its valuation, which means it is
not worth as much as a company that does need to give investors candy to commit
capital to it. So, a dividend
paying stock has to be far superior to a non-dividend paying stock for reasons
other than the dividend. If it is
not, there’s no point looking for dividend paying products to trade, there are
plenty of non-dividend paying Indexes to trade.
2.
Price/Book Ratio: the problem is this metric varies across industries and from
company to company, as the asset base and capital structures of companies
change over time. It lacks cross sector applicability and accounting complexity
arises from a firm’s capital structure as it changes due to
acquisitions/divestments/CAPEX for new product lines; or, product line
cut-backs, as recently seen in the restructuring of major US car companies.
3. Price/Cash Flow Ratio (the cousin of
the P/E): accounting laws on depreciation vary across Asia, Europe and US. As accounting rules are driven by tax
codes, which change considerably across regions despite adoption of global
accounting standards, there is a lack of uniformity in homogenizing a
fundamental ratio that will fit as a common benchmark across geographies.
These
metrics fail to help you compare say a Dell parented in the US to an Acer
parented in Taiwan; but, is listed as an ADR in the US, even though both are
competitors in the same sector as computer manufacturers.
Furthermore,
the current dislocated cost of capital in credit markets, impairs the ability
of corporations to optimize the operating cost of their balance sheets. In essence, corporations are left with
the working capital cash flows remaining on their balance sheets, as testament
to their financial strength. Do not waste your money on Fundamental Analysis
software or research paper subscriptions.
As there is a fundamental flaw in fundamental analysis
and stock picking, how do you select trades? Trade the options of a broad-based Equity Index to replace
single stock exposure. To replace
Fundamental Analysis, use the Relative Strength measure based on Point &
Figure methods.
What
is Relative Strength? It is
nothing more than taking one price as the Numerator, divided by another price
as the Denominator, then multiplied by 100. RS = (Price 1 / Price 2) x 100. Typically, RS calculations use daily closing prices. Though simple in its mathematical
construction, RS is ingeniously powerful when it is applied not only within a
sector; but, across sectors and between asset classes.
Let’s start of within a sector. For example, if you choose 2 semiconductor stocks trading at different prices, how do you know if one stock is outperforming the other in the same sector, when the 2 stocks have price changes at different rates and the sector’s price is also changing?
Price1 RS1 Price2 RS2
Numerator1: BRCM 33.15 7.33 33.80 7.23
Numerator2: TSM 9.91 2.19 13.43 2.87
Common Denominator: SOX 452.24 467.81
SOX = Semiconductor Sector Index, trades up from 452.24 to 467.81.
BRCM's price rises from 33.15 to 33.80 and TSM's price also rises from 9.91 to 13.43
Simply because BRCM is a larger stock, does that mean it benefits from the SOX trading up? No, the RS reading (RS1 compared to RS2) tells us, BRCM has weakened against TSM.
BRCM’s RS1 = (33.15/452.24) x 100 = 7.33. BRCM's RS2 = (33.80/467.81) x 100 = 7.23
TSM’s RS1 = (9.91/452.24) x 100 = 2.19. TSM's RS2 = (13.43/467.81) x 100 = 2.87.
You
can replace BRCM or TSM with Indexes or ETFs. Using Indexes with Relative Strength enables a common
denominator to compare Equities against Bonds, Commodities and Currencies, to
crossover into asset classes other than stocks to trade. It’s not that Relative Strength is
infallible. But compared to the
fundamental metrics cited above, Relative Strength fails the least. Break the mould on what you learnt
about stock option trading.