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Stock Option Trading – Fundamental Flaw in Fundamental Analysis and Stock Picking
Sticking to fundamental analysis and stock picking software only keeps you stuck in trading equities. Trading in this way creates the risk of compound concentration in one asset class and fails to adequately diversify risks across equities, bonds, currencies and commodities. There is more to stock option trading than stocks.
I am Benjamin F. Cites King’s study, which has been cited repeatedly since 1966, because it is valid and has yet to be proven to the point of refuting his argument.
Market and Industry Factors, Journal of Business, January 1966: ” Stock movements . . .
- 31% can be attributed to the general stock market,
- 13% for industry impact,
- 36% for the influence of other groups and the rest
- 20% is fantastic for a stock.”
If only 20% is unique to the underlying equity in question, there should be a more compelling reason for you to trade the stock without just the movement. Think of it, in terms of fundamental analysis or stock picking software that you buy on a $1 per basis. For every $1 dollar you spend, you “outsource” analysis at a cost of 80 cents, only to get back 20 cents worth of work. Shouldn’t the 80:20 rule of “outsourcing” be the opposite? The problem is that you are still stuck with 80% of the work to analyze the price movement! Moreover, the more FA techniques/stock picking software you use, the more trading capital is tied up in equities alone.
Now, you might say that “special” research papers help you pick stocks. Let’s look at some of the more common fundamental metrics in these research subscriptions:
1. Dividend Income: The problem lies in the variability of income as companies are in different stages of their business development. A mature company that dominates an established sub-sector/sector will be able to generate separate dividend income; Conversely, a young company in a growth-oriented sector; Conversely, a small firm in a growing sector that may not be able to afford dividend payouts. Remember that there is nothing special about companies that pay dividends.
A company that pays out a portion of its retained earnings—that is, a dividend—effectively pays out a portion of its valuation, meaning that a company is not worth as much candy as investors need to capitalize on. . So, a dividend-paying stock should outperform a non-dividend-paying stock for reasons other than dividends. If not, there is no point in looking for dividend paying products to trade, there are plenty of non-dividend paying indices to trade.
2. Price/Book Ratio: The problem is that this metric varies across industries and by company, as companies’ asset base and capital structure change over time. It lacks cross sector applicability and accounting complexity arises from the firm’s capital structure due to acquisitions/investments/CAPEX changes for new product lines; Or, product line cut-backs, recently seen in the restructuring of major US car companies.
3. Price/cash flow ratio (a cousin of P/E): Accounting laws on depreciation vary across Asia, Europe and the US. Accounting rules are driven by tax codes, which vary widely across regions despite the adoption of global accounting standards, lacking uniformity in harmonizing basic ratios that fit as a common benchmark across geographies.
These metrics can’t help comparing US-parent Dell to Taiwan-parent Acer; But, in the US it is listed as ADR, although both are competitors in the same field as computer manufacturers.
Furthermore, the current displaced cost of capital in credit markets impairs the ability of corporations to optimize the operating cost of their balance sheets. In short, corporations have working capital cash flow balances on their balance sheets as evidence of their financial strength. Don’t waste your money on fundamental analysis software or research paper subscriptions.
Fundamental Flaws in Fundamental Analysis and Stock Picking How Do You Pick Trades? Trade broad-based equity index options to replace single stock exposure. To replace fundamental analysis, use relative strength measurements based on point and diagram methods.
What is relative power? Taking one price as the numerator, dividing by another price as the denominator, then multiplying by 100. RS = (Price 1 / Price 2) x 100. Typically, RS calculations use daily closing prices. Although simple in its mathematical construction, RS is ingeniously powerful when applied not only in the field; But, across sectors and asset classes.
Let’s start with a sector. For example, if you choose 2 semiconductor stocks trading at different prices, how do you know that one stock in the same sector is outperforming the other, when the price of the 2 stocks fluctuates at different rates; Also, is the price of the area also changing?
SOX = Semiconductor Sector Index, trades from 452.24 to 467.81.
Issue1: Price1 = BRCM 33.15 RS1 = 7.33 Price2 = 33.80 RS2 = 7.23
Issue2: Price1 = TSM 9.91 RS1 = 2.19 Price2 = 13.43 RS2 = 2.87
Common denominator: SOX Price 1 = 452.24 Price 2 = 467.81
RS1 of BRCM = (33.15/452.24) x 100 = 7.33. RS2 of BRCM = (33.80/467.81) x 100 = 7.23.
RS1 of TSM = (9.91/452.24) x 100 = 2.19. RS2 of TSM = (13.43/467.81) x 100 = 2.87.
BRCM price increases from 33.15 to 33.80 and TSM price also increases from 9.91 to 13.43. Just because BRCM is a big stock, does that mean it benefits from SOX trading up? No, the RS reading (RS1 compared to RS2) shows BRCM’s RS reading dropped (7.33 to 7.23) compared to TSM’s RS reading increased (2.19 to 2.87). RS confirmed TSM as BRCM’s weak price increased against price strength. RS is built on pure pricing principles. Using the index as a denominator acts as a more durable benchmark and is structurally more reliable than any “magical” TA indicator; Or, a combination of income statement, balance sheet, and cash flow statements in a stock picking program.
You can replace BRCM or TSM with an index or ETF. Using indexes with relative strength makes it possible to compare stocks with bonds, commodities and currencies, crossover into asset classes other than stocks. It is not that relative strength is incommensurable. But compared to the basic metrics cited above, relative strength is the least likely to fail. Break the mold with what you’ve learned about stock option trading.
What is an example of an alternative and consistently profitable portfolio that trades using relative strength across multiple asset classes? yes Follow the link under the heading “Consistent Results” to view a retail online options trading portfolio that excludes single stocks and the use of fundamental analysis using broad based equity indexes, commodity ETFs and currency ETFs. No need to trade FX directly. Only trade options on currency ETFs.
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