Stock Option Trading – Fundamental Flaw in Fundamental Analysis and Stock Picking


By hanging on to fundamental analysis and stock selection software, all you do is get stuck in stock trading. Trading in this way worsens the risk of concentration in an asset class and fails to adequately diversify the risk between stocks, bonds, currencies, and commodities. There is much more to trading stock options than the stocks themselves.

I am quoting Benjamin F. King's study, cited repeatedly since 1966, as it remains valid and has yet to be disproved to the point of ruling out its logic.

Market and Industry Factors, Journal of Business, January 1966: "Of a stock & # 39; s move …

  • 31% can be allocated to the general scholarship,
  • 13% to industry influence,
  • 36% to the influence of other groupings, and the rest
  • 20% is specific to a single title. "

There must be a more compelling reason for you to trade stocks other than just for the movement, if only 20% is unique to the underlying stock in question. Consider this, in the context of fundamental analysis or the stock picking software you bought on the dollar. For every dollar you spend, you 'outsourced' the analysis at a cost of 80 cents, to receive only 20 cents of labor. Shouldn't the 80:20 rule of "outsourcing" be the other way around? The problem is, you are still stuck with 80% of the work, to analyze the price movement! Also, the more FA techniques / security selection software you use, the more trading capital is locked in only in stocks.

Now you can say "special" research papers help you choose stocks. Let's take a look at some of the most common foundational metrics in these research subscriptions:

1. Dividend yield: The problem lies in the variability of yields, with companies at different stages of their business development. A mature company that dominates in a well established sub-segment / sector will be able to afford a different dividend yield; versus, a young company in a growth-oriented field; versus a small business in a growing region that might not be able to pay a dividend. Keep in mind that companies that pay a dividend are nothing special.

A company that gives away part of its retained earnings – what is a dividend – is in fact giving up some of its valuation, which means it is not worth as much as a company that owes it. give sweets to investors to invest in capital. . Thus, a stock paying a dividend must be much higher than a stock without a dividend for reasons other than the dividend. If not, there is no point in looking for dividend paying products to trade, there are plenty of non-paying indices to trade.

2. Price / Pound Ratio: The problem is that this metric varies across industries and across businesses, as the asset base and capital structure of businesses change over time. . It lacks cross-industry applicability and accounting complexity arises from a company's capital structure when it changes due to acquisitions / divestitures / CAPEX for new product lines; or, product line reductions, as seen recently in the restructuring of major US automakers.

3. Price / Cash Flow Ratio (P / E's cousin): Depreciation accounting laws vary across Asia, Europe, and the United States. Since accounting rules are governed by tax codes, which change significantly from region to region despite the adoption of global accounting standards, the homogenization of a ratio fundamental that will serve as a common benchmark across geographic areas lacks consistency.

These metrics do not help you compare, say, a Dell parent in the US to an Acer parent in Taiwan; but, is listed as ADR in the United States, even though both are competitors in the same industry as computer manufacturers.

Additionally, the current cost of dislocated capital in credit markets is hampering the ability of companies to optimize the cost of operating their balance sheets. Essentially, companies end up with working capital cash flows that remain on their balance sheets, a testament to their financial strength. Don't waste your money on fundamental analysis software or research paper subscriptions.

Since there is a fundamental flaw in fundamental analysis and stock selection, how do you select trades? Trade the options of a broad stock index to replace single exposure to stocks. To replace fundamental analysis, use the measurement of relative strength based on Point & Figure methods.

What is relative strength? It is nothing more than taking a price as the numerator, divided by another price as the denominator, and then multiplied by 100. RS = (Price 1 / Price 2) x 100. In general, RS calculations use the daily closing prices. Although simple in its mathematical construction, RS is ingeniously powerful when applied not only in an area; but, between sectors and between asset classes.

Let's start with in an area. For example, if you choose 2 semiconductor stocks traded at different prices, how do you know if one stock is outperforming the other in the same industry, when the 2 stocks have price changes at different rates; Moreover, the price of the sector itself also changes?

SOX = index of the semiconductor sector, goes from 452.24 to 467.81.

Numerator1: Price1 = BRCM 33.15 RS1 = 7.33 Price2 = 33.80 RS2 = 7.23

Numerator2: 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.

The price of BRCM goes from 33.15 to 33.80 and the price of TSM also goes from 9.91 to 13.43. Just because BRCM is a larger stock, does that mean it is profiting from SOX trading? No, the RS reading (RS1 versus RS2) shows that the RS reading of BRCM has dropped (7.33 to 7.23) compared to the RS reading of TSM, which has increased (2.19 to 2.87 ). RS confirms that TSM is the rising outperformance of price strength versus the weaker price of BRCM. RS is built on pure pricing rules. Using an index as the denominator, acts as a much longer lasting benchmark and is structurally more reliable, compared to any "magic" AT indicator; or, a combination of income statements, balance sheets and cash flow statements touted in stock picking programs.

You can replace BRCM or TSM with indices or ETFs. Using indices with relative strength allows a common denominator to compare stocks with bonds, commodities and currencies, moving to asset classes other than stocks to trade . It is not that the Relative Force is infallible. But compared to the fundamental metrics cited above, relative strength fails the least. Break the mold on what you have learned about stock options trading.

Is there an example of an optional and still profitable portfolio that trades using relative strength across multiple asset classes? Yes. Follow the link below, titled 'Consistent Results' to view a retail online options trading portfolio that excludes the use of single stocks and fundamental analysis, using broad based equity indices, commodity ETFs and currency ETFs. There is no need to trade currencies directly. Simply trade currency ETF options.

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