A Noisy World
by OptionSage - July 6th, 2008 12:04 pm
All around us signals are transmitted and received each day. Within those signals valuable information is intertwined with spurious content. As a result, receiving devices have filters built in to discern the ’signal’ from the ‘noise’. High Signal to Noise ratios convey A LOT of information while low Signal to Noise ratios convey very little information! Indeed, when the noise levels increase above threshold levels, signals may be corrupted entirely, resulting in no information at the receiving end.
But what has this to do with the stock market? As traders, we are receiving information each day that we must learn to process and indeed we must learn to filter some of it out. This is an enormously challenging task because our natural inclination is to apply bias to the information we receive. For example, if we are bullish on a stock and an analyst disseminates a report that aligns with our views, our opinions are more likely to strengthen. In order to achieve our objective of trading without bias, we must recognize that history is laden with examples of the stock market confounding expectations.
In the 1970s, few envisioned that commodity prices would elevate to the degree they did or that bond yields would rise up to 15% by 1981 or that bond yields would decline to around 3% in 2003 or that a protracted equity bull market would ensue. Few expected that almost two deacdes after the Japanese market reached its peak, it would still be down 60% from its highs. Few recognized in 2000 that commodity prices were at historic lows while China and India were emerging rapidly.
Recognizing that the opinions you hear from others originate from a place of vested interest means critically analyzing comments becomes imperative. For example, just a couple of months ago, Lehman’s CEO announced that "the worst is behind us". It is evident from the chart below that the worst had certainly not been priced into the stock yet!
Clearly a delineation between expressed views and market action took place in all previous examples. The insurmountable challenge most traders encounter when confronted with such a delineation is their own attempt to justify the action. Why did Lehman go down? Why did bond yields surge? Why did commodity prices soar? Why has the Japanese market not recovered? A lot of calories may be wasted in striving to justify market action. The reason they are wasted is not because it…
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DiggBlame It On The Beatles!
by OptionSage - June 29th, 2008 5:02 pm
Maybe we can blame it all on the Beatles invasion of America. The bustling 60s with its expressions of freedom was the time when the transition seemed to sweep the nation. Instead of purchasing what we wished AFTER we had earned the capital to do so, as in generations past, we learned to purchase BEFORE we had earned sufficient capital to match our desires. The availability of credit has forced grown-ups to take a grown-up version of The Marshmallow Test.
Recall the MarshMallow Test was a test given to youngsters to determine the correlation between patience, self-discipline and success in life. A marshmallow would be placed in front of a child, who was told if the marshmallow had not been consumed by the time the adult returned to the room, the child would recieve a second marshmallow. The end result being children who passed the Marshmallow Test did better financially in life!
Most of the population are tempted by the proverbial marshmallow every day under the guise of credit offerings. These days credit card offerings are expected daily in the mail and homes have been turned into ATM machines. And those homes were in turn purchased through borrowing. The excesses are compounded by the fact that some studies have reported that over 9 out of 10 borrowers mis-represent their net worth during applications. Not only is most of the public failing the Marshmallow Test, but the government is too. A balanced budget, once demanded as part of fiscal responsibility, is now all but a distant memory.
The pervasive excesses of borrowing inevitably lead to greater gains during upswings and greater losses during corrective phases. During the declines, few stock market participants have a containment strategy. Account value fluctuations are exacerbated and panic sets in. Growth-oriented investors realize that declines in future earnings inflate P/E multiples and bargains soon turn into over-priced securities. Supposedly sophisticated quant funds who rely on black box models are often most at risk because leverage is frequently so integral to their performance. And as the models stop working, the losses are exacerbated by the earlier dependence on leverage.
For most it is too late to salvage a virtual portfolio or to take corrective action when the news media frenzy reaches peak levels and the front covers of magazines tell tales of stock market woes. But the difference between defeat and failure is the difference…
(The Real) Super-Spike Theory!
by OptionSage - June 24th, 2008 3:01 am
Firstly, the snapshot of the major indexes…
DJIA: 11,842.36 down 0.33 points
S&P 500: 1,318.00 up 0.07 points
Nasdaq: 2,385.74 down 20.35 points
In spite of today’s action doing absolutely nothing to inspire confidence in banking sector – you need only look at the action in the XLF today – we decided to go hunting, believing that certainly, somewhere out there, a solid bank existed (even if its stock had been taken out for a beating of late).
Well the search took us across the Atlantic to Ireland. Oh sure, Ireland has its share of problems right now, but Bank of Ireland reported a 5% increase in underlying profits for the year to March 31st – IN SPITE OF doubling its bad debt charge due to the slowdown in the Irish property market.
In spite of its relative outperformance in its peer group, its 12.5% dividend yield and the fact that it’s trading well below 50% of its average 10-year book value, the stock keeps going lower!
One of the big questions is whether the dividend is safe. According to Ireland’s leading full-service broker (you could say the Goldman Sachs of Ireland), Davy, the dividend is rock solid and should not be in any jeopardy. Indeed management is implying the greater likelihood is that dividend growth will be flat this year. For emphasis, note their focus is not on cutting the dividend, it is on not increasing the dividend!
At $38 per share, and a dividend of almost $5 per share that is considered safe, the time window is diminishing before the value players start to differentiate between what appears to be a broken stock, but not a broken company.
On the whole, we decided against publishing a Trade Alert this week because uncertainty reached peak levels. For the bears, the danger is being whipsawed by a quick reversal. Just look at the period past the March lows to see how rapidly the indexes moved up for for evidence of how dangerous it can be to go short at the end of a long downtrend. Yet for the bulls, the danger of John Maynard Keynes line coming into effect is high – "the market can stay irrational longer than you can stay solvent".
At this time, we’re quite happy keeping our heavy cash pile safe for now. While most of January to May has been profitable, June has been a different story! And we’re weathering a dark…
7 Steps To 40%
by OptionSage - June 15th, 2008 3:30 pm
Just a couple of decades ago it would have been almost unfathomable for the retail investor to consider generating consistent returns above 20% per year. Indeed, those who competed in arguably the most competitive financial market place, the stock market, were considered gurus when they beat the S&P 500 year in and year out.
Others, such as Jerome Kohlberg, Henry Kravis and George Roberts made a name for themselves in private equity as did Peter Peterson and Stephen Schwarzman with the Blackstone Group. Gains in the stock market for Joe Public were subjected to a limiting factor – the inability to leverage substantially. Joe Public was also limited in participating in private equity investments; they were the domain of the rich – the insiders. These days, private equity still remains the domain of the rich, but leveraging is possible through the purchase of equity derivatives. And the sale of those same equity derivatives can be highly profitable too.
Whereas it would have been unthinkable years ago to consider making big profits year in and year out on a stock that doesn’t move much – because the only source of income, dividends, tended to be in the low single digits in percentage terms - these days options afford us the opportunity to sit tight and profit while holding stock positions. This can easily be achieved through the sale of short call options against stock holdings, otherwise known as the Covered Call strategy. While the Covered Call strategy may appear straightforward when first encountered, many applications may be employed. In this article, we will consider the application that Stock and Option Trades labels: 7 Steps to 40% per year!
Step 1: Wait for a selloff
Ok, so you want to skip this step and move on to Step 2. Wait!
One of the great quotes in investing comes from Jesse Livermore and pertains to this concept of patience. In Reminiscences of a Stock Operator, it is stated:
"It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I’ve known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level…
Dare To Fail (Greatly)!
by OptionSage - June 8th, 2008 4:47 pm
"Only those who dare to fail greatly can ever achieve greatly" – Robert Kennedy
It seems fitting with so many tributes to Robert Kennedy this past week to include a quote from him that can easily be applied to stock market trading. Indeed the quotation may be considered analagous to Buffett’s famous adage: "Buy Fear and Sell Greed".
What is not so well known is that Buffett later revised his quote. Recognizing that few have the mental fortitude to trade bullishly in the midst of panic and bearishly in the midst of exuberance, he expanded upon his statement with this more recent remark:
"You know, I always say you should get greedy when others are fearful and fearful when others are greedy. But that’s too much to expect. Of course, you shouldn’t get greedy when others get greedy and fearful when others get fearful. At a minimum, try to stay away from that."
Moreover, Buffett commented that
"Stocks are a better buy today than they were a year ago. Or three years ago."
But how many will have panicked following Friday’s move and failed Buffett’s ammended statement? The likelihood is fewer still will have dared consider any bullish position.
At Stock and Option Trades, we were fortunate to side-step both Thursday’s greed and Friday’s fear. Indeed, in Thursday’s blog, we stated:
"Factoring in the fickle nature of the markets recently, it only reinforces the fact that caution and patience are needed when trading. We have seen far too many attempted breakouts fail during an unstable market."
With that said, we have commented that more aggressive investors can start to dabble (buying the fear). And by dabble, we mean scale gently into the market. We expected conservative investors could start to dip their toes in the water in the middle of this month and commented hitherto that we would favor this course of action ourselves.
That doesn’t mean sitting on the sidelines. We’re still trading as evidenced by each week’s Trade Alerts, but we’re still holding heavy cash positions. And we’re selfishly hoping for more to the downside so we can swoop up bargains at the bottom.
Even if buying stocks proves too difficult, it is definitely worth considering option premiums on bull put spread trades when panic levels really skyrocket. You will find numerous stocks during selloffs like Friday’s that have great fundamentals and will be great long-term winners, and are already undervalued; we…
Sneak A Peak
by OptionSage - June 1st, 2008 3:13 am
This week we considered a position on the XLF, the Financial Select Sector SPDR. But before deciding whether to enter a trade, we needed to sneak a peak behind the XLF in order to view its consituent components and hence discover whether the reward to risk ratio might be attractive at this point in time.
The first step in uncovering the XLF is to discover the primary holdings for the Select SPDR. Yahoo! Finance reports that the top 10 holdings are:
American Express (AXP) – 2.48%
American International Group (AIG) – 5.95%
Bank of America (BAC) – 8.84%
Bank of New York Mellon (BK) – 2.5%
Citigroup (C) – 5.93%
Goldman Sachs (GS) – 3.38%
JP Morgan Chase (JPM) – 6.84%
US Bancorp (USB) – 2.77%
Wachovia (WB) – 3.03%
Wells Fargo (WFC) – 4.94%
Looking at some of the major holders in some more detail, we can find out even more about the XLF. Let’s start with American Express.
American Express started an uptrend in March and so far the uptrend has remained intact despite the most recent correction in the market and in financials on the whole. That’s a good start if we’re considering a bullish thesis on the XLF.
AIG has had its share of woes lately, but late in the week received an upgrade from Morgan Stanley citing the most recent correction as being ‘overdone’.
Certainly from a reward to risk perspective, AIG is looking attractive as a longer term play. 2-0 for the bulls.
If good companies trading at multi-year lows based on dismal sentiment constitutes good reward to risk ratios, then Bank of America is a contender for the prize ceremony.
Bank of America is now trading at 4-year lows. If ever there was a time to speculate on BAC, now might be it!
Next on the list is a top-performer in the group, Bank of New York Mellon, which has maintained tremendous chart strength in the face of what could be described as a sector collapse earlier in the year.
Nothing for the bears to grab hold of here, 4-0 to the bulls!
And onward to the famed Citigroup. Probably it’s best to let Phil and Meredith Whitney take this one to round 12. We side with Phil on this one, as well as some top-rated analysts who predict the probability of a rosy future is much greater than…
When Sloth Is Good!
by OptionSage - May 26th, 2008 3:03 pm
From a young age, many of us are conditioned to believe that the harder we work, the greater will be our successes. The advice stands up to scrutiny in most respects. Whether studying hard to graduate from school or working hard on the sports fields to ‘make the team’ and ‘beat the competition’, hard work pays off. And then we transition into the professional world and soon discover that promotion and increases in pay follow from going the ‘extra mile’. So, by the time we have amassed a level wealth with which we can trade or invest in the stock market, we our heavily conditioned to believe that hard work means greater success; the habit was formed through a lifetime of practice. The cause (hard work) and effect (greater success) relationship becomes so ingrained that we often consider it indisputable.
Yet, for many new traders and indeed many experienced ones, translating the habit of working hard into stock market trading does not lead to the expected level of reward. The attraction for so many is to confuse working hard with trading actively. Working hard in the stock market is necessary for long-term success. It means conducting due diligence: fundamental, technical, sentimental, and economic. However, trading frequently should not be so easily equated to working hard. While many outstanding traders engage in active, short-term day-trades, a great many others engage in trading excessively because it offers a level of excitement. Indeed, Tony Robbins contends that two of the six primary needs of humans are certainty and uncertainty. As humans, we need to be excited on a regular basis in order for our interest levels to be maintained.
Examining aspects of our lives, we can quickly see that this contention may be very accurate. Why is it that we like to go to see a new movie? Is it not because there is a degree of uncertainty attached to the series of events throughout the movie? And further is not because we have been conditioned by the movie industry to trust that overwhelmingly the final outcome will be positive; we have a certainty that this will be the case. If we are internally wired to NEED uncertainty and excitement, is it not eminently feasible that we create this uncertainty and excitement in our stock market trading also?
If we assume that most traders are unaware of their…
Murky World!
by OptionSage - May 17th, 2008 2:29 pm
This weekend, let’s digress into the murky world of psychology! Murky only because it is not often as clear as the clean world of technical analysis that can provide crystal clear buy and sell points! And murky because it involves something less tangible than fundamental or technical due diligence. Instead, it demands an understanding of the human psyche and how we can be affected by different behaviors and circumstances. In this section, we will share with you some findings from leading psychologists and we encourage you to relate the findings to your own stock market trading. If possible, look honestly at your own trading activity and try to improve from the observations noted below.
In stock market trading, understanding the psychology of the crowd is critically important when attempting to improve your own trading activites. Psychologists are aware that the psychology of a crowd differs from that of the separate individuals composing that crowd. It is generally considered that there is a crowd of separate individuals and a composite crowd in which the emotional natures of the units seem to blend and fuse. The change arises from the influence of attention or deep emotional appeals, or common interest. Think only of the fear that dominates traders’ minds and drives their actions when big sell-offs occur. The predominant characteristics of this "composite-mindedness" of a crowd are the evidences of extreme suggestibility (hitting the panic button and selling all positions!), response to appeals to emotion (fear-driven panic sales), vivid imagination (it could get worse!) and action arising from imitation (everyone else is selling so I should too!)
Professor Frederick Morgan Davenport once noted
"The crowd is united and governed by emotion rather than by reason. The explanation of this is that the attention of the crowd is always directed by the circumstances of the occasion"
And Emile Durkheim observed in his psychological research that the average individual is "intimidated by the mass" of the crowd around him, or before him, and experiences that peculiar psychological influence exerted by the mere number of people as against his individual self…..a suggestible person (may be) brought under the direct fire of the imitative suggestions of those on all sides who are experiencing emotional activities and who are manifesting them outwardly….
Human beings in times of panic, fright, or deep emotion of any kind, manifest the imitative tendency of sheep, and the tendency…
(Lessons From) A Trader’s Diary
by OptionSage - May 10th, 2008 11:08 pm
Dear Diary,
Last week’s Market Commentary to members concluded:
"Technical analysts will cite bullish breakouts and push retail traders into bullish trades now. We spoke in recent weeks of the potential for the stock market to remain bullish through early May, which would lull investors into complacency, believing that "Sell in May and Stay Away" would not materialize. Everything is going according to plan in that regard. The markets remained bullish through last week and optimism is high again that 13,500 will be just around the corner…..we are highly skeptical of any meaningfull bullish follow-through. By week’s end we will be very surprised if the strength has been maintained and, as a result, are entering bearish positions"
As it turned out, the Dow Jones Industrial Average ended 3 of last week’s 5 trading days lower and ended the week substantially lower.
On April 14th we wrote in our Monday blog that we expected "strength over the next couple of weeks in the markets assuming the 1325 level can hold…we’re looking for anything above that key threshold level to signal high likelihood of a bullish follow through to the end of the month."
As expected, the bullish follow through materialized once the critical 1,325 level held firm.
One of the factors we consider heavily when trading is general sentiment in the market. In early May, optimism was high. The Volatility Index, for example, had not been quite as low since the December and October peaks in the market. Had all the pessimism of recent months really been eroded? Had we forgotten so quickly the problems of the past? We didn’t think so.
While many were optimistic about the Dow crossing 13,000, we exercised extreme caution and refused to abandon discipline, preferring to stay safe than risk a big correction. And the correction from approximately 13,100 to 12,745 soon followed.
Although the correction so far has been just under 3%, it is still almost 3% in 1 week! If all you could do was improve your virtual portfolio performance by 3% at the end of the year, the effect on compounded gains would be substantial over time.
For example, $100,000 compounded at 10% over 20 years amounts to just over $670,000 (assuming a qualifed account) while $100,000 compounded at 13% over 20 years amounts to over $1,150,000, almost twice the amount!
When making big money in the market, the devil is in the details and saving…
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Philip R. Davis is a founder Phil's Stock World, a stock and options trading site that teaches the art of options trading to newcomers and devises advanced strategies for expert traders...
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