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

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,
  • 13% 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; plus, the sector’s price itself is also changing?

SOX = Semiconductor Sector Index, trades up 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

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.

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) shows BRCM’s RS reading dropped (7.33 down to 7.23) against TSM’s RS reading, which increased (2.19 to 2.87). RS confirms TSM as the outperformer rising in price strength versus BRCM’s weakened price. RS is constructed on pure price rules. Using an Index as the denominator, acts as a much more durable benchmark and is structurally more reliable, compared to any “magical” TA indicator; or, combination of income statements, balance sheets and cash flow statements touted in stock picking programmes.

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.

Is there an example of an optionable and consistently profitable portfolio that trades using Relative Strength across multiple asset classes? Yes. Follow the link below, entitled “Consistent Results” to see a retail online option 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 FX directly. Just trade the options of Currency ETFs.

Source by Clinton Lee

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