Cash Flow Statement Is Based On Cash Basis Of Accounting Stock Option Trading – Fundamental Flaw in Fundamental Analysis and Stock Picking

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

If you stick to fundamental analysis and stock picking software, you’re stuck just trading stocks. Trading in this way increases the concentration of risk in one asset class and fails to adequately spread risks across stocks, bonds, currencies and commodities. Stock options trading is much more than just a stock.

I cite Benjamin F. King’s study, which has been cited many times since 1966, because it remains valid and has yet to be refuted to the point of discarding its logic.

Market and Industry Factors, Journal of Business, January 1966: “Stock Scratching . . .

  • 31% can be attributed to the general stock market,
  • 13% on the impact of industry,
  • 36% to the influence of other groups, and the rest
  • 20% is typical of one stock.”

There must be a more compelling reason to trade a stock other than just for movement if only 20% is unique to the underlying equity in question. Think of this in the context of a fundamental analysis or stock picking software that you bought for $1. For every $1 you spend, you’ve “outsourced” the analysis at a cost of 80 cents, only to get back 20 cents worth of work. Shouldn’t the 80:20 “outsourcing” rule be reversed? The problem is that you are still stuck with 80% of the work to analyze price movements! Also, the more you use FA techniques/stock picking software, the more trading capital is left in stocks alone.

Now you can say that “special” research papers help you pick stocks. Let’s take a look at some of the more common core metrics in these research subscriptions:

1. Dividend yield: the problem lies in the variability of yields, as companies are at different stages of their business development. A mature company that dominates a well-established sub-segment/sector will be able to afford a different dividend yield; versus, a young company in the field of growth; compared to a small company in a growth area that may not be able to afford to pay dividends. Note that dividend paying companies are nothing special.

A company that gives away a portion of its retained earnings — which is a dividend — is actually giving away a portion of its valuation, which means it’s not worth as much as a company that has to hand candy to investors to put capital into it. . So a dividend-paying stock must be much better than 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 that you can trade.

2. Price-to-book ratio: The problem is that this metric varies across industries and from company to company, as companies’ fixed assets and capital structures change over time. It has no cross-sector applicability, and the accounting complexity comes from the company’s capital structure as it changes due to acquisitions/divestments/CAPEX for new product lines; or the downsizing of production lines, as seen recently in the restructuring of major US auto companies.

3. Price-to-Cash Flow Ratio (P/E cousin): Depreciation accounting laws differ across Asia, Europe and the US. Since accounting rules are determined by tax codes that vary considerably across regions despite the adoption of global accounting standards, there is no uniformity in the homogenization of a fundamental ratio that would fit as a common measure of performance across different geographies.

These metrics don’t help you compare, say, a US-parent Dell to a Taiwan-parent Acer; however, it is listed as ADR in the US, even though both are competitors in the same sector as computer manufacturers.

In addition, the current dislocated cost of capital in credit markets reduces the ability of corporations to optimize the operating costs of their balance sheets. In essence, corporations are left with working capital cash flows on their balance sheets as evidence of their financial strength. Don’t waste money on fundamental analysis software or research paper subscriptions.

Since there is a fundamental flaw in fundamental analysis and stock picking, how do you pick trades? Trade broad-based stock index options to offset individual stock exposure. To replace fundamental analysis, use a measure of relative strength based on point and figure methods.

What is relative strength? This is nothing more than taking one price as the numerator, dividing by another price as the denominator, then multiplying by 100. RS = (Price 1 / Price 2) x 100. RS calculations usually use daily closing prices. Although simple in its mathematical construction, RS is ingeniously powerful when applied not only within a sector; but between sectors and between asset classes.

Let’s start within the sector. For example, if you pick 2 semiconductor stocks that trade at different prices, how do you know if one stock is better than the other in the same sector when the prices of the two stocks are changing at different rates; moreover, the price of the sector itself is also changing?

SOX = Semiconductor Sector Index, trading from 452.24 to 467.81.

Counter1: Price1 = BRCM 33.15 RS1 = 7.33 Price2 = 33.80 RS2 = 7.23

Counter2: 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 BRCM = (33.15/452.24) x 100 = 7.33. RS2 BRCM = (33.80/467.81) x 100 = 7.23.

RS1 TSM = (9.91/452.24) x 100 = 2.19. RS2 TSM = (13.43/467.81) x 100 = 2.87.

BRCM price rises from 33.15 to 33.80 and TSM price also rises from 9.91 to 13.43. Just because BRCM is the bigger stock, does that mean it benefits from trading SOX upside? No, the RS reading (RS1 vs RS2) shows that the BRCM RS reading has dropped (7.33 to 7.23) compared to the TSM RS reading which has increased (2.19 to 2.87). RS confirms that TSM is better as the price increases compared to the weakened price of BRCM. RS is built on pure price rules. Using the index as the denominator acts as a much more durable measure of performance and is structurally more reliable compared to any “magic” TA indicator; or a combination of income statements, balance sheets, and cash flow statements advertised in stock-picking programs.

You can replace BRCM or TSM with indices or ETFs. The use of relative strength indices provides a common denominator for comparing equities with bonds, commodities and currencies, to move into asset classes other than stocks for trading. It is not that relative strength is infallible. But compared to the fundamental metrics listed above, relative strength fails to say the least. Break the mold of what you’ve learned about stock options trading.

Is there an example of a selective and consistently profitable portfolio that trades using relative strength across multiple asset classes? yes Follow the link below titled “Consistent Results” to view a retail portfolio of options trading online that excludes the use of individual stocks and fundamental analysis using broad-based stock indices, commodity ETFs and currency ETFs. No need to trade FX directly. Just trade options on currency ETFs.

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