Stock option trading: fundamental flaw in fundamental analysis and stock selection

Holding onto fundamental analysis and stock picking software only keeps you stuck in stock trading. Trading in this way aggravates the risk of concentration in an asset class and fails to adequately diversify risks between stocks, bonds, currencies, and commodities. Trading in stock options involves much more than the stock itself.

I quote Benjamin F. King’s study, cited repeatedly since 1966, because it is still valid and has not yet been refuted to the point of dismissing its logic.

Market and Industry Factors, Journal of Business, January 1966: “On the Move of a Stock …

• 31% can be attributed to the general stock market,
• 13% to industry influence,
• 36% influenced by other groups, and the remaining
• 20% is peculiar to an action. “

There must be a more compelling reason to trade stocks other than just because of the movement, if only 20% is exclusive to the underlying equity in question. Consider this, in the context of fundamental analysis or stock picking software you bought for every dollar. For every dollar you spend, you “outsource” the analysis at a cost of 80 cents, only to receive 20 cents in labor. Shouldn’t the 80:20 rule of “outsourcing” be the other way around? The problem is that you are still stuck with 80% of the work to analyze the price movement! Also, the more you use FA / stock picking software techniques, the more trading capital will be trapped in stocks alone.

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

1. Dividend yield: the problem is in the variability of the returns, since companies are in different stages of their business development. A mature company dominating a well-established subsegment / 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 area that may not be able to pay a dividend. Keep in mind that there is nothing special about companies that pay dividends.

A company that gives away a part of its retained earnings, which is what a dividend is, effectively gives away part of its valuation, which means that it is not worth as much as a company that needs to give investors candy to commit capital. . Therefore, a dividend-paying stock has to be far superior to a non-dividend-paying stock for reasons other than dividend. If not, there is no point in looking for dividend-paying products to trade, there are many indices that do not pay dividends to trade.

2. Price / Book Value: The problem is that this metric varies from industry to industry and company to company, as the asset base and capital structures of companies change over time. It lacks cross-industry applicability and accounting complexity arises from a company’s capital structure as it changes due to acquisitions / divestitures / CAPEX for new product lines; or cuts in the product line, as seen recently in the restructuring of major US auto companies.

3. Price / Cash Flow Ratio (P / E Premium): Depreciation accounting laws vary in Asia, Europe, and the US Since accounting rules are governed by tax codes, which vary considerably between regions despite After the adoption of global accounting standards, there is a lack of uniformity in the homogenization of a fundamental index that is adjusted as a common reference point in all geographies.

These metrics don’t help you compare, say, a Dell with parents in the US versus an Acer with parents in Taiwan; but it is listed as ADR in the US, even though both are competitors in the same industry as computer manufacturers.

In addition, the current dislocated cost of capital in credit markets affects the ability of companies to optimize the operating cost of their balance sheets. In essence, corporations keep any remaining working capital cash flows on their balance sheets, as a testament to their financial strength. Don’t waste your money on fundamental analysis software or research subscriptions.

Since there is a fundamental flaw in fundamental analysis and stock selection, how are trades selected? Trade broad-based stock index options to replace individual stock exposure. To replace fundamental analysis, use relative force measurement based on point and 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. Normally, RS calculations use daily closing prices. Although simple in its mathematical construction, RS is ingeniously powerful when applied not just within a sector; target, across industries and across asset classes.

Let’s start from within a sector. For example, if you choose 2 semiconductor stocks that are trading at different prices, how can you tell if one stock is outperforming the other in the same sector, when the 2 stocks have price changes at different rates? Furthermore, is the price of the sector itself also changing?

SOX = Semiconductor Industry Index, trading 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 rises from 33.15 to 33.80 and the price of TSM also rises from 9.91 to 13.43. Simply because BRCM is a larger stock, does that mean it benefits from the SOX listing? No, the RS reading (RS1 compared to RS2) shows that the RS reading of BRCM fell (7.33 to 7.23) against the RS reading of TSM, which increased (2.19 to 2.87). RS confirms TSM as the best competitor that increases the strength of the price against the weak price of BRCM. RS is based on pure pricing rules. Using an index as a denominator acts as a much more durable benchmark and is structurally more reliable, compared to any “magic” TA indicator; or a combination of income statements, balance sheets, and cash flow statements that are promoted in stock selection programs.

You can replace BRCM or TSM with indices or ETFs. The use of indices with relative strength allows a common denominator to compare stocks with bonds, commodities and currencies, to cross into asset classes other than stocks for trading. Not that relative strength is infallible. But compared to the fundamental metrics cited above, relative strength fails the least. Break the mold with what you learn about stock options trading.

Is there an example of an optional and consistently profitable portfolio that trades using relative strength across various asset classes? Yes. Follow the link below, titled “Consistent Results” to view an online retail options trading portfolio that excludes the use of individual stocks and fundamental analysis, using broad-based equity indices, commodity ETFs, and currency ETFs. There is no need to trade directly with FX. Just trade the options of the currency ETFs.