Showing posts with label fundamental-analysis-example. Show all posts
Showing posts with label fundamental-analysis-example. Show all posts

THE OPTIONS COURSE- How to Spot Explosive Opportunities

THE OPTIONS COURSE


How to Spot Explosive Opportunities

Locating exceptional investment opportunities is the key to successful trading. The main objective is to discover opportunities that:

• Meet all the criteria for a good investment.
• Use your investment capital in the most efficient manner.
• Produce substantial returns in a relatively short period of time.

Throughout the years I have been investing and trading, I have thought of myself as being fairly successful, while in the eyes of others, I have been perceived as extremely successful. However, contrary to popular belief, I know that deep down inside I still have more room to grow. Over the past few years, I have been able to accelerate my profitability by being patient (as much as I could be) and by being selective when I made an investment.

I have to admit that I love the day-to-day excitement and the financial rewards of trading. However, I make a great deal more money by looking for opportunity intelligently. In other words, instead of being in the markets just because I feel I need to be, now I wait like a cheetah in the jungle, looking for a wounded animal to pounce upon. Although the cheetah can catch any animal, wounded or not, it preys on the sure thing. I have learned that this is the best way to trade—wait for everything to look right, then attack with speed and confidence.

Initially it may not be easy for you to do the same. However, this confidence and patience will come over time as you build up experience and increase your investment account through successful trades. How do you spot explosive profit opportunities? It’s an awareness that needs to be developed, and if done correctly will enable you to make 100 percent on your money, sometimes in minutes, hours, or days, instead of years.

How do you find the growing money trees hidden deep within the information forest? Simply use the vast amounts of information available to you; learn to filter the data and find the best investments. The problem is that there is so much information. This can be overwhelming and quite confusing. Many would-be investors pick up a newspaper, look at the financial section, quickly decide that they can’t make heads or tails out of the information, and promptly give up. The general feeling is that anything this complicated must be extremely difficult to succeed in.

What if you gave up the first time you fell off a bicycle? What if you gave up the first time you sat behind the wheel of a car to learn to drive? What if you gave up on anything halfway challenging? You wouldn’t get anywhere—which is why many people never succeed. Successful individuals persevere. This also is true in learning the financial markets. It may seem difficult at first; but once you know the basics about how to ride the bike, it gets easier. After a while, you’re cruising down the road yelling, “Look, Mom—no hands!” 

Recognizing an excellent trade when you see it is just half the battle. As a trader, you must know how to go about finding explosive profit opportunities. There are an overwhelming number of methods used by the investment community to evaluate trading opportunities. I will not attempt to impart an exhaustive study of analysis techniques—there are far too many of them, and most do not work on a long-term basis. However, there are two basic categories that should be included as basic components of a trader’s arsenal: fundamental analysis and technical analysis.

FUNDAMENTAL ANALYSIS

Fundamental analysis is a trading approach used to predict the future price movements of a market based on the careful analysis of an investment’s true worth. Various economic data—including income statements, past records of earnings, sales, assets, management, and product development—assist in predicting the future success or failure of the company. Thus, a fundamental analyst studies the fundamentals of a business—its products, customers, consumption, profit outlook, management strength, and supply of and demand for outputs (i.e., oil, soybeans, wheat, etc.). Fundamental analysts use this data to anticipate price transitions. They see a company or market as it is now in the present, and they attempt to forecast where it is going in the future. 

Annual reports and quarterly financial statements (and their close government-mandated cousins for publicly traded companies, the 10-K and 10-Q, respectively) are part of the information used in fundamental analysis. The first question is, “Why should we be concerned about financial statements?” They are, after all, simply a restatement of the past, not a road map to the future. There are two primary reasons. The first reason for looking at financial statements is to determine how well management has handled the affairs of the company, because if you own shares or have a bullish position on the stock using options, these people are handling your investments. Is management operating the company well or poorly? Is management efficient or inefficient? How is this firm’s management as compared to its competitors?

The second reason for looking at financial statements is to determine if the firm is positioned to carry out the goals of management. For instance, if they are about to run out of cash, expansion projects are probably not going to be realized. The first step in studying financial statements is to get one’s hands on the items from the annual or quarterly report. There are many sources for acquiring an annual report. The most direct way is to call or write the investor relations department of the firm you are interested in analyzing, and simply ask them to send you one. If you already own one or more shares in the firm, they will automatically send you both the annual report and the quarterly financial information. 

Most companies will post at least the numbers from their financial statement on their web site. Your local library will often have copies of firms of local interest. In addition, there are a number of web sites, including EDGAR Online, that will give you access to a firm’s 10-K statement and other financial information. Libraries also carry many other sources of financial data on a firm. One final bit of housekeeping: Which is better, a 10-K or an annual report? A 10-K is a financial statement required by the Securities and Exchange Commission to be filed with the SEC by every publicly traded company on an annual basis. The report is a comprehensive look at the financial dealings of the firm throughout the year. 

The difference between the 10-K and the annual report is that the 10-K requires all firms to file certain detailed information and to list it in a specific order. The annual report will often include the 10-K, but even if it doesn’t, it has basically all the information required in the 10-K, and sometimes with even more detail. Personally, I prefer an annual report because I like to look at all the photos of smiling employees and happy customers, as well as the management discussions that usually accompany the dry numbers. Okay, say you have an annual report in front of you. Where do you start? The first thing you should realize is that there are no absolutes in financial statements. Unlike the basic laws of physics, what you see is not necessarily what you get; and everything is always open to interpretation.

What we will be concerned with is not necessarily in coming to a conclusion on a particular annual report, but rather to point out the pitfalls and areas to be aware of when you start to analyze a statement. Remember: First, foremost, and always, an annual report is often a sales pitch—management pays for the annual report, and they will be putting their best foot forward in the presentation. Therefore, don’t let subjective statements sway your opinion of the company too much. Most fundamental analysts dig deeper inside the report and study the actual numbers.  Some traders overlook fundamental analysis. However, as most trades are not totally neutral (in other words you have a bias as to whether you would prefer the shares to go up or down), studying the fundamentals of a firm should at least help you to be in front of the trend. 

If you are looking at a strong company in a strong industry, you should think twice before putting a bearish trade on that stock and vice versa. This is especially true for longer-term trades. There are three important factors to consider when studying the income statement and also three from the balance sheet. On the income statement, you want to look at sales, gross profit (or operating income), and net income. From the balance sheet, you need current assets, current liabilities, and total assets. In addition to these six numbers, the curious investor will have to do a couple of divisions to glean about 80 percent of the information available. Sales are good. They are necessary to generate income, so more is generally better than less. 

In addition to the raw number, most investors divide this year’s sales by last year’s sales to look at the rate of growth. Increasing growth is generally better than decreasing growth, providing each sale is generating more revenue than it costs to produce it. To determine if a firm is generating profitable sales, we use the second number from the income statement, the gross profit. Dividing gross profit by sales gives the gross profit margin, a number that describes what percent of each sales dollar is available (after the direct costs of producing that sale) to pay for overhead, debt repayment, taxes, and, of course, dividends. Larger is better. A gross profit margin that is deteriorating from prior years is generally not so good. 

It may not be a problem, but a deteriorating number should raise a red flag so that your antennae are tuned into looking for the reasons when you read articles about that company. The reasons for a deteriorating gross profit margin can come from many things. Raw material and employee costs can escalate faster than the firm is able to raise prices; this is typically not a very good situation. On the other hand, the firm could simply be changing its sales mix (selling a larger percentage of low-margin products) or be going after sales that are less profitable (possibly large orders with associated discounts, etc.), which could be a good strategy. The idea, here, is for the investor to simply be aware that there is something happening.

Finally, the net profit line on the income statement is important. As a bullish investor, you want to see this number positive and increasing. If you are looking for a bearish position, negative and decreasing is your ideal. However, remember that net profit is a result of many things, not just the operations of the company. From your perusal of the footnotes and the auditor’s letter, you should be able to judge just how much confidence you can place on this particular number. While the income statement gives us a picture of just how well the firm prospered over the past year, the balance sheet gives us a glimpse as to how conservative the firm is with its assets and how efficiently it is using them. Current assets and current liabilities are defined as those assets and liabilities that either are or will, in the normal course of business, be turned into cash over the next 12 months. 

Thus, receivables will be collected, inventory will be sold, prepaid expenses will be utilized (et cetera) in the upcoming year. Similarly, all accounts will be paid, notes and loans will be paid, and unpaid taxes will, by definition, be paid during the upcoming year. Thus, if current assets are greater than current liabilities, there should be no trouble (barring some unforeseen circumstance) meeting all obligations with cash collected from various accounts, even if there are temporary glitches in sales, collections, or production. Obviously, the larger the difference in those two numbers (current assets and current liabilities), the better. The final number that we are concerned with on the balance sheet is total assets. By dividing “net income” by “total assets,” we get return on assets (ROA). 

This is a measure of just how efficient management is in utilizing the assets at its disposal. This is a more accurate measure of management efficiency than is the return on equity (ROE) that many investors utilize. ROE is a direct result of ROA, adjusted for the amount of debt management has assumed. By simply borrowing more money, management can usually increase the ROE without doing anything better operationally. In fact, the total profit will decrease, as additional funds will be needed to pay the interest costs of the new debt. If carried to the extreme, or if the firm hits a patch of trouble, the increased leverage of the additional debt will become critical. The standard income statement is generally constructed utilizing what is called “accrual basis accounting.” 

In layman’s terms, this means that management chooses when a sale is final and then records it, regardless of when the firm actually receives cash for that good or service. This gives rise to the balance sheet account called “accounts receivable,” or the amount of money owed the firm by its customers for goods and services delivered but not yet paid for. To fairly represent the true profitability of the firm, the costs of those raw materials used in the products delivered are then listed on the income statement as a cost, regardless of when they are paid for. Similarly, assets such as buildings and equipment are depreciated, or expensed a little bit each year as management feels they are used up, again regardless of when they are actually paid for.

The statement of cash flows, then, is the vehicle that converts accrual accounting back to a cash basis, and hence is far more critical than most investors give it credit for being. If the firm cannot generate enough cash from its operations to pay for those operations, it will never be able to pay for new investments needed for continuing operations nor be able to repay debt previously borrowed nor pay dividends to shareholders. Thus, the “net cash provided by operating activities” should always be positive (if the company is going to prosper), and the second major category (investing activities) should not always be negative. A negative number in this category is fine if the firm is doing major expansions, but it should, after a few years, turn positive. 

Finally, a glance at the financing activities section should clue you in on how the firm is paying for all the cash needs it has. Is it raising cash through debt (adding risk) or through the sale of more equity (diluting the shareholder’s position)? Or, as one would hope in a mature company, is it repaying past borrowings? The final section of numbers that the trader should look at is the “Reconciliation of Retained Earnings.” This statement is a detailed look at the depreciation and other noncash adjustments that resulted in the final balance of the shareholders’ equity account on the balance sheet. This account lists extraordinary items that have taken place during the accounting period as well as adjustments to prior years’ statements that do not directly flow through the income statement or any of the other balance sheet accounts. 

This statement should tie in with your investigation of the footnotes. While you are not looking for anything specific, strange entries should raise questions. Again, there is no right or wrong answer to any of these particular categories. You are just trying to get a feel for the general health of the firm. If too many of the numbers turn up negative, then you should recognize that this firm is not a slam-dunk gold-plated investment, and appropriate precautions must be taken in your trading efforts. Entire industries are built around fundamental analysis. Every major brokerage firm has armies of analysts to review industries, companies, and commodities markets. The majority of what you see and hear on television or read in the newspapers is fundamental analysis. Fundamental analysis comes in many shapes and forms. 

For example, you may hear that a company’s product is selling like hotcakes, or perhaps there has been a management change. Maybe the weather is killing the orange juice crop. It’s up to you to learn how to apply this information tomaking money in the markets. Typically, I don’t listen to others, because too often they are wrong. On the other hand, I love to find opportunities to do the opposite of everyone else. This is known as the contrarian approach—when all the information is too positive, look for an opportunity to sell, and when it is too negative, look for an opportunity to buy. Moral of the story: Listen to the market. It will tell you a great deal. Use a discerning ear when listening to anyone else.

TECHNICAL ANALYSIS

Technical analysis evaluates securities by analyzing statistics generated from market activity, such as past prices and volume, to gauge the forces of supply and demand. Furthermore, technical analysis is built in part on the theory that prices display repetitive patterns. These patterns can be utilized to forecast future price movement and potential profit opportunities. Technical analysts study the markets using graphs and charts to determine price trends and gauge the strength or weakness of an investment (stock, futures, index, etc.). 

The technical analyst is trying to understand the past price trends of the stock or commodity in order to try to determine price patterns that will forecast future price movements. The type of analysts that use this method of predicting stock movements are sometimes called technicians or chartists. Do I believe in technical analysis? Absolutely. I believe a good technician can look at many factors and determine future price action with a certain degree of accuracy. In fact, since many option strategies are relatively short-term in nature, it’s important to use technical trading tools to help improve the timing of certain trades. Many options traders use technical analysis more than fundamental analysis for that reason. 

However, no person or computer can predict the future 100 percent of the time.  We need to use all the information available about the markets in the past and present to attempt to forecast the future. Although many a profit has been made from complex technical charts, there are no crystal balls. Therefore, we recommend studying technical analysis and using it when implementing trading strategies, but don’t rely exclusively on charts, patterns, or other technical trading tools. The simplest and most widely used technical analysis tool is a moving average. 

A moving average is the analysis of price action over a specified period of time on an average basis. This typically includes two variables (more can be used). For example, we may look at the price of gold trading right now and how that price compares to the average over the past 10 days and the average price over the past 30 days. When the 10-day average goes below the 30-day average, you sell; and, conversely, when the 10-day average goes above the 30-day average, you buy. Technicians go to great lengths to fine-tune which time spans and averages to use. When you find the right time frames, the moving average is probably the simplest and most effective technical tool.

Moving averages and crossovers can be very useful tools. To keep their strengths and benefits in perspective follow these five suggestions regarding their use:

1. If you get a buy or sell signal and you take on a position, keep that position until the 18-day line goes flat or changes direction. Do not take on a new position until there is a proper realignment of all
three averages.
2. To protect accumulated profits along the way use the 50-day moving average as an exit point.
3. Think of the 50-day moving average as a support or resistance line.
4. Moving averages work very well in uptrends and downtrends and not as well in sideways markets. That’s because in sideways markets, you can get buy signals near tops and sell signals near the bottom. If you trade on those signals, you will more than likely incur losses.
5. Finally, because moving averages do not work that well in sideways markets, which can occur a fair amount of time, use caution. Try to find stocks that trend a great deal if you plan to rely on this tool.

Moving averages are a time-tested tool, and I would urge any new market technician to understand their proper use and application. 

Another technique is to use a momentum indicator. This technical market indicator utilizes price and volume statistics for predicting the strength or weakness of a current market and any overbought or oversold conditions, and can also note turning points within the market. This can be used to initiate momentum investing, a strategy in which you trade with (or against) the momentum of the market in hopes of profiting from it. It’s one of my favorite ways to trade because I can spot stocks, futures, and options with the potential to make money on an accelerated basis. Finding these explosive profit opportunities is the key to highly profitable trading. 

Briefly, a momentum investor looks for a market that is making a fast move up or down at a specific point in time, or there is an indication of an impending movement. Like a volcano about to erupt, a great deal of pressure starts to build, followed by an explosion for some time, with a calm thereafter. A momentum investor might miss the eruption but be able to catch the market move right after the eruption. Different techniques are used in each case. To catch the first move (another example is that of a surfer trying to ride a wave), you have to see the signs, place the appropriate strategy, and then get ready to get off when the momentum (or eruption, or wave) fizzles. This can be hours, days, or weeks. 

If you miss the first move, it’s best to wait until the movement fizzles and then look to place a contrarian trade. If you wait until there is a slowdown, you can then anticipate a reversal. If you employ a contrarian approach, you will be trading against the majority view of the marketplace. A contrarian is said to fade the trend (which suits me just fine). Very fast moves up lead to very fast moves down, and vice versa. Trading, investing, and price action are driven by two elements— fear and greed. If you can learn to identify both, you can profit handsomely. Momentum investing plays off of these two human emotions perfectly: greed not to miss a profit opportunity and fear that profits made will be lost if the market reverses course, thus intensifying the reversal in many cases. 

There are hundreds of technical analysis tools out in the marketplace. Be very cautious with those that you decide to use. Make sure you thoroughly test these systems over a long period of time (i.e., 10 years or more). Both fundamental and technical analyses have their proponents. Some traders swear by one and hold great disdain for the other method. Other traders integrate both methods successfully. For example, fundamental analysis can be used to forecast market direction while technical analysis prompts profitable trading entrances and exits. Most investors have had to use trial and error to determine which methods work best for them. 

Ultimately, it depends on what kind of trading you are more inclined to use, and which methods you are most comfortable employing. When you begin to select investment methods, try to determine why they work, when they work best, and when they are not effective. Test each method over a sufficient period of time and keep an accurate account of your experiences. If possible, you should always back-test systems as well. You can use trading software to back-test almost any technical analysis technique available. Inevitably, as the markets change, suitable methods of analysis will change also. The key is to remain open-minded and flexible so that you can take advantage of what works.

SENTIMENTAL ANALYSIS

The stock market is a fascinating place. It is particularly interesting in that the day-to-day fluctuations reflect the views, expectations, and forecasts of investors around the world. Indeed, it is an arena in which the final outcome depends not on one individual decision maker, but on the activity of millions of investors. Given that market moves are due to decisions of a mass of market participants, or the crowd and not one individual decision maker, history is replete with episodes of crowd or mob behavior. Basically, under certain decision-making situations, the individual may act quite rationally, but as part of a crowd, will act based on feelings and emotion. In the words of Humphrey B. Neill:

Because a crowd does not think, but acts on impulses, public opinions are frequently wrong. By the same token, because a crowd is carried away by feeling, or sentiment, you will find the public participating enthusiastically in various manias after the mania has got well under momentum. This is illustrated in the stock market. The crowd—the public—will remain indifferent when prices are low and fluctuating but little. The public is attracted by activity and by the movement of prices. It is especially attracted to rising prices(The Art of Contrary Thinking, 1963).

As an example, take the contagion that spread throughout global financial markets in the fall of 1998. The fact that the sell-off of one stock market in one country eventually led to a drop in another, and then another, was an example of extreme crowd behavior. It was labeled contagion: defined as the ready transmission of an idea, response, emotion, and so on. However, given that global financial markets recovered toward the end of 1998 and early 1999, obviously the panic selling and drop in global financial markets was overdone. In that case, it was the opposite of a mania, but still an example of crowd psychology in its worst form—fear, panic, and disengagement.

Given the nature and impact of crowd psychology on financial markets, many traders use sentiment analysis to gauge the overall attitude of the mass of investors, or the crowd. Studying market sentiment, in turn, is an endeavor in contrary thinking. In other words, one of the premises underlying the study of sentiment data is that, during certain periods of time, it pays to go against the masses. Specifically, when market sentiment becomes extreme in one direction or another, the contrary thinker will act in a manner opposite to the crowd. For example, at the apex of panic selling during the global financial crisis of 1998, the contrary thinker armed with an understanding of sentiment data may well have turned into a buyer: just as the crowd was getting rid of shares. 

Indeed, when the market is gripped with fear and panic, it usually turns out to be the best buying opportunity. An often-heard saying in the stock market is that investors are “right on the trend, but wrong at both ends.” In a rising or bull market, investors are better served buying shares. In a declining or bear market, the trend is downward and it is a better time to sell. In short, during significant market trends, it is more profitable to go in the direction of the market rather than contrary to it. So the crowd is not always wrong. The turning points, however, often catch investors unaware. Sentiment analysis offers a variety of tools for identifying the extreme crowd behavior or “the ends.” Let’s start by taking a closer look at put/call ratios.

Put/call ratios are widely used and easy to obtain. All of the necessary data is available on the Chicago Board Options Exchange. As the name implies, the put/call ratio is computed by dividing puts by calls. It can be done for shares or index options. I focus on two put/call ratios: the CBOE total put-to-call and index put-to-call ratios. While the CBOE put/call ratio uses the total of all option trades on the Chicago Board Options Exchange, the index ratio considers only index trading. For example, February 12, 2004, 508,743 put options and 916,360 calls traded on the CBOE. So the put-to-call ratio was .56 (or 508,743/916,360). The same analysis is repeated for the CBOE index put-to-call ratio, but the equation considers only index options. 

Put/call ratios are used as a contrary indicator. Since calls make money when shares or indexes rise, they often represent bullish bets on the part of investors. Conversely, puts increase in value when a stock or index moves lower and, therefore, reflect bearish bets. So when the put/call ratio increases, it suggests that there are a greater number of puts traded relative to calls, and market sentiment is turning bearish. When it falls, call buying is increasing in comparison to put buying. Again, studying put/call ratios is an exercise in contrary thinking. Specifically, if most market participants, or the crowd, are buying puts, it is a sign of negative sentiment and reason to turn bullish. Conversely, a low put/call ratio is interpreted as a market negative since the crowd is excessively bullish, but probably wrong.

In practice, readings of .50 or less from the total put-to-call ratio are a sign of heavy call activity and extremely bullish sentiment. In that case, the contrarian would turn more cautious or bearish. On the other hand, readings of 1.00 or more are a sign of excessive bearishness and reason to be bullish. The index put-to-call ratio will rise above 2.00 when investors are too bearish and drop below 1.00 when bullish sentiment is extreme. Adviser sentiment, which is used to measure excessive bearish and bullish positions, is one of the more popular contrarian indicators and is certainly one I employ. If adviser bearish sentiment is greater than 60 percent, this is a signal that a possible bottom is forming. If adviser optimism is greater than 70 percent, this signals a market top.

The mutual fund liquid assets ratio is based on the premise that cash balances rise as the trend nears a bottom when increased buying power exerts a bullish effect. If buying power is greater than 10 percent of balances, this is bullish. The Investment Company Institute (ICI) releases the number monthly. The first cousin of this indicator is customer credit balances and is based on the fact that the cash balances rise or fall as the market bottoms or peaks. The short interest ratio indicator consists of ratios of short interest to average daily trading volume. Readings above 1.75 are bullish and ratios under 1.0 are bearish. A related indicator is odd-lot short sales, which typically are wildly speculative in the wrong direction.

The final three contrarian indicators I look at are the over-the-counter (OTC) relative volume, market P/E ratio, and the Dow Jones Industrial Average dividend yield. OTC volume breakouts above 80 percent provide bearish signals of excessive speculation. Price-earnings ratios of 5 and 25 are approximate lower- and upper-trend boundaries. DJIA yields get as low as 3 percent at market tops and as high as 18 percent at market bottoms. The different numbers I have used for quantification purposes are typical rules of thumb used by most contrarian traders. I basically use them as a ballpark figure versus an absolute. They will change through time and should be considered in light of their long-term trends. 

As far as finding the latest readings for these indicators, information can be found in Barron’s, Value Line, and Investor’s Business DailyIn conclusion, there is a wide variety of sentiment tools that can be used to enhance your trading, especially if you are interested in becoming a contrarian trader. The premise holds that the crowd is not always wrong, but invariably on the wrong side of the market during major turning points. The goal behind using sentiment analysis, therefore, is to identify extreme cases of bullishness or bearishness and then trade in the opposite direction because the major turning points generally turn out to be the most profitable trading opportunities.

The rightmost column shows how each indicator can be used by market technicians to keep up with changing market trends. The market is always going to bounce around, and this constant fluctuation may indicate that there’s never an exactly right time to enter a trade, but there will always be a time that’s better than another. Professional traders use timing and technical indicators to secure the best moment of entry and exit. They take advantage of the market’s swings rather than letting volatility take advantage of them. That’s why it is so important to learn how to use timing indicators—to put the odds in your favor and dollars in your trading account.



TABLE  Key Contrary Indicators


TABLE  (Continued)


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