Stock Options Trading: Fundamental Flaw in Fundamental Analysis and Stock Picking

Holding on to fundamental analysis and stock picking software only keeps you stuck in stock trading. Trading in this way compounds concentration risk in one asset class and fails to adequately diversify risks among stocks, bonds, currencies and commodities. There is much more to stock options trading than the stock itself.

I cite Benjamin F. King’s study, cited repeatedly since 1966, because it remains valid and has not yet been refuted to the point of ruling out its logic.

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

  • 31% can be attributed to the general stock market,
  • 13% to industry influence,
  • 36% to the influence of other groups, and the rest
  • 20% is owned by a single share.

There must be a more compelling reason for you to trade stocks other than just the move, if only 20% is unique to the underlying equity in question. Consider this, in the context of the fundamental analysis or stock picking software you bought for $1. For every dollar you spend, you “outsource” the analysis at a cost of 80 cents, only to receive 20 cents of work. Shouldn’t the 80:20 “outsourcing” rule 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 AM techniques/stock picking software, the more trading capital you will be stuck in just stocks.

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

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

A company that gives away a portion of its retained earnings, which is what a dividend is, is actually giving away part of its valuation, which means it’s not worth nearly 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 the dividend. If not, there is no point in looking for dividend paying products to trade, there are plenty of non-dividend paying indices to trade.

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

3. Price/Cash Flow Ratio (cousin of P/E): Accounting laws on depreciation vary across Asia, Europe, and the US, as accounting rules are driven by tax codes, which vary considerably from region to region. Despite the adoption of global accounting standards, there is a lack of uniformity in the homogenization of a fundamental relationship that will fit as a common point of reference in all geographies.

These metrics don’t help you compare, say, a US-sourced Dell to a Taiwan-sourced Acer; but 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 hurts the ability of corporations to optimize the operating cost of their balance sheets. In essence, corporations keep the 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 paper subscriptions.

Since there is a fundamental flaw in fundamental analysis and stock selection, how do you select trades? Trade options on a broad-based stock index to replace exposure to individual stocks. To replace fundamental analysis, use relative strength measurement based on point-and-figure methods.

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

Let’s start within a sector. For example, if you pick 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? In addition, is the price of the sector itself also changing?

SOX = Semiconductor Sector Index, trading higher 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.

SST RS1 = (9.91/452.24) x 100 = 2.19. SST RS2 = (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 a bigger stock, does that mean it profits from SOX trading? No, the RS reading (RS1 compared to RS2) shows that the BRCM RS reading fell (from 7.33 to 7.23) versus the TSM RS reading which increased (from 2.19 to 2 .87). RS confirms TSM as the best performer on the rise in price strength versus BRCM’s weakened price. RS is built on pure pricing rules. Using an index as a denominator acts as a much more durable reference point and is structurally more reliable, compared to any “magic” TA indicator; or a combination of income statements, balance sheets, and cash flow statements promoted in stock selection programs.

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

Are there any examples of a consistently profitable optional portfolio that trades using relative strength across multiple asset classes? Yes. Follow the link below titled “Consistent Results” to view an online options retail 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 FX directly. Simply trade options on currency ETFs.

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