Wiser Trader Stocks and Options Newsletter

 

 

1.0 Modeling

 

      This is not really a math newsletter.  It’s simply that profit and loss models are important to us as traders.  In last week’s newsletter a model was introduced with the title “Precision Money Management”.  It was designed to model a natural relationship between trading system performance, trade position size, stop loss settings and profit goals. After studying the model the past week, I’d like to follow up with an interesting observation.  

 

      In brief, the model consists of two equations,

 

      F_P = F_C F_G + (1 – F_C) F_L                                                                                                    (1)

 

      F_P = D_G / (C N)                                                                                                                 (2)

     

Where,

      F_P is the average fractional profit for N trades that each uses an average amount of capital C

      F_C is the fraction of trades chosen in the correct direction

      F_G is the average fractional gain for N_G winning trades

      F_L is the average fractional loss for N_L losing trades

      D_G is the profit goal that one sets, expressed in dollars

 

      The model is based on average values of historical trading system performance and is only applicable when a trading system is consistently followed.  The model should not be applied to unstructured trading across a variety of instruments requiring varying trading techniques.  Each trading system or technique generates a unique set of statistics to which this methodology can be applied on an individual basis.  For a more detailed explanation, please refer to the web page Precision Money Management.  Details are also in last week’s newsletter.

 

      Last week it was seen how the model can be used to set precise profit goals and meet them with proper stop loss settings and position size.  Looking at equation (2), one can view the profit goal D_G as a simple multiple of the average capital per trade C because both D_G and C are considered constant for any given series of N trades.  When the profit goal is set equal to the average amount of each trade, D_G  and  C  both  drop  out  of  the  equation  and  N  becomes  the number of trades needed to earn a profit equal to the average trade size.  Equation (2) then becomes, F_P = 1/ N. 

 

 

 

      More to the point, N = 1/ F_P, an important conclusion.  It says that the number of trades needed to earn an amount equal to the average trade size is 1/ F_P.

 

      A chart of N = 1/ F_P is plotted in Figure 1. 

 

 

 

FIGURE 1

 

 

      When the average number of trades is identified over a fixed amount of time, the chart in Figure 1 gives the rate that C worth of profit can be obtained using a fixed average trading size C.  The chart shows that when F_P is less than about 0.1, the number of trades required to earn the average traded amount grows exponentially.  When a trading system’s performance is improved by increasing F_P from 0.1 to 0.2, the number of required trades is cut in half from 10 to 5.  An F_P of 0.5 requires only two trades.  While increasing F_P above 0.5 may improve one’s odds for success, it does not substantially reduce the number of required trades to meet a given profit goal.  These details are useful and are based on the easiest trading system parameter to obtain, F_P, which defines overall trading system performance.

 

      Experienced traders typically do not set profit targets because there has not been a clear relationship between profits and trading methods until now.  Typically they hunker down and use position sizing and stop loss settings and resign profit results to the mercy of whatever statistical gods there might be.  For example, the best traders will advise that you use no more than 4% of your capital for any given trade and set your trailing stop at -25% so that you can lose no more than 1% of your portfolio on any single trade.  Stop losses are tightened once a profit is shown on paper so as not to allow a winning trade to turn into a losing one.  These methods produce the desired results, that is, to retain profits, minimize losses and maximize one’s chances of living to trade another day.  But somehow one lacks a sense of control and the ability to see where profits are headed.   The above profit-loss model simply removes the blind folds.

1.1 Perspectives and Short Takes

 

Capital Gains

 

      In the microcosm of our day to day short term option trading, we need to be aware that taking short term profits carries with it a higher tax on capital gains if we compare it with holding winning trades for the long term.  Even with options we can buy leaps and hold them for the amount of time needed to qualify for long term capital gains and a lower tax rate.  This could be a mute point.  Brokers report the sale of stocks to the IRS but do not report the sale of options. The IRS refuses option sales information because options are not securities. 

 

Market Value

 

      Most of us are aware that a company’s stock is fairly valued when its price to book and price to sales ratios are less than or equal to one.  Arnold Van Den Berg of Century Management observes that the ratio of the value of the entire stock market to the U.S. Gross Domestic Product has historically averaged 0.76 over the last 40 years.  Today it is 1.36.  Jeremy Grantham, manager of GMO, an $80 billion hedge fund, cites that the fair value of the S&P500 is around 700 compared to its 1200 level today.  He sites historical evidence implying that before the market ultimately bottoms within the next 2 years, the PE ratio for the S&P500 must drop from a present value of 21 to around 12.25.

 

 

Gold

 

      We have seen the US dollar price of gold increase by 40.5% over the last five years.  This was mainly due to a fall in the value of the US dollar due to deficit spending and a negative balance of trade.  But in terms of Euro dollars, the price of gold has not budged.  It only increased by 5.8%.  However, the inability of European governments to avoid deficit spending and stay within agreed upon budgets will cause the Euro to fall in a manner similar to that seen by the US dollar.  When that happens, the price of gold, it is estimated by some, will surge to $3,000 an ounce over the next 10 years.  This trend will also be driven by the propensity for Asia Pacific populations to own personal gold and a growing movement among Muslim countries to base their currencies on gold.  All of this will intensify effects of an already reduced capacity for gold production. 

 

Oil

 

      Oil production capacity today is only about 2 million barrels a day (2.44%) more than consumption.  New discoveries are rare, existing oil fields are becoming depleted and capacity has just about peaked.  Oil prices are expected to move to $100 a barrel as India and China increase demand while supplies begin to decrease.

1.2 Option Alerts

 

Alert No. 4

 

      The remaining open alert, KBH July 115 Calls (alert no. 4) recovered somewhat from the shock and bandwagon effect of analysts suddenly realizing that real estate prices will not rise forever. The Home Building Industry was downgraded by Smith Barney and Citigroup last Friday in addition to numerous advisories echoing the sentiment. The Home Construction Index bottomed out on Tuesday, a little earlier than expected.  But it is not yet out of the woods, still well beneath its high for the year.  The option was sold at $10.40, -6.3% below the maximum buy price.  This brings the average alert profit to 5.7% per trade for a total of 4 trades.  A profit of 5.95%, compounded monthly, is needed to arrive at 100% profit for the year.  The first month’s operations end on February 28^th.

 

Alert No. 5 - was closed.   There are no alerts today.  There could be one this week in energy, healthcare or basic materials. 

 

1.3 Trading & Advising versus Trading Systems

 

      A subscriber and fellow engineer recently asked, “If traders are successful, why do they advise?”  It is a valid question that I had often asked myself.  There are many possible reasons.  Here are just a few.  It is far easier to teach others how to manage risk than it is to endure risk by oneself.  Another reason for teaching is to leverage one’s knowledge.  Multiple streams of income are far better than having only one.  A third is that trading may not fully support one’s life style. Successful trading does not necessarily make one rich.

 

Hunter-Traders

 

      I often view traders as hunters.  My website was set up to market hunting tools in the form of stock filters and trading systems because I believe in their use.  I’m finding that only a very small percentage of traders will invest in these tools even though they are a sound investment.  This is somewhat mysterious because the small 12% percent of traders who are successful (again, not necessarily rich) is very close to the small percentage using trading systems.  Most traders are individualists, as we have to be to get involved in such a risky venture as short term trading.   We don’t mind being shown what and where, especially if the information is free.  This is viewed as an abundance of game.  Natural hunting instincts tell us that if game is plentiful then there is nothing more to be concerned about, at least for now.  We are less interested in the habits of our quarry and are hesitant to pay for information on how and why, choosing to learn from personal experience.  It is not until the supply of game decreases that we really begin to notice how important it is to understand the habits of our game.  After being independent for so long it becomes a matter of pride.  Then it’s even harder to submit to instructions that others provide, even when it’s free.  After ammunition (capital) has dwindled with only a few shots remaining, we sometimes submit to instruction with the highest demand that each scrap of information be perfect.  Of course, this is a formula for disappointment. 

 

How Things Have Evolved

 

      As traders, we need to become convinced that we can sharply improve our methods before reaching a point of desperation.  I thought that by providing portfolio examples of how a simple low cost trading system can be used to make profits, more traders would see the value of investing in a low cost trading system.  After all, we’re averaging 11% per trade.  However, I am slowly becoming convinced that the majority of traders will always prefer tips rather than employ the means to develop tips on their own.  The watch list pages were created to provide free tips.  Traffic to these pages has become, by far, the largest traffic on the web site. 

 

Where Things Are Now

 

      Since bills need to be paid, this led me to announce an option alert service that provides focused tips and trade timing, eventually for a fee.  I am not quite sure where that falls in the hunter-trader analogy but that is where things stand today.  The latest pricing is posted on the site.

 

Where Things are Likely to Go

 

      It is difficult to conclude that, after association with this site, traders do not see value in the consistency of trading systems.  I believe they just need to be given more incentive to take the leap.  As an affiliate merchant, I have little pricing flexibility other than to provide the broadest possible range of pricing and types of systems.

 

      There is another approach.  Most traders like to think they are already using a trading system, even though they are not keeping records of their trades and their methods evolve continuously.  What would be more appealing to the independent nature of traders than an opportunity to be shown how to develop their methods into a true trading system?  What if traders were given the opportunity to take a 7 hour web based training seminar on how to develop a trading system taught by former members of the Chicago Board of Trade having a combined 32 years experience?  What if they received the training at a sizeable discount? 

 

      According to the instructors, immediately after the seminar, the student will be able to: (1) trade using  his own trading system developed during the class (2) evaluate every kind of trading system, if necessary (3) identify profitable trading systems from scam systems and (4) have a system that fits his financial goals.

 

      I will be working to arrange the best price possible.  Seminars are given monthly with the first one occurring on February 27^th from 10:00 AM to 5:00 PM.  They have announced that prices will increase after that.  I don’t know if that is an advertising statement but even at the regular price, I think the course is worth looking into.  I doubt if arrangements will be completed before their next seminar, though. I will contact you when something firm happens.

 

      To help with the negotiations, if I could say how many traders were just potentially interested, this would clarify the kind of discount we could receive.  So I am asking anyone who is interested in developing his own trading system to send me an email by simply clicking on this link to show a potential interest in the seminar.  Remember, this is not a commitment to sign up, just an indication of potential interest. – Thanks.

 

2.0 Market Analysis

 

      A redistribution of large fund holdings and surprisingly low interest rates for long term bonds in the face of rising inflation and rising short term interest rates has led me to take a shorter term view of industry leadership in Table 1 below. 

 

 

            Table 1

 Market Summary

 Week ending 02/19/05:

 Major Indices:

 Dow Jones     -0.1%

 NASDAQ        -0.9%

 S&P500 Index  -0.3%

 Russell 2000  -0.7%

 Industry Leaders

 For the Past Week

 Pipelines  

 Nonferrous Metals

 Integrated Oil & Gas

 Steel  

 Industrial Metals

 Oil & Gas Producers

 Forestry

 General Mining

 Oil & Gas

 Aluminum

 Industry Leaders

 For the Past Month

 Integrated Oil & Gas  

 Oil & Gas Producers

 Exploration & Production

 Heavy Construction

 Oil & Gas

 Steel

 Coal

 Pipelines 

 Marine Transportation

 Oil Equipment, Services & Dis.

 Gold for the past 30 days:

 USD    +1.04%

 CAD    +1.58%

 CHF    +0.82%

 GBP    -0.34%

 EUR    +0.67%

 JPY    +3.98%

 30 Year Bond 4.6%

 10 Year Note 4.26%

      The aggregate increase in operating earnings for the S&P 500 now looks to come in near 20%.  That’s on top of a 28% gain in the fourth quarter last year.  The number of companies guiding earnings estimates lower has increased significantly from recent quarters. This has the market concerned that earnings growth will slow to 5% to 7% in the first quarter. The market is also concerned about rising inflation and rising interest rates.  When bond yields rise high enough, bonds begin to look more attractive than risky over-priced stocks.  The 5 day and 5 week RSI for the DOW, S&P500 and the NASDAQ are all neutral.  Other sentiment indicators are given in Table 2.

 

Table 2

Sentiment Indicators 02/19/05

3.0 Procedure

 

      The following stock screens were generated with tools from AAII.  The short term trading filter used for Table 3a looks for optionable stocks whose percentage relative strength over the past 6 months is greater than 90%, EPS Growth over the past 12 months is greater than 80% and are within 5% of their 52 week  high  with  a  minimum  price  of  $50.   When a trigger has been received, call or put options are supplied depending on the direction of trend as reflected by the respective positive or negative slope of the 30 day SMA. 

 

Table 3a

Short Term Options (Original Stock Candidate Filter) as of   02/19/05

 

 

Key

 

 

      The stock filter resulting in Table 3b is for the potential to write covered call options.  The only difference between filters for Tables 3a and 3b is that in 3b the maximum stock price is $20. 

 

Table 3b

Short Term Covered Call Writing Screen as of   02/19/05

 

 

 

 

 

      For the screen in Table 3c, the number of selections is reduced by eliminating stocks having P/E’s greater than 30.  

 

 

 

Table 3c

Growth Momentum (Intermediate Term) Screen as of   02/19/05

 

 

 

      For the Peter Lynch screen in Table 3d, again the number of selections for this screen is reduced by eliminating stocks having P/E’s greater than 30.   

 

 

Table 3d

Peter Lynch Value (Intermediate Term) Screen as of   02/19/05