FINA 408-FC Lecture 10-11-12 PDF

Lecture 10 Trading Strategies & Portfolio Management - Trade can be based on: (i) performance, (ii) catching large trends, and (iii) diversification. One has to choose the right market (security) to trade based on the following factors: Costs - Time consumption, opportunity costs...

Lecture 10 Trading Strategies & Portfolio Management - Trade can be based on: (i) performance, (ii) catching large trends, and (iii) diversification. One has to choose the right market (security) to trade based on the following factors: Costs - Time consumption, opportunity costs, trading losses from learning curve – trading is a full time job! - Set up costs; computer, high speed internet, trading platform order execution, chart service. - Commission, slippage, missing orders in fast markets, errors. Personal risk tolerance - Leverage use; futures vs. stocks, going on margin. Suitability - Based on your experience and personality. - Choose “slower” or lower risk markets when starting. Volatility - The more volatility the higher the potential profit but the greater the potential costs. Liquidity - Ability to transact many shares without bringing about a large price change. - Dependent on bid-ask size, as narrow spreads do not always guarantee liquidity. Volume - You want issues with heavy volume that have liquidity. 1|Page Three Types of trading for different time horizons: - Trading different time horizons requires different experience levels and strategies. 1. Scalping - Taking very small profits between bid-ask spreads and accumulating liquidity credits. - Requires time, an excellent order entry system, and experience. - Extremely short term (minutes) and fast paced. 2. Day trading - Trading an issue and closing all positions by the end of the day, therefore not taking any overnight risk. - “Screen trading” by using intraday technical analysis signals. - Very short-term. Minute and hour bars are used. 3. Swing trading - Catching small trends or counter trends over several days or weeks. - Less experience required in comparison to day trading. - Not as short term, less time consuming. 2|Page Two approaches used to select investments 1. Top Down  Selection starting from the type of market (stocks, bonds) → country → industry sector → security  Relative strength analysis, intermarket relationships 2. Bottom Up  Security → industry sector → country  Security selection first also based relative strength and additional screening criteria. Industry sectors and sector rotation theories  Selecting sectors based on the business cycle.  Ratio (relative strength) analysis. Relative Strength  A simple but effective method of stock screening.  Ratio is determined between two investments, sectors, industry groups, indexes, etc, to see which is outperforming the other. 3|Page O’Neil – CANSLIM stock selection method  Focuses on “leading” growth stocks.  Stocks are ranked according to the calculation of 12 month relative price strength, with 3 month price strength weighted more heavily in percentiles from 0 -99, 99 being the strongest.  O’Neil found that the average relative strength percentile by his calculations was 87 before large upward moves.  Uses a 7-8% strict stop loss rule.  Hold position if stock rises greater than 20% within 1-3 weeks.  Buys the pattern breakouts within 5% of breakout price. ◦ Patterns used: Cup and handle/saucer ; Flat base ; Double bottom  Allow for a minimum of 7 weeks for a pattern to develop. Best time to buy is on a breakout from a pattern with at least a 50% increase in volume. 4|Page CANSLIM – The Fundamentals C Current Quarterly Earnings +25% or more in recent quarters Research shows earnings growth is the No. 1 indicator of a stock's potential to make big gains. That’s why it’s important to look for stocks with strong current results, as well as history of solid earnings growth. A Annual Earnings +25% or more in each of the past three years N New Product, Management, Highs Explosive stock growth doesn't happen by accident. The biggest stock winners had new products, new management or new conditions in an industry that propelled the company to astounding height. Some investors pass over a great stock because it’s already reaching a new price high. But that’s precisely the point where many of the best stocks gain steam and begin their biggest price moves! S Supply & Demand The most basic economic principles is the law of supply and demand and one of the places its power is most sharply demonstrated is in the stock market. Remember our earlier discussion of new price highs? The law of supply and demand is what’s driving those new highs. Strong demand for a limited supply of available shares will push a stock's price up. On the flip side, an oversupply of shares and weak demand will cause the price to sag. L Leaders: Choosing To Win Steer clear of stocks that are laggards. In the stock market, that sad-looking stock at the bottom of the pack often just falls further behind the leaders. 5|Page  But when you choose stocks that have solid fundamental characteristics — like earnings growth and profit margins — and are thriving in the best sectors, your prospects are better because you are selecting "institutional quality" stocks that get noticed by the biggest traders — the institutional investors like mutual fund and pension fund managers. I Institutional Sponsorship Big institutional investors, like mutual funds, hedge funds, banks and insurance companies, are the driving force behind much of the trading activity in the stock market. M Market Direction Buying a stock during a market downturn can be like trying to swim against the ocean tide: You might make some progress, but the going will be tough, and a big enough wave of selling could drown you. 6|Page Elliott Wave Theory and Fibonacci Fibonacci Sequence Discovered by Leonardo Pisano a.k.a “Fibonacci” of Pisa, Italy Discovered the sequence where last number is added to the previous number to get the next number ◦ 1,1,2,3,5,8,13,21,34,55,89,144 gives us the Fibonacci sequence. Golden Ratio – The Divine Ratio / Proportion, (Fibonacci Ratio) The Fibonacci sequence and golden ratio gives us Gives us Fibonacci retracement levels using horizontal lines at 38.2%, 50%, 61.8%, 100%* Indicate where the price could potentially find support or resistance, there are no assurances the price will stop there. Fibonacci retracements can be used to place entry orders, determine stop-loss levels, or set price targets. For example, a trader may see a stock moving higher. After a move up, it retraces to the 61.8% level. Then, it starts to go up again. Since the bounce occurred at a Fibonacci level during an uptrend, the trader decides to buy. The trader might set a stop loss at the 61.8% level, as a return below that level could indicate that the rally has failed. 7|Page EWT (Elliott Wave Theory)  Elliott Wave Theory, which states that stock prices are governed by irregular cycles founded upon the Fibonacci series (1-2-3-5-8-13-21…).  Impulse waves (move with trend) with corrective (counter trend) waves against trend.  5 motive waves, (waves 1,2,3,4,5), 3 impulse waves (waves 1, 3, 5)  3 corrective waves: A, B, C  The market moves with “three steps forward and two steps back” 8|Page 3 types of corrective waves  1. Zig zags: A-B-C, A & C impulse, B corrective  2. Flats: A-B-C moves sideways with overlapping sub waves  3. Triangles: Like triangle patterns with five waves A-B-C-D-E 9|Page EWT Basic rules (that cannot be broken and must always hold)  Wave 2 may not break below the origin of wave 1.  Wave 3 is never shorter than wave 1 and 5, but it does not necessarily have to be the longest wave.  Wave 4 cannot overlap the termination of wave 1. EWT Guidelines (not always expected)  Alternation: Types of corrective waves in wave 2 and 4 alternate (a flat is followed by a zig-zag, or triangle)  Equality: At least 2 of the 3 impulse sub waves in a 5-sub wave sequence are often equal in length (i.e. waves 1 and 5 usually are equal in length)  Truncation: Occasionally the fifth wave fails to exceed the third wave, and gets “truncated.”  Channeling of waves, and according to Fibonacci retracement and targets.  Channel lines can be drawn connecting waves 1 & 3, parallel to trend line starting from the low of wave 2, and this can be used to forecast waves 4 and the end of wave 5  Wave projections become targets based on Fibonacci ratios.  Corrective waves tend to correct approximately 61.8 or 38.2% of their corresponding impulse waves and are related to each other. 10 | P a g e Wave characteristics in an equity bull market , the reverse in bear markets 11 | P a g e LECTURE 11: Sentiment  Sentiment is defined as the net amount of any group of market players’ optimism or pessimism reflected in any asset or market price at a particular time.  When a stock or commodity is trading at a price considerably above or below its intrinsic value, something we often will not know until considerably later, the difference or deviation from that value will be accompanied by sentiment.  When emotion becomes excessive and prices thereby deviate substantially from the norm, a price reversal is usually due, a reversion to the mean. It is thus important for the technical analyst to know when prices are reflecting emotional extremes.  The market is made up of 3 types of players. - The informed, the uninformed and liquidity players. We will concentrate on the first 2.  The majority of market players are the uniformed players. The retail investors – the public at large, those who tend to chase the market. They are the ones who tend to buy at peaks and sell at market bottoms. Even professionals can be classified as uninformed. It is the timing of their actions that qualifies them as uniformed players.  The informed market players tend to act in a way that is contrary to the majority. The informed players tend to sell at tops and buy at market bottoms. They need not be professionals.  If the technical analyst can determine how each group is acting, some knowledge of the direction of future prices can be gained.  Presumably the informed players will act correctly and the uniformed act incorrectly, especially at market extremes. 12 | P a g e CROWD BEHAVIOR:  People tend to conform to their group, making taking an opposite view difficult, fear of rejection, ridicule, hostility etc.  People feel secure in accepting the opinions of others or “experts”.  As people “follow the herd” they get caught up in extreme buying or selling, pushing prices to extreme levels.  These emotional excesses can result in crashes or bubbles. CONTRARY OPINION:  Is a school of thought in investing which is the opposite of crowd behavior.  It involves doing the opposite of what the majority is currently doing. That is, to sell when the majority is buying and to buy when the majority is selling.  The task of the contrarian player is to find a way in which to quantify which direction the majority of market players is headed and to question whether they are reaching an extreme and whether there is enough energy to keep the market moving in that direction. Sentiment Indicators  Are data sets that give the technical analyst some feeling for how much prices are at emotionally excessive levels. With this information, potential future reversals in trend can be better anticipated.  Generally, sentiment indicators are more useful in analyzing markets than individual securities.  Emotional excess is often sharpest at market bottoms when panic has occurred. On the other hand, optimism can last for a long while. Therefore, most sentiment indicators are more useful in determining market bottoms when fear has reached an excess. 13 | P a g e How is sentiment of uninformed players measured? Most sentiment indicators focus on the uninformed players who are usually wrong at market turns and are therefore used as contrarian indicators. I. SENTIMENT INDICATORS BASED ON OPTIONS AND VOLATILITY:  Back in the day, speculation was measured by odd lot trading. The smaller, uninformed, and less capitalized investors who did not have the means to trade board lot stocks would trade odd lot stocks. This would gauge speculation from the side of the uniformed investor.  Today, this has been replaced by listed options contracts. Call buyers = bullish view of the market or particular stock Put buyers = bearish view of the market or particular stock A. PUT/CALL RATIO Total volume of puts traded in a day/Total volume of calls traded in a day. If the put/call ratio is high, this would represent more puts being traded with respect to calls, which in turn, means that the market participants are more bearish than bullish. A low put/call ratio would imply the opposite.  One should take a contrarian approach to this by coming away with the notion that when the put/call ratio is high (> 0.80) signifying that the majority is net bearish, the market actually should rise.  When put/call ratio is low (< 0.35) signifying that the market is net bullish, the market actually should fall. In summary:  If put/call ratio is ↑ then the market should ↓  If put/call ratio is ↓ then the market should ↑ 14 | P a g e B. VOLATILITY  Historical volatility is the standard deviation of prices in the underlying security  Volatility is mean reverting, that is, when it gets out of line from where it has been on average, we can assume that it will return to its mean.  We can use volatility to measure sentiment too. We look at the VIX which is the implied volatility of the S&P 500 options. As implied volatility measures are forward-looking and not backward looking, we can use them to gauge where the market will be going in the future.  High Volatility tends to occur at periods of stress, emotion, uncertainty, fear and nervousness most often peaking at a panic bottom.  Low Volatility tends to occur during market rises and market peaks when emotions are calm, content and relaxed. Interpreting the VIX:  Generally, when the VIX trades high, there is some sort of a sell-off that occurs, and when it trades at a low level, the market tends to increase.  Most often, the VIX tends to rise exponentially when the market comes under selling pressure. 15 | P a g e II. POLLS:  A straightforward way of gauging market sentiment is simply to ask the players if they are bearish or bullish. Sampling problems do exist though. Poll results if measured over a constant time can give some idea of the public mood.  Poll results are CONTRARY INDICATORS because they express optimism at market tops and pessimism at market bottoms. A. ADVISORY OPINION (www.investorsintelligence.com)  Investor Intelligence reads approximately 120 investment advisory newsletter every week and determines the percentage of them that are bullish, bearish or expecting a correction. B. AMERICAN ASSOCIATION of INDIVIDUAL INVESTORS (AAII) (www.aaii.com)  Compiles a weekly poll from its 150 000 members on what they believe the stock market will do over the next 6 months. C. CONSENSUS BULLISH SENTIMENT INDEX (www.consensus-inc.com)  Compiled from an extensive mix of both brokerage house analysts and independent advisory services, to create the Consensus Bullish Sentiment Index.  The data covers a broad spectrum of approaches to the market, including the fundamental, technical, and cyclical. They consider only opinions that have been committed to publication and therefore have an influence on the trading public. D. MARKET VANE (www.marketvane.net)  Polls 100 leading commodity trading advisors for their opinion of the futures markets principally; stock indexes, T-bonds, gold, silver, Yen crude oil, soy beans etc. This data is then used to construct the Bullish Consensus statistics, which is published in Barron’s weekly. 16 | P a g e E. THE SENTIX INDEX (www.sentix.de)  Is a comprehensive poll of German investors regarding their views on the German as well as the US stock and bond markets. They poll 3100 participants (of which 690 are institutional investors) on what their opinion is for different markets over the next month and next six months. F. CONSUMER CONFIDENCE INDEX (www.conference-board.org)  Producers of the index of leading economic indicators and the help wanted index, each reports each month on consumer confidence.  The Consumer Confidence Index is based on a representative sample of 5000 US households. The survey is based on expectations of the US economy. Like most other opinion polls, the survey has been a contrary indicator to the stock market. III. OTHER MEASURES OF CONTRARY OPINION:  MUTUAL FUND STATISTICS: because mutual fund investors are mostly from the uninformed public sector, mutual fund statistics can often be useful in determining what the uniformed is thinking. A. MUTUAL FUND CASH AS A PERCENTAGE OF ASSETS  Mutual fund cash holdings are contrary indicators for the stock market.  There are many reasons for mutual funds to hold cash, but the bottom line is that high levels of cash usually occur at stock market bottoms. B. MARGIN BALANCES  Each week, Barron’s reports the NYSE margin debt for the previous month. Margin debt should reflect what the uniformed investor is doing (as margin debt is usually comprised of individual investors taking on debt to speculate on the market). This measure has been proven not to be as useful as previously thought due to the ability to take positions with derivatives 17 | P a g e C. NASDAQ to NYSE VOLUME  A ratio of volume traded on the NASDAQ relative to the NYSE is a measure of speculation. Generally, as enthusiasm for speculative stocks (which usually trade on the NASDAQ) increases, the volume traded on the NASDAQ increases relative to the NYSE.  The peak in the market tends to coincide with the peak in this ratio, and the bottom of the trend occurs after the bottom of the ratio. D. UNINFORMED SHORT SELLING  Generally short selling has been used a contrary indicator. The short interest ratio is calculated monthly by taking the total amount of stocks sold short and dividing by the average volume for the month.  When percentage of short sales to total trades increases, this indicates a bearish extreme and the market is likely to rise. IV. UNQUANTIFIABLE CONTRARY INDICATORS: E. MAGAZINE COVERS THEORY  The media covers the news with a strong bias. If the stock market is high and ready to decline, the media would be unlikely to report this point of view. Instead, it would emphasize the current fact that the market has risen and is strong.  When major magazines such as Time, Newsweek, Barron’s, Business Week… include on their cover an article on the stock market, up or down, they are emphasizing what the public believes and already knows – and has been shown previously. The public is generally wrong, at least at extremes. 18 | P a g e How is sentiment of Informed players measured? When basing our decisions on informed players, we would like to mimic their actions, as opposed to taking a contrarian view like we do with the uniformed players. A. INSIDERS  Are the ultimate informed players. No one knows their business, industry or company like an insider. SEC regulations require that insiders must report their transactions within 2 days now, and these stats are published by the SEC. B. SELL/BUY Ratio  It takes into account the total number of insider buy and sell transactions for each company, the percentage change in insider holdings, the unanimity of the transactions within each company, reversals in transaction patterns and very large transactions. Total # insider sales if > than 2.25 = bearish Total # insider buys if < than 2.00 = bullish C. LARGE BLOCKS  Tend to be transacted on behalf of professionals, or the informed players. Large institutional clients are the ones who transact these blocks, and most often than not, whether they are buying or selling has a say in what will likely happen in the future to the stock.  The ‘smart’ money tends to be behind these trades. D. COMMITMENT OF TRADERS (COT) REPORTS  The CFTC (Commodity Futures Trading Commission) publishes the Commitment of Traders (COT) report on a weekly release that shows open interest broken down into 3 categories. Reportable positions of non-commercials (large speculators) 19 | P a g e  Reportable positions of commercials (hedgers) Non reportable positions (small traders)  This report covers positions held in over 22 different futures markets; stocks, bonds, metals, agriculture etc.  Reportable positions refer to open contracts of each commodity that a trader holds, if that trader holds more than a certain number of contracts specified by the CFTC. In order to be in this category, the trader must be large.  In theory, the large commercial traders are the informed players and the small traders are the uniformed players. If the large commercial traders are buying and the small traders are selling, it is a good indication that prices will rise. If the large commercial traders are selling and the small traders are buying, it is a good indication that prices will fall.  The COT report can also be used as a contrarian tool by looking at extreme positioning. Large non-commercial traders can have a big impact on prices if they decide to liquidate their positions. Because funds frequently make trading decisions based on the same market signals, many funds are apt to buy or sell at the same time. If the COT shows that the funds have an unusually large position, there is a risk that prices may suddenly reverse. 20 | P a g e  LECTURE 12 Intermarket Analysis  The basic premise of intermarket analysis is that all financial markets are linked in some way. Although the relationships may shift on occasion, they are always present in one form or another.  All financial markets are linked because they are all manifestations of the economic cycle. The economic cycle affects a market in one way and another market in another way with all markets impacting each other.  The 4 market groups that we will discuss are: currencies, commodities, bonds, and stocks. Phase 1: Bonds up, stocks down When the economy is weak, bonds usually do better than stocks for a while because the earnings environment is poor. Phase 2: Bonds up, stocks up Then stocks start to move up because lower interest rates get investors to buy in anticipation of an improved economy and therefore, better earnings. 21 | P a g e Phase 3: Bonds down, stocks up Later the economy is actually strengthening, with increased credit demand and improved pricing and earnings are rising. Phase 4: Bonds down, stocks down Eventually, higher interest rates cause investors to be concerned that economic activity will slow down and therefore, earnings will soon weaken. Commodities and Bonds  When looking at commodities, we always look first to gold because it is a leading indicator and a gauge of expected inflation.  However, a more representative benchmark would be to use the CRB Index. Oil is also a good proxy for commodities.  There is an inverse relationship between bond prices and commodities.  Rising commodity prices (as measured by the CRB index) is an indication of economic strength and is an early inflation warning that would push interest rates higher (bond prices lower) and thus also offering an early warning to stock traders. Commodities and the USD  A ↑ USD signals a decrease in future inflation, resulting in commodities selling off, which is in turn good for the bond and stock markets.  A rising USD is negative for commodities since many commodities are priced in USD.  A ↑ in the CRB index is generally bad for the bond and stock markets as it signals increased inflation and possible increases in interest rates. 22 | P a g e  Commodities, Bonds, Stocks  Please note that the inverse relationship between commodities and bonds & stocks holds true during inflationary & disinflationary periods, but not necessarily during deflationary periods.  In a deflationary environment, decreasing commodities are generally positive for bonds, but not necessarily good for stocks. Disinflationary scenario: Commodities ↓ Bonds ↑ Stocks ↑ Deflationary scenario: Commodities ↓ Bonds ↑ Stocks ↓ USD & Multinationals When USD ↓, multinational earnings ↑ because: ↓ USD means that US goods are more attractive overseas. Products sold overseas (example, Europe) will have to be converted back into a weaker USD which in turn results in a bigger bottom line. When the USD ↓, drug stocks tend to do well, because: Most of their sales are derived overseas. So when the market is weak, they tend to outperform the other sectors as a result. This goes beyond the fact that they are defensive in nature. Small Cap Stocks are generally domestic, whereas Multinationals are usually larger. Therefore, small caps are not as impacted by currency swings as the large caps. 23 | P a g e  ↑ USD favours small caps ↓ USD favours large caps Summary of Relationships  Bond prices & stocks trend in the same direction  Bond prices change direction ahead of stocks  Commodities trend in the opposite direction of bond prices  USD trends opposite to the direction of commodities (↓ USD and ↑ commodities)  ↑ USD is good for US stocks & bonds  ↓ USD is bad for US bonds & stocks, when commodities are ↑ (due to ↑ interest rates)  Bonds decouple during periods of deflation (bonds ↑, stocks ↓) **Please note that all these relationships are theoretical. They represent what should happen, but as with everything in life, they do not always happen the way they should. 24 | P a g e