Share Synthesis

There are 2 indicators which are often used to gauge the market sentiment . They are put/call ratios and VIX. Both are calculated based on US equities and Index options.

In most cases these indicators are used as contrarian tools: when market participants are most bullish, the likelihood of a downside reversal is greatest; when investors become overly bearish, a market rally may
be on the horizon.

PCR Ratio
Put/call ratios provide us with an excellent window into what investors are doing. When speculation in calls gets too excessive, the put/call ratio will be low. When investors are bearish and speculation in puts gets excessive, the put/call ratio will be high.

It might be more accurate to use equity-only put/call ratio as professional money mangers might use index options to hedge portfolio of stocks.

VIX
VIX is a measure of the level of implied volatility - not historical or statistical volatility - of a wide range of options based on the S&P 500

When the VIX (which is related to the S&P500) is under 20, there is excessive complacency, and over 30 is excessive fear.  But just as the Nasdaq is more volatile than the S&P500, the VXN is also more volatile, so anything under 25 is excessive complacency, and over 35 is excessive fear which usually happens when we are close to a bottom.

The importance of these 2 indicators cant be discounted as non economic factors are increasingly becoming important elements and they are best used in conjunction with other indicators. I might consider to use this as one of the factor to determine my entry/exit point (i.e wont buy if its overly bullish) but this might contradict with momentum style so I guess an optimal balance in mixing the strategy can only be achieved through real time experiment.

Free tools to gauge the sentiment can be found at schaeffersresearch.com .


Reproduced with permission from http://melynn-lynch.blogspot.com 

The position size of each trade I take will be based on volatility and the indicator which I will use to measure is ATR.

ATR is the difference between the high and low price on any given day. It reveals information about how volatile a stock is. Large ranges indicate high volatility and small ranges indicate low volatility

One weakness of using this strategy to determine stop loss is that it might cause my system to be susceptible to noise resulting in unnecessary brokerage costs incurred. To overcome it, all 3 factors which I discussed earlier has to be implemented together..

I don't really know much on this area yet so if anyone happened to come across this blog, please feel free to comment on it or contribute.

As of now, following are the indicators which I used to check the stock's momentum .

1. Relative Strength 
Relative strength, or RS, measures how a stock has performed compared to the overall market over a specified time frame. This info is only easily accessible for US markets.

Six-month relative strength >= 75.
Three-month relative strength >= 65.

For example, a 6 -month relative strength of 75 means that a stock has outperformed 75% of all stocks, in terms of price performance, over the past 6 months.

2. On Balance Volume
OBV attempts to detect when a financial instrument (stock, bond, etc.) is being accumulated by a large number of buyers or sold by many sellers. Traders will use an upward sloping OBV to confirm an uptrend, while a downward sloping OBV is used to confirm a downtrend. Finding a downward sloping OBV while the price of an asset is trending upward can be used to suggest that the "smart" traders are starting to exit their positions and that a shift in trend may be coming. (By investopedia)

If the OBV is moving in the same direction as the existing trend, it is a signal that the strength of the trend remains. When the OBV starts to move against the trend, it is a signal that the existing trend is weakening and may reverse. 

3. ADX
Analysis of ADX is a method of evaluating trend and can help traders to choose the strongest trends and also how to let profits run when the trend is strong.  (By investopedia)

A low ADX value (generally less than 20) can indicate a non-trending market with low volumes; a cross above 20, on the other hand, may indicate the start of a trend (either up or down). If the ADX is over 40 and begins to fall, it can indicate the slowdown of a current trend. This indicator can also be used to identify non-trending markets or a deterioration of an ongoing trend. Although market direction is important in its calculation, the ADX is not a directional indicator.

4. Moving Averages
Occurrences of fast moving averages crossing over the slow moving average is a bullish signal while the vice versa is a bearish.Current moving average I'm using is 14,25 and 200

Pitfalls of Momentum Trading 
Here they are: 

My entry/sell point is currently based on the following 3 factors Fundamental, Momentum and Volatility. I will be doing trial and error to adjust the weightage of each factors but for a start, I will allocate more weight to fundamentals.

I have decided to abolish the use of forecast values as one of my entry criteria after giving some thought reason being :

1) Future is uncertain. The model requires one to project most of the inputs much ahead (like 5,10 years) which is not realistic in my opinion.

2) Tendency to use them to reinforce my decision when faced with uncertainty regardless of its relevancy.

Therefore instead of relying on forecasts, I will value the stock based on real results(i.e trailing p.e) even though  this only tells me what the stock "should" have been worth based on earnings from the past . This is a trade off I'm taking but I believe the risk of relying on my own forecasts is much more dangerous.

I have mentioned on the theory of reflexity in my previous posts and even though I have yet to grasp hold of the concept but just the initial understanding has already intrigued me to find out more. I did an extensive search on the net and found an article discussing on this..

This concept is founded by Soros and he attempted to explain his concept of reflexity in the following statement :

"There is an active relationship between thinking and reality, as well as the passive one which is the only one recognized by natural science and, by way of false analogy, also by economic theory. I call the passive relationship the “cognitive function” and the active relationship the “participating function,” and the interaction between the two functions I call “reflexivity.” Reflexivity is, in effect, a two-way feedback mechanism in which reality helps shape the participants’ thinking and the participants’ thinking helps shape reality in an unending process…”

Example (Extracted from the article)
Consider the relationship between a company and its publicly traded stock under normal business conditions. It is intuitive that when the fundamentals improve the share price rises. However, does it make sense that a changing share price might, in turn, impact the fundamentals? Sometimes the answer is yes.

A simple and timely example is seen from the effect of credit ratings. When Moody’s or S&P downgrades the credit ratings of a given financial institution (think AIG), it can have an impact on the amount of collateral the company must pledge to back its obligations. A downgrade also increases the cost of capital for new debt issuances. The view of the S&P analyst is, in part, subjective. The perception of the company’s future prospects and current financial condition plays an important role in the assignment of the credit rating, and and a falling stock price gives a bad impression. The negative feedback loop between capital requirements (fundamentals), stock price, and credit ratings (perception) causes a vicious cycle.

Common to all recessions are forces that cause dynamic disequilibrium between fundamentals and prices. 

Some of these are,
A. Jobs losses --> declining consumer spending/confidence --> contraction in businesses targeting consumers --> more job losses due to business contraction, etc.

B. Credit crunches: Business and consumer balance sheets deteriorate --> tighter lending standards and less credit available --> business/consumer spending slowdown --> worsening balance sheets, etc.

C. Stock market declines --> reduced “wealth effect” --> decline in consumer spending --> business contraction --> more stock market declines, etc.

D. Stock market declines --> lower capital gains tax revenues --> rising government deficits --> decreasing investor sentiment -- > more stock market declines, etc.

Details can be found here

His ideology is often mistaken as trend following but one contrasting difference is that he always managed to enter/exit at the reversal point so from this, I gather a clue. I need to come up with an objective view by looking at a bigger picture and in order to do that, I must constantly remind myself not to be distracted/mislead by the daily reports and news.



Reproduced with permission from http://melynn-lynch.blogspot.com 

I have been looking at my past trades stretching back to the first very trade I have made since year 2007 which was the bull period. Back then, I always thought I am good stock picker whereby nearly all stocks I bought were multi baggers earning me 20-30 % return in a few months leading me to have an illusion that everything is within my control. During that period, I also tend to think stocks will move as per my expectation, ie picking stocks which is fundamentally sound and buying them no matter how over valued they seem to be by coming up with an estimated price near the present as a support. Therefore whenever I have made a decision, I will find evidence to support it rather than finding ways to refute it. This might sound counter intuitive as the norm will be buying stocks based on evidence instead..

Eventually, when stocks started to plunge a few basis point everyday, I will still see it as a form of correction and cost average it as I believe the value will revert back to the mean eventually. I was apparently suffering from gambler's fallacy where I thought a stock will recover after a few days of consecutive big plunge when in fact, it wont. All these are said on hindsight but i hope I can improve my investment by acknowledging my mistakes soon and correct them.

Nevertheless, i never doubt value investing despite not practicing it firmly. I hope to improve this method by mixing momentum and value together to avoid from incurring opportunity cost by holding on undervalued securities that languish a long time before recovering. Instead of bottoming fishing where a price can always go lower than my estimated price, why not wait for the price to raise a bit (momentum) before entering? Ideally, I would want to pick the highest momentum stocks with the cheapest valuation.. Possible? Downside is that by adopting this strategy, I will inevitably follow the fool game so an important thing is to exit when the expectation is different from the reality on a large scale.This is easier say than done and its something which I have yet to figure out

Firm fundamental investors will buy/hold a stock in an indefinite period and assumption is that large emphasis is placed on the stock fundamentals and not the price volatility but thinking from another perspective, a prolonged plunge in stock price will affect the fundamentals too isn't it.

I will share more thoughts on Soros reflexivity philosophy in the next post which I happened to come across a few days back. Also note that each of my posts might be jumbled up or not related to one another as I am just trying to pen down whatever thoughts that came across my mind so I will like to apologize in advance if it causes any confusion. 



Reproduced with permission from http://melynn-lynch.blogspot.com 

Position sizing..


I have chance upon a blog  discussing using of ATR to derive the position and it sounds feasible hence I have decided to give it a try as money management is an integral part of a system..

ATR basically shows the amount of volatility that a stock has over a period of time.. A common convention is to use a 14 days ATR..  In his blog , his strategy works something like this..

- Determine the amount of money in account
- Determine the amount to risk(Can i integrate fundamental analysis to derive risk(
- Find out the ATR
- Multiply ATR by 2(static)
- Position can be derived by taking amount to risk (5000) divide by the above sum

Scenario

A stock cost $4.
I have 20 000 in account and able to risk 4% for the particular trade.. ATR is currently 0.246 for the stock..

Risk : $800
Stop : 0.246 * 2 = 0.492
Position : 800 / 0.492= 2 Lot (round off)
Sop loss at 3.508.

Question : Possible to use the ATR accordingly  based on some factors like fundamentals , time horizon.

My first step in devising a new strategy is to think through what are the factors that caused a stock to surge and what are the factors that caused a stock to plunge.. Intuitive it sounds but all these are some points which I missed out previously.


As far as I know, there are currently 2 school of well known thoughts - Fundamental analysis and technical analysis... Is it possible to fuse these 2  together to determine the buying and selling price even when they are contradicting in nature usually? To start off, I am thinking of segregating the fundamental factors into Short Term and  Long term. Short Term factors are like - Latest quarter result posted by the company, macro economic sentiment, industry trend. This list is not exhaustive as I am still in the process of researching.. Long Term factors are like 5 year company financial results, macro trend, potential to be a market leader and etc..


For technical analysis, I will also segregate the factors into short term and long term.. I am still a greenhorn in this area and I know that by mixing technical and fundamentals will definitely invite criticisms but in today's volatile market, I believe by having the knowledge to apprehend charts will let me know more on other investors' psychology. Some short term factors I can think of are  momentum indicators like MACD, moving average to determine the support and resistant and long term factors are like the 5 years trend of the stock.


The reason why I think mixing these 2 school of thoughts is important because I used to overlook a point in fundamental analysis. I used to think that only fundamentals affect stock price but stock price actually affect the fundamentals too because a low stock price will affect the company's ability to raise equity resulting in taking more debt and also might affect the company's reputation too as a company with low stock price may deemed to be "lower quality". I also hope by combining the both strategies, I can avoid the mistakes of behavioral finance pitfalls


So how can I actually determine the entry price and exit price using the mentioned strategies. Also how can I determine the position sizing to manage risk?


Reproduced with permission from http://melynn-lynch.blogspot.com

This unprecedented 2009 financial crisis have helped me to learn quite a bit through the hard way.. My portfolio total value has shed around 50% since inception so I have been wondering is it a wrong move to buy and hold? It's always easy to answer such question on hindsight using present information which are unavailable at that point of time. I was and still a firm believer of fundamental analysis but with the lack of information which are sometimes inaccessible to retail investors, can we still make a soundly judgement ? How confident can we be that the stock is still fundamentally sound when it's fundamentals are changing dynamically. There are currently too many weaknesses in my strategy therefore I will try to improve on it based on the following points which I will be exploring further.


1. Lack of risk management
Need to think of a way to spread my portfolio risk.. Having say that, I don't intend to over diversify or use beta/variance to diversify risk..  I'm thinking of aligning fundamental analysis to risk management.


2. Emotions(behavioural finance)
Investors are sometimes their own worst enemies and personally, I am a victim of my own emotion (i.e averaging down a company's stock even when its prospect seems to be not as good as last time) .. Best way to overcome such problem is to create a system and stick to it rigidly.


3. Strategy
I am currently using fundamental analysis to buy/sell stocks but personally, I think there are some downsides for retail investors like me to use this 100%.(i.e a we are just minor share holders therefore we cant actually change the company fundamentals like what the great sage Waren Buffett does) .Can technical analysis blend with fundamental even though they oftenly contradict each other? Need to devise a rule to sell stocks.....


My journey to create a strategy starts here and I will be using the stock market to experiment it.. When I first started investing, I have used paper trading to test my strategy but for now, I think real $ should be used instead because emotions will be involved and this is one point which I hope to overcome.  I will try to jot down all my findings and thoughts and if possible , I hope readers (if any) can give some feedback .. Criticisms are strongly welcomed