Four fundamentals of stock value

Investors can attribute a share price to four basic factors – the price-to-book ratio, price-to-earnings ratio, the price-to-earnings-growth ratio, and the dividend yield.

Price-to-Book Ratio

The P/B (price-to-book) ratio represents the value of a company if it were to be taken apart and sold today. This is good to know because while the growth of some mature industries may stall, their assets may still hold value. The book value of a company includes anything that can be sold, including equipment, buildings, land, and other investments. In purely financial companies, the book value can fluctuate with the market as these stocks tend to have assets that go up and down in value. In contrast, industrial companies tend to have a book value based on physical assets, which depreciate year after year according to accounting rules.

In either scenario, a low P/B ratio can protect you, but only if it’s accurate, and an investor may need to investigate the assets contributing to the ratio.

Price-to-Earnings Ratio

The P/E (price-to-earnings) ratio is the most scrutinised of all four ratios. Although a stock’s value can go up without the P/E ratio rising, the P/E ratio is generally what causes it to stay up, or fall back to earlier levels.

The reasoning behind this is simply that a P/E ratio can be thought of as how long a stock will take to pay back your investment if there is no change to the business. For example, a stock trading at $50 per share with earnings of $2 per share has a P/E ratio of 25, meaning you’ll make your money back in 25 years if nothing changes. The reason stocks tend to have high P/E ratios is that investors try to predict which stocks will enjoy progressively larger earnings, which will result in a shorter payoff period.

If this fails to happen, the stock is likely to fall to a more reasonable P/E ratio. If it does manage to increase its earnings, it will probably continue trading at a high P/E ratio.

Investors should note that they should only compare P/E ratios between companies in similar sectors and markets.

Price-to-Earnings-Growth

Many investors also use the PEG (price-to-earnings-growth) ratio, as this incorporates the historical growth rate of a company’s earnings and can assist investors in forecasting future growth. The PEG ratio is calculated by taking the P/E ratio of a company and dividing it by the year-on-year growth rate of its earnings. The lower the value of the PEG ratio, the better deal you’re getting for the stock’s future estimated earnings.

By comparing two stocks using the PEG (in the same sector) ratio, you can see how much you’re paying for growth in each case. A PEG of 1 means you’re breaking even if growth continues as it has in the past. A PEG of 2 means that you’re paying twice as much for projected growth than you paid for a stock with a PEG of 1. However, using the PEG ratio to predict future growth is speculative, as there are no guarantees that growth will continue as it did in the past.

Dividend Yield

Dividend-paying stocks are attractive to many investors, as even when share prices fall you still get paid (perhaps not as much as when the share price was higher, but it’s better than nothing). The dividend yield is the annual dividends per share divided by the share price, so tells you your return on your investment. For example, if a company’s shares are trading at $20 and they pay a dividend of $1 per share, that is a 5% return on your investment ($1/$20 = 5%).

Inconsistent dividends or suspended payments in the past could mean that the future dividend yield isn’t dependable. Also, dividends can vary by sector, with some industries being quite generous while others reinvest their earnings to fuel expansion.

Conclusion

Each factor has too narrow a focus to be an independent measure of a stock. However, combining these methods of valuation can help investors better evaluate a stock’s value. Although any one of these can be influenced by creative accounting, the more tools you add to your valuation methods, the easier it will be to pinpoint discrepancies.

Trading videos

Just a selection of trading videos for those getting started:

Introduction to forex

Beware the carry trade

The carry trade is a popular forex strategy, hence its inclusion here. I'm a big fan of Paddy Hirsch and think he makes economics both interesting and easy to understand. If you get a chance, check out his derivatives video.

What are stock options?

 Very energetic (a bit overdone, in fact), but easy to understand with a good metaphor of coupons for options.

What is a CFD?

Interest rates

Paddy Hirsch again! Not strictly trading, but interest rates have such a large impact on the fx market that it's a good idea to have an understanding of them.

Enjoy!

Trading with pivot points

Pivot points are a versatile technical tool that can be used in a range of trading styles and, when combined with other technical tools, can be used effectively across a range of markets.

A pivot point is the average of the previous period’s high, low and close. As you can define the previous period, pivot points can be used by intra-day traders, day traders, swing traders and as a part of longer-term strategies.

The pivot point can then be used to calculate potential support and resistance for the current period.

Resistance 1 = (2 x pivot point) – previous low

Support 1 = (2 x pivot point) – previous high

Resistance 2 = (pivot point – support 1) + resistance 1

Support 2 = pivot point – (resistance 1 – support 1)

Resistance 2 = (pivot point – support 2) + resistance 2

Support 2 = pivot point – (resistance 2 – support 2)

If we use the daily prices of the EUR/USD forex pair as an example, on August 3 the high was 1.43723, the low was 1.41438 and the close was 1.43432. This would make the pivot point 1.42864 ([1.43723 + 1.41438 + 1.43432]/3).

Consequently, support and resistance levels for August 4 would be:

Resistance 1 = (2 x 1.42864) – 1.41438 = 1.4429

Support 1 = (2 x 1.42864) – 1.43723 = 1.42005

Resistance 2 = (1.42864 – 1.42005) + 1.4429 = 1.45149

Support 2 = 1.42864 – (1.4429 – 1.42005) = 1.40579

Resistance 3 = (1.42864 – 1.40579) + 1.45149 = 1.47434

Support 3 = 1.42864 – (1.45149 – 1.40579) = 1.38294

In actual fact, the August 4 trading range was between 1.43685 and 1.40595, so we can see that these levels don’t hold 100% of the time.

However, between the inception of the euro in 1999 and October 2006, it was found that:

The actual low was lower than Support 1 44% of the time

The actual high was higher than Resistance 1 42% of the time

The actual low/high was lower/higher than Support/Resistance 2 17% of the time

The actual low/high was lower/higher than Support/Resistance 3 3% of the time

Consequently, these levels still provide a decent gauge for trading ranges, with the probability of the currency pair trading within support and resistance levels increasing with each level (so there was a higher probability that trading would occur between Support and Resistance 3 than between Support and Resistance 1).

This allows a trader to place a stop below Support 1 and know that probability is on his side, as the currency pair will only fall below that level 44% of the time. The trader could also place a limit order to automatically close his trade just below Resistance 1, as the high of the day surpasses this level only 42% of the time.

That being said, these are just probabilities, and can vary, especially in times of extreme volatility.

Conclusion

Pivot points can be useful for determining potential support and resistance levels across a range of trading styles – intra-day traders could use 15-minute or 1-hour periods to calculate pivot points, while day-traders could use daily periods, swing traders could use weekly periods and position traders could use monthly periods. As only the time frame changes, the system remains the same for every style.

It is also a good strategy across a range of markets, though the size and liquidity of the forex market makes it particularly useful, as this guards the forex market against market manipulation and results in it holding better to technical principles.

5 mistakes of day traders

There are certain mistakes that day traders make that, if made regularly, are likely to empty his account. Traders often use strategies to try and exaggerate their returns, but the following methods often result in lower returns, or even losses.

1. Averaging down

Averaging down is when a trader adds to a losing trade to bring down the average value of the units in his position. 

If we use share trading as an example, a trader might have 1000 Qantas shares he bought at AUD2.80. When they dropped to AUD1.50, he bought another 1000. This makes the total cost of his position ADU4,300 ([AUD2.80 x 1000 shares] + [AUD1.50 x 1000 shares] = AUD4,300), and the average value of each share AUD2.15. This means that the share price no longer needs to rise above AUD2.80 for him to make a profit, it only needs to rise to AUD2.15.

If the share price then falls to AUD1.00 he might buy another 1000 shares, bringing the total cost of his position to AUD5,300 and the value of each share AUD1.77. The shares will have to rise by 77 cents for the trader to break even, and more for him to make a profit. Although this is possible, there is no telling when the market might turn to that degree, and the trader is more likely to make a loss than a profit.

When it comes to instruments traded on a margin, such as CFDs on shares or forex, a trader can access a wide position for a relatively small deposit. Although this can magnify the return on his initial investment, it will magnify his losses to the same degree.

If you were to trade Qantas share CFDs rather than Qantas shares, you could open a position with a deposit that is only a fraction of the value of the position. For this example, we’ll assume a margin requirement of 5%, meaning that your initial position on 1000 shares valued at AUD2.80 could be opened with a deposit of AUD140 (AUD2.80 x 1000 x 5% = AUD140).

When the shares dropped to AUD1.50, you could open a position on another 1000 shares with a deposit of AUD75. When the shares dropped again to AUD1.00, you could open another position on another 1000 shares for AUD50.

You have paid a total of AUD265 for your positions on 3000 Qantas shares. As the share price has dropped to AUD1.00 per share, the total value of your positions is AUD3,000. The average value of each share based on their initial prices is the same as it was when you were trading conventional shares: AUD1.77.

If the share price rises to AUD2, you could close your positions on 3000 shares for AUD6,000, whether you were trading shares or share CFDs (excluding commissions, financing charges and dividends). To buy 3000 shares you needed to pay a total of AUD5,300, leaving you with a profit of AUD700.

However, when trading CFDs you only made a deposit on AUD265, leaving you with a profit of AUD5,735. 

This example reveals why it is so tempting to average down with geared products like CFDs; if you are depositing so little, why not?

Because you can lose just as much as you can gain.

If the share price had dropped again to AUD0.95 you may have decided to take the loss. The 3000 shares would now be worth AUD2,850. In conventional share trading you would have lost AUD2,450, or 46% of your investment of AUD5,300.

You would have lost the same amount when trading CFDs. As share CFDs mirror every aspect of share trading, the opening value of each position was the same as the opening value of every thousand Qantas shares you would have purchased conventionally. The first thousand were worth AUD2,800, the second thousand were worth AUD1,500 and the third thousand were worth AUD1,000. This means you also lost AUD2,450. However, where that was 46% of your investment in shares, it is now 924.5% of your AUD265 investment in CFDs.

Although some traders might be tempted to keep averaging down until the market turns, this is not advisable. When, or even whether, the market will turn is never certain, and sustaining such a great loss in respect to your initial investment can leave you subject to a margin call.

Prepositioning for news

News events can often have a large impact on the market, and traders can make great profits if they use this in their trading.

However, more often than not, the direction in which the market will move is not known in advance. 

Something quite simple, like an interest rate announcement, might be expected to appreciate or depreciate a forex pair, but the trader cannot know what additional statements, figures or forecasts will accompany it.

Frequently volatility surges following a large announcement, and it is difficult to determine a trend in the market, or even if the announcement resulted in a trend following the initial volatility. For these reasons, taking a single position before a news announcement can jeopardise a trader’s chance of success.

One strategy for trading an upcoming announcement is using a spread, which may reap profits as long as the market moves, even if you don’t know the direction it will take.

Trading right after news

Although there are some trading strategies that may be successful following reports and economic announcements, trading announcements without a system can be just as risk as placing a trade before a release.

News announcements can result in large volumes of trades in both directions, meaning that many traders will make losses as it swings back and forth. Entering a trade like this without any risk management, such as using stops and limit orders can result in you losing more than you wanted to risk. In fact, entering a trade like this with stop and limit orders can result in your stops being triggered over and over as the market swings back and forth.

Day traders wanting to trade economic announcements should watch the market after the announcement has been made, and take a position after the initial volatility has subsided.

Risking too much

As seen when discussing averaging down, risking large amounts does not equate to proportionate returns. All traders lose at some point, and those who risk large amounts of capital on single trades will be hit harder than most as they will lose a larger percentage of their account.

A common rule of thumb is that a trade should risk no more than 2% of his capital on a single trade, though some traders set lower limits.

It is also a good idea to set limits on the amount you are willing to risk over a certain period. In day trading, it is a good idea not to risk more than 1-2% a day. So, if you made four trades a day with a 1% limit on your risk for the day, each trade would risk 0.25% of your account. 

The amount you are willing to risk will depend on your profit targets, your level of capital, and whether you are trading intra-day or over a few weeks or months. Just keep in mind the amount you are willing to lose, rather than potential profits that may not eventuate.

Unrealistic expectations

Unrealistic expectations are usually the foundation of the previous four mistakes:

1.       The trader who unrealistically expects the down-trending stock to turn around and win back his losses

2.       The trader who thinks he can predict the market reaction to news and make large profits (admittedly it has been done, but is very risky)

3.       The trader who immediately trades after an announcement, expecting to make a larger profit by jumping into the trade sooner

4.       Expecting eventual profits to offset high levels of risk

Unfortunately the market doesn’t take our expectations into consideration. It is largely driven by people, who are also illogical, so being able to profit on every single move is not possible and will result in errors of judgement.

Conclusion

The best way to avoid these mistakes is to create a trading system and then stick to it. Your trading system should cover your criteria for entering and exiting trades as well as the amount you are willing to risk and profit targets, which will assist you in placing trades as well as stop losses and limit orders. If it yields consistent profits, don’t change it.

Using a combination of fundamental and technical analysis can help you plan trades and evaluate possible market reactions to events, but if the signals you are using don’t back up what you think will happen, then it is safer to follow them and stay out of the trade. Likewise, if your stop is about to be hit, don’t move it in the hope that the market will turn! The hardest part of using a trading system is following its rules in all situations; but doing it will reward you with more consistent profits over time.

Using mergers and acquisitions in forex trading

The relationship between the stock and forex markets

The stock market can impact the forex market in a number of ways. For instance, if a strong stock market rally  happens in the UK, with the FTSE 100 and FTSE AIM All-Share making large moves, this is likely to result in a flow of foreign capital into the UK as international investors want to profit on the trend. As a result, the British pound would rise as foreign investors would have to purchase GBP in order to participate in the British markets, increasing demand for the currency.

The opposite is also true – if the UK stock market falls, foreign investors will choose a better-performing market, selling their pounds to invest in another currency, resulting in the GBP falling in value as supply overtakes demand.

Taking this one step further, we can infer that mergers and acquisitions (M&As) which boost the stock market are likely to boost the local currency. Professional currency traders will usually focus on cross-border M&As worth over USD1 billion. As cross-border transactions will result in the acquiring company having to pay the price for the target company in the target company’s currency (in the case of a merger, a deal in which one of the currencies is converted is also likely to take place).

Large M&A deals cause the domestic currency of the target company to appreciate relative to the acquirer’s currency, according to a study conducted by Francis Breedon and Francesca Fornasari of Lehman Brothers in 2000. They found that for every USD1 billion deal, the target company’s currency would increase by 0.5%, and would be 1% stronger fifty days after the announcement. However, the study found that the currency impact tends to peak around 5%.

So if an American company took-over an Australian company, the AUD/USD pair would quickly rise by 0.5%, registering a 1% gain at the fifty day mark.

Determining the impact

Each deal can have a different impact on the forex market, and one way to predict the potential size of the impact is to check how the deal is structured. An all-cash deal will have a much more significant impact on the forex market than an all-stock deal.

An all-cash deal would result in a large transaction and, consequently, a large demand for the target company’s currency, whereas an all-stock deal would result in smaller currency movements over time as foreign shareholders buy and sell the shares. An all-stock deal could also result in a diverse geographical distribution of shareholders, resulting in international investors repatriating their dividend payments, which may also impact the currency value.

The impact of a deal that is a combination of stock and cash will depend on the proportion of the deal that is cash – the higher the cash proportion, the larger the impact on the forex market.

Trading forex with mergers and acquisitions

Although numerous factors impact different currency pairs, the announcement of a large M&A deal can have a meaningful impact on a pair’s price.

On February 9, the Deutsche Bourse confirmed a takeover deal with the NYSE. The deal was valued at USD10 billion and, to make the takeover, the Deutsche Bourse would need to convert Euros into US dollars, thus creating a higher demand for US dollars.

On February 9, the EUR/USD forex pair rose from its opening price of 1.36251 to a high of 1.37440, a jump of 118.9 pips in one day. Over the next fifty days, the pair reached a high of 1.42484 on March 22, falling to 1.4174 on March 30, or day fifty. This is a total increase of 522 pips, or a gross profit of USD5,220.

EUR/USD February to April 2011. Source - Onada

The following chart shows the AUD/CAD from August to November 2010. On the weekend of August 14, Canadian firm Agrium Inc made an unsolicited bid for Australian grain seller AWB Ltd of AUD1.2 billion. 

Although there wasn’t much movement in the currency pair that weekend, on Monday the 16^th the pair rose from an opening price of 0.93089 to a high of 0.93905, a rise of 81 pips. Over the next fifty days, the pair rose to 0.99276. It continued to rise to 1.00536 before the pair grew more volatile in November through to March, though this subsequent rise was probably unrelated to the takeover bid.

AUD/CAD August to November 2010. Source - Onada

Although numerous factors affect the forex market, take large, cross-border mergers and acquisitions into consideration when you trade can help you identify trading opportunities that others might miss.

Use GDP in your forex trading

Economic releases are essential for the fundamental trader, and can also help the technical trader when judging how long a trend is likely to last.

Gross domestic product, or GDP, is one of the most important releases, covering an economy’s consumption, investment, government spending and investment, and exports. The sum of these numbers is the GDP. 

As GDP takes a number of macroeconomic factors into consideration, it serves as evidence of growth in a productive economy, or shrinkage in a weakening one. Consequently, forex traders often go long on the currencies of countries with higher GDPs in the belief that interest rates will also rise. If an economy is growing, the benefits should trickle down to the consumer who will be more likely to spend, resulting in higher prices and higher interest rates as central banks try to ward off inflation.

Expectations and their affect on the forex market

GDP figures are released in three versions, advanced, preliminary and final. Currency professionals will use the advanced version when trading; however, they will then compare this with the preliminary and final ones as they are released. There are three possibilities when the final version is released – the GDP figure will be higher than expected, lower than expected or as expected.

If the advanced release predicted GDP growth of 1.5% and the final release announced 4% GDP growth, the underlying currency is likely to strengthen in relation to other currencies, as forex traders think it is a better investment. Typically, the higher the GDP figure, the sharper the currency’s incline.

An expected figure generally requires some more comparison. A trader should compare the current figure to that of the previous quarter or the previous year to evaluate the situation. If GDP growth is positive, but not as high as the previous quarter, this is likely to be negative for the currency. Likewise, if GDP growth is higher than the previous quarter or year, traders are likely to invest.

On the other hand, if an advanced release predicts 3.5% GDP growth and the final version only states 2% GDP growth, that economy’s currency is likely to drop as traders sell-off, following the lower reading. A lower GDP figure would warn of an economic contraction and lower interest rates, lowering the value of assets denominated in that currency.

Example

UK GDP for the second quarter in 2011 only increased by 0.2%, following a 0.5% increase in the first quarter. Although special events associated with the quarter, such as the royal wedding and the Japanese tsunami, may have had an impact, growth was lower than expected.

If we look at the GBP/EUR chart approaching the July 26 preliminary GDP release, the pound hits a two-week low against the euro ahead of economic data. The figures, released at 8:30am, were expected to show faltering economic recovery, with GDP growing just 0.2% in the second quarter. The release did, in fact, release the expected figures.

As the figures were to be expected, and the eurozone also hasn’t been performing well recently, this could be a good opportunity to go long. This is backed up by the chart over the following days – having hit a low of 1.2566 against the euro, the forex pair started to climb following the expected release, trading within the 1.138 and 1.144 range until the August 1 US debt ceiling announcement. 

 GBP/EUR

If the release had been worse than expected, the pair may have tested its early-July low of 1.10089. And, if the release had been better, traders could expect a steeper rise, though there would always have been further volatility surrounding the US debt ceiling agreement.

Conclusion

The GDP reports of any major currency will always be an important fundamental to consider when it comes to trading forex. Releases that vary from expectations can be great opportunities for traders to cash in on large currency movements.

Seasonal patterns in stock indices

As stock indices are a compilation of a group of companies, often the leading companies in a particular economy, they can be representative of economies at large. As such, indices can move in seasonal patterns, moving with regular economic announcements.

Obviously politics, company announcements and once-off economic releases can impact this and obscure broader patterns in the market, however, these patterns do tend to persist year-on-year. And, like any pattern, this is something of which the astute trader can take advantage.

Once example was illustrated in the book ‘The Behaviour of Prices on Wall Street’ by Art Merrill, which demonstrated the existence of preholiday behaviour in the Dow Jones, concluding that there was a high probability of the index having higher closing prices before major US holidays.

Another example is the S&P 500 index – from 1980 to today, the market has usually rallied from late January until early June. From June until late August the market tends to trade sideways, before falling from late August until late October. From late October the market has a steeper climb until the end of the year.

However, these patterns may not occur every year – in February 2009 the S&P 500 index fell dramatically, even though the seasonal bias indicated that the market should be climbing higher.