Anatomy of a Trade: Three Ways to Play Apple

Dec. 9.09 | About: Apple Inc. (AAPL)

This is a true story. It illustrates an important and little-understood point about markets. Let us start with the popular and incorrect idea.

The stock market is a zero-sum game. Therefore, when a trade takes place there will always be a winner and a loser.

The first statement is true, but the second is not. A stock trade can actually benefit both sides. How so?

An investment in a stock seeks a risk-adjusted expected return, with a specific time horizon.

This means that depending upon your time horizon and risk tolerance, your mileage may vary. Take a look at the chart below, the interesting example of Apple Computer, Inc. (NASDAQ:AAPL). In particular, please note that the stock recently dropped below the 50-day moving average (the red line). The green line is the 200-day moving average. These reflect different investor and trader time horizons.

Aapl dec 09

Same Situation, Differing Participants

Let us look at this stock from three different perspectives:

  1. The long-term holder
  2. A potential long-term investor -- think of this as one of my new accounts
  3. The trader

By way of background, let me say that my own price target for Apple is 260, based upon backing out cash, adjusting earnings for the earlier realization of revenue from the iPhone service plans, and applying a P/E ratio for one of the few true growth stocks. I think that the increasing market share for computers is a big kicker. I basically ignore the many rumors around the stock as a source of noise. I have written more on Apple in the past, but the fundamental analysis, merely summarized here, explains my perspective. (Another firm initiated coverage with the same target yesterday. Another cited 240 last week. Jim Cramer has also been bullish with a recent price target of 300).

So let us consider the participants:

The long-term holder (most of my accounts, including my own) occasionally rebalance their holdings. We lightened up on positions after big gains. We were kicking ourselves as the stock moved higher, but that did not mean the decision was incorrect. Periodic rebalancing is a key to long-term risk-adjusted returns. The rebalance timing is an educated guess.

The new accounts have been waiting for a good buying opportunity in one of the best growth stocks. These investors should be hopeful for a "dip." So I bought for the new accounts. Perhaps I acted too soon, since the technical traders are driving the stock lower. The decision of when to buy is an educated guess. (A digression -- I once had a client who canceled her account when I bought a stock and it immediately moved lower. The stock later tripled, and other holdings also would have done well. People need to take a longer view in evaluating managers.)

The trader is trying to time the stock, buying and selling based upon technical indicators. A colleague in the investment management business, someone for whom I have great respect, was reducing positions because the stock dipped below the 50-day moving average. This may be a winning decision for my friend, assuming that he moves quickly to get back in on a bounce. My own experience in Apple is that there are many news-driven gaps. It is often psychologically difficult to "chase" the stock after such a move, so you might miss a big rally. This does not mean that my friend is wrong. It means that he must be both aggressive and disciplined. He is a pro, and knows how to react.

To summarize, we have three different players. Some are selling on the way up, and selling too soon. Some are buying on the way down, and perhaps too soon. Some are selling on the way down, trying to make a profitable trade, and needing to buy back quickly if the situation changes.

The Surprising Conclusion

All three may be correct! And all three may be winners on their decisions.

The correct and winning investment decision depends upon risk tolerance and time frame.

I study and implement many winning trading strategies. Sometimes one strategy says "sell" and the other says "buy" on the very same day! Both strategies have long-term records of success.

Briefly put, one trader can sell to another and both can be correct in terms of their proven and successful strategies.

In my experience, this situation is completely typical. I face it every week.

The Individual Investor Mistake

There is one definite losing strategy. It happens when you chase a winning stock (buying high) and sell it on a decline (selling low) and fail to get back in when things change. Unfortunately, this is the psychology of many individual investors. It helps to explain why most investors trail the market averages, while many pros are consistent winners.

Television ads perpetuate this myth, encouraging trading (their own source of revenue) and excessive confidence in the customer's "feel" for the market.

Author's Disclosure: Long AAPL in personal and client accounts