By Chris Tell at http://capitalistexploits.at/
Fundamentals matter. Every piece of history I've read indicates this to be the case. When investing, which is to say placing capital with a long-term view of a particular outcome, fundamental analysis works.
Trading the markets however can often involve an entirely different approach and yet be profitable at the same time. Amongst other things, taking advantage of temporary mis-pricing, momentum, trend following and arbitrage for example.
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I've often used a strategy that brings both worlds together, but with nowhere near the success of my friend Brad Thomas. Brad focuses on fundamentals and has a systematic, disciplined process he uses in his trading. His success has led him to being sought after to manage Ultra High Net Worth investor money.
He is now partly retired from the frenzy and largely manages his own capital. Gratefully he takes my phone calls and spends time discussing his trades with me. I say "gratefully" because his experience in the trenches is invaluable! When it comes to profitable trading Brad is a giant in my book.
We've been publishing Trading Alerts for a while now to our readers. Earlier today we sent out Brad's latest Alert. The company Brad is trading is breaking out of a long-term trading range bottom. That's the technical part. Fundamentally the company has a forward P/E of less than 12x and a price to book value of just 0.95. Both technically and fundamentally the downside appears limited.
Brad has made his fortune identifying and profiting from these sort of opportunities, but as anyone who has been trading their own capital for any length of time knows, the profits go to those who know how to systematically apply their knowledge, maintain discipline and pull the trigger. Profits do not automatically go to those who identify the opportunity. Holding a view is not enough to make money.
I queried Brad on this and his response was:
"I find that those who really make substantial money in the market are those who not only have the right view, but apply their view in the most efficient manner to get the biggest payout and not get knocked off the trade prematurely. How many times have you heard someone talking about the prospects of a stock versus how often have you heard someone talking about the risk vs reward of a position?
The latter just doesn't happen, everyone talks about the view as if nothing else mattered and its why most people lose money trading."
The dirty truth about trading is that the one-hit-wonders are aplenty, and as their namesake implies, they don't make consistent profits. It's the ability to adequately size positions, manage risk and systematically follow a strategy that leads to profits.
Brad elaborated some more on his strategy with me:
"I like to get into positions where I am reasonably confident there is limited downside. This often coincides with trades that most wouldn't dare consider. Ironically this is often when stocks are trading at very cheap fundamental levels, and of course when no one can see a reason for the stock to move to the upside. I also make sure that the options I buy are trading at very cheap levels. This is where things get interesting and it is where the leverage I try to capitalise on lies.
More often than not when a stock is "bombed out", it is trading at very cheap fundamental levels, and has gone nowhere for a considerable length of time. Option writers extrapolate the behaviour of the stocks recent range bound past into the future when pricing options, the result being that they severely under estimate volatility and significantly under price the option. I think my recent trade on US Steel (NYSE:X) is a classic example of this. It has gone nowhere in a couple of years and, if the near record low levels in options prices are anything to go by, traders are expecting it to go nowhere over the coming couple of years. This behaviour is what leads to such outsized payoffs when the stock in question starts to rise, because a little movement in the stock price leads to exponential moves in the options price."
Brad is dead right. One actually only needs volatility to increase and the options move like a greyhound after a rabbit.
Speaking of that trade in US Steel (NYSE:X), Brad recommended it to our readers on October 8th. He said:
"Buy 2 Jan 2016, $25 strike calls on US Steel (X) @ $3.50 GTC"
As of today US Steel stock closed just over $23.50, and the $25 options Brad recommended at $3.50 closed at $4.56, an increase of 30% in about 2 weeks! Not too shabby.
Positioning oneself long volatility (expecting volatility to increase) in fundamentally undervalued stocks makes a lot of sense. Brad is correct when he talks about ensuring that the pricing of the options is very low, as this is how you protect your downside.
As margins are compressed, options pricing is typically reduced down to very cheap levels. Lack of volatility too reduces options prices. The former relates to fundamentals of a stock and the latter the market perception of the stock. As such, a return to volatility can punch options values rapidly higher on its own regardless of the fundamentals of a stock. When you're making that bet, and you're trading a company that has strong fundamentals behind it, you significantly reduce your risk. Margin expansion due to fundamentals and a broader market realisation of the stocks value, together with increased volatility, can provide outsized returns.
Finding those asymmetric trade setups is something Nassim Taleb discusses in his latest book, Antifragile: Things That Gain from Disorder. I have some personal experience with this. My very first big hit many years ago was trading LEAPS on oil contracts. I spoke about this in a blog entitled "Trading lessons from a Reformed Idiot". This trade netted me a massive return, followed shortly by my wiping out close to 100% of my capital! Call it youth or whatever, but it was due to my hubris, lack of systematic trading approach and a story of a boiler room fraud…but I digress.
I asked Brad why he focuses on options. After all he's been in the markets for nearly 30 years and has traded every imaginable instrument.
"I started out trading using leverage, initially on futures and then using CFDs. However, I quickly realised that leverage meant that you had a liability to someone else. Furthermore there was no asymmetry and you were at the whims of volatility, in fact volatility was your enemy. So some 10 years ago I gave options a go and learned the power of asymmetry and how volatility couldn't knock you out of a trade prematurely as it happens all to often when trading using leverage. It also meant that I could sleep easy at night knowing exactly what my risk was.
The other thing I learned is that humans tend to extrapolate the recent past into the future and that, if something has been relatively quiet for a couple of years, option writers had an overwhelming tendency to under price volatility so that ultra long dated options tended to be priced way too cheaply by option writers."
If you're interested in receiving our Trade Alerts, courtesy of Brad and a few of our other trusted colleagues, you can do so for the next 60 days - complimentary - by clicking on the link below and just dropping in your email address.
"Put yourself in situations where favorable consequences are much larger than unfavorable ones…Indeed, the notion of asymmetric outcomes is the central idea of this book: I will never get to know the unknown since, by definition, it is unknown. However, I can always guess how it might affect me, and I should base my decisions around that." - Nassim Taleb, The Black Swan