Strategies for stock trading

Strategies for Stock Trading

An experienced trader should know what to do during a market reversal. Here I would
like to address some issues faced by less experienced traders. If you are turning over a lot of stock without making money, or is making less money than you would buying
an index mutual fund, then you belong to the less experienced trader category.

The traders that I know of who lose money in the stock market generally use the
following approach to stock trading:

(1) They buy into a stock because it is hot, everybody is talking about it;
(2) When the stock begin to make some money, they sell it;
(3) If the stock goes down and they begin to lose money, they hold on to it. Eventually,
they end up cutting loss at the bottom in a panic.

This kind of strategy is doomed to lose money based on the following analysis:

Supposed we divide all the stocks you would buy into 5 categories based on their
profit potential.

(a) Those that would go up a lot after you buy it;
(b) Those that would go up a little bit after you buy it;
(c) Those that neither go up nor down;
(d) Those that would go down a little bit after you buy it;
(e) Those that would go down a lot after you buy it.

With the above trading strategy, you would make a bit of money in categories (a) and
(b), not making any money in (c), lose a bit in (d), and lose a lot in (e). Adding them
all together, you'll be losing money on average. Note that this calculation holds true
regardless how you define "a bit" and "a lot".

A quick-learning trader would see a consistently money-losing strategy and immediately
knows that he has found a good strategy, because all he needs is to do the exact opposite,
and he will be making money consistently.

For example, the above strategy can be reversed by switching "buys" and "sells": instead
of buying the hot stocks, short sell them. If they continue to go up (to the same threshold
where previously you would have sold it), buy it back to cover the short. If they go down,
you hold on to the shorts (again until the same threshold where you would have cut loss),
then you take profit at the bottom.

This reversed strategy may be psychologically difficult to operate, but it should work.
While it is hard to short sell a hot stock, and harder to pretend to panic while you are making
money, the basic trueth in this reversed strategy is worth remembering: you let your profit
grow until it stops growing, while you cut loss before the loss grows too big. Then, on
average, you will be making money.

The Time Dimension

A stock may go up, go down, or stay roughly the same. But there is another dimension to
a stock that is worth considering.

Supposed you have a choice to make 10% in a few days or to make 50% in a few months,
which choice would you pick?

The 10% choice is obviously a better choice, in fact it is better by about an order of
magnitude. The way to compare them is to normalize the returns to the same time period.

Like interests, trading profits compound. Making a little bit of money in a short time is
better than making a bit more money in a much longer time. This, of course, is based on the
assumption that your basic strategy is already a consistently good strategy.

Dichotomy of Stock Prices

Last week I commented on the transient nature of the market, and said that all the hot
stocks will eventually come down.

In fact, every stock price in the market can be divided into two components: a transient
component and a more fundamental component. The transient component may be due to
sudden news exposure, irrational exuberence, herd mentality or other undue optimism.
This portion of the price will go up quickly and come down quickly. The fundamental
component will track the performance of the company much more closely and is subject
to less fluctuation.

If a stock is going up faster than the underlying business, then we can safely assume that
much of the surge is due to the transient component.

Knowing about this dichotomy should bode well for both day traders and long term
investors. As a long term investor, you would be wise to avoid buying a stock when it is
most popular.

Actually, even this dichotomy can be further subdivided. The slower moving "fundamental"
component can itself be divided into a longer-period transient component and an even
more "fundamental" component. Even the business performance of the company can be
divided into transient and relatively stable components.

The following is a list of companies in four categories, with their valuations in terms of
price/sales ratio. The P/S ratio of the established traditional companies tend to gravitates
toward the S&P500 average of 2.13. One can only assume that the current crop of
high-tech and internet companies, once their growth curves level off, will have a similar
P/S ratio. Can we seriously assume that AOL's business will grow another 20 fold, Yahoo's
another 100 fold, Phone.com's another 500 fold, before their growth curve levels off?
Of course not. Instead, their stock prices will come down as soon as the growth rate begins
to slow. When Dell's growth rate slows from 50% to 40% -- it still grow at a rate of
almost 40% a year -- its stock fell almost 40%.

Category	Company	P/S Ratio
Traditional	Exxon-Mobil (XOM)	1.91
	Walt Disney (DIS)	2.47
	Coca Cola (KO)	8.03
Trad. Technology	Dell (DELL)	4.48
	Intel (INTC)	8.38
	Microsoft (MSFT)	22.87
Major Internet	Amazon (AMZN)	29.88
	America Online (AOL)	40.45
	Yahoo (YHOO)	213.94
New Internet	Phone.com (PHCM)	979.20
	Internet Capital (ICGE)	1420.59
	InterTrust (ITRU)	4253.12

Lessons of Life

In life as well as in the stock market, it helps knowing when to hold on, when to cut loss,
and use time efficiently. Holding on to a hopelessly lossing cause will not benefit anyone. Still, the comparison can only go so far. I may be a perpetual bear on momemtum stocks,
but I believe in the general goodness of humankind, therefore I am a perpetual optimist
in life. Perhaps in life there is something that is worthy of "buy and hold".

12.11.99