Stock Valuations Can Make a Difference In Your Trading Results

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John Forman - The Essentials of Trading author

I came across a post on the Generation X Finance website yesterday which discusses the value of using Price/Earnings (PE) ratios to estimate the likely return of the stock market looking forward. In this particular case, the author uses what is called the PE10, which is Price divided by the 10-year average earnings. The normal PE that we talk about would be PE1 - price divided by the last year’s earnings. And of course there is the forward PE which compares current price to expected earnings for the next year.

The article attempts to make the point that young investors should pull for a major correction in the markets because the current PE10 is at about 25, a high reading which implies poor future returns. Research has definitely indicated that low valuation investments outperform high valuation ones, but this particular article falls way short of hitting the target.

Firstly, the estimates are based on a linear regression model of market returns and academia has long sinces started moving away from those types of forecasts methods as market returns are most certainly not linear and do not conform to a normal distribution.

More importantly, though, the results of this author’s research tends to contradict his point. His figures show that the longer one stays in the market, the more irrelevant the initial valuation level. The variation in expected returns is by far the largest in the first 10 years, then rapidly moves toward zero. Presumably, a young investor has a multi-decade investing horizon, so initial valuation doesn’t mean anything. It’s the investor on the back side of their careers who need to concern themself with valuations - according to this particular study.

I personally am primarily a technical trader, but when trading stocks I do try to find relatively low valuation situations (or high for shorts) as they oftentimes can create that extra momentum in the stock price to really get things moving. It’s not a question of hard and fast rules, though. Valuation is a relative thing.

Trading is All About You

Chris Perunna wrote Focus on You on his blog yesterday. It echos a lot of what I wrote recently in My First Major Lesson: Trade to Your Personality, though Chris leans a bit more toward Sun Tzu in terms of the know thyself idea, extending it to suggest that knowing one’s self means knowing one’s enemy - that enemy being other traders in the market.

Obviously, this is an adverserial view on trading. He makes that very clear by stating, “It is you versus the other trader.” By definition in some markets you are literally trading opposite another trader (The Zero Sum Game). As such, it is competition in a somewhat indirect way. You never really get to face your opponent, though.

My concern with the way Chris expresses things in that regard, though, is that there’s a difference between individual psychology and mass psychology. Let’s face it. Individuals can be subject to enormous numbers of different personality quirks. If I understand myself, that doesn’t mean I’m going to understand someone else, especially someone with a very different developmental path and background to my own.

It doesn’t matter whether I understand Trader X, though. The markets are a collective expression. Prices move o nteh basis of group psychology, not the mental processes of Trader X. It’s these broader patterns on which we need to be focused - though certainly understanding how we ourselves react to the stresses and strains of trading can help in that regard, at least to a degree.

Still, Chris’s point that your success or failure in trading comes primarily from inside yourself is spot on. I’m not talking here about trading psychology as folks often think about it, but rather in the broader mental approach to trading that determines where you focus your efforts.

Brett Steenbarger takes things a step further in Eternal Truths About Trading Success. In his post the good doctor discusses some key trader mental traits of good traders. It ties in nicely with Chris’s broader discussion.

What is Your Trading R?

Do you know your trading R? Do you even know what R is?

In trading parlance, R is the amount of risk you are taking on a trade. So for example, if you are risking 5 points on a given trade, then your R for that trade is 5 points. You can measure R in whatever terms makes sense to you - points, dollars, etc. - so long as you make sure you do so on a consistent basis.

When you ave determined your R for a trade you can then measure your performance on that trade in terms of R. If your risk was 5 points and you made 10 points on the trade, that would be a +2R. If you lost 2 points, it would be a -0.4R.

Van Tharp can probably be given considerable credit for popularizing the use of R as he discussed extensively in his book Trade Your Way to Financial Freedom. It’s a book I definitely recommend reading. Tharp does a really good job of helping you quantify your trading.

The advantage to using R in assesing your trading performance is that it allows you to normalize your trades if you don’t take exactly the same risk each time you put on a trade. I certainly know that what I risk in point terms varies considerably from position to position. Thinking in terms of R lets me look at my trades as a collective in a comparative fashion.

By pulling together Rs of all my trades I can see what my average performance is on my trades in a unified expression. That is something quite useful for comparing trading systems and for talking with other traders about their performance, since talking in points or pips tends to be meaningless.

Understanding Open Interest in Futures and Options Trading

One of the less well understood statistics in the basic daily trading data set is open interest. It’s a statistic that is generally included in end-of-day price quotes along with volume, but a lot of traders tend to ignore it, potentially to their detriment.

Open interest is the total number of open contracts in futures and options trading. Recall that in derivatives markets like futures and options there must always be matching longs and shorts. For every mini S&P 500 futures contract that I am long, there is a short out there somewhere, and vice versa.

Let’s look at it in very basic terms with a simple two trader market.

Trader A goes long 10 contracts, with Trader B taking the short side. That increases open interest by 10 contracts.

Trader A later offsets 3 of those longs, and by extenstion Trader B offsets 3 of his shorts, to push the open interest down by 3 contracts to 7.

Open interest, therefore tells us how many active open positions there are in the market at the end of each trading day. It rises and falls on a daily basis as traders continuously enter and exit positions. Generally speaking, it is presented as an aggregate figure for all active contracts, though especially in options you can see the contract-by-contract figures as well.

The value of the open interest data (as Bill Rempel and I were discussing yesterday - Warning Sign: Open Interest Declining) is in its ability to highlight whether traders are building positions (more participation) or taking them off (less participation), especially when combined with volume data and a look at the weekly Commitment of Traders report. The latter shows a breakdown of the positions of the three primary sets of traders.

Learn How to Trade and Get Started in Trading

Trading certainly offers a great deal of potential, but it’s also a rather complex undertaking which many people find daunting - at least at first. There are different markets to look at and different ways to trade them. For someone just getting started, even the mechanics of buying and selling, entering orders and tracking profits and losses, can be challenging.

With a little guidance, though, it’s something that can be learned quite rapidly.

A while back I put together a guide to explain the ins and outs of getting started in trading and the markets.

Click here to get a free introductory guide to help learn trading.

Want to Learn Forex Trading?

The forex market (also known at foreign exchange or currency) is one that offers a great deal of opportunity to traders. It provides access to the world’s largest market, one which trades about $3 trillion per day, 24 hours a day, from the Asian open on Monday morning (Sunday evening New York Time) through Friday’s close in New York. Some brokers even allow trading over the weekend, though that’s quite limited.

Forex trading is readily accessable to just about anyone because it doesn’t take much money to be able to trade and can be traded in many different ways.

A while back I put together a guide to explain the ins and outs of forex trading and the forex market.

Click here to get a free introductory guide to help learn forex trading.

Want to Learn Futures Trading?

The futures market is one that offers a great deal of opportunity to traders. If there’s a market out there, it can probably be traded through futures. Although a lot of folks think first of commodities (and indeed many still refer to futures as the commodities market), that is just a portion of what’s available.

Yes, through futures you can trade gold, oil, corn, suger, cotton, pork bellies, and other so-called hard commodities. You can also, however, trade all kinds of fixed income instruments like US T-Bonds, German Bunds, Eurodollars, and Short Sterling. Currencies can be traded via the futures market. So too can stock indices like the S&P 500, the NIKKEI, and the DAX. There are even futures on single stocks, not to mention a whole bunch of other markets you probably never even thought existed.

Futures trading is rather different than trading in stocks, though. In involves considerable leverage and the understanding of the deriviative instrument mechanism. It’s not as complicated as that might make it sound, though.

A while back - at the request of a futures broker friend of mine - I put together a guide to explain the ins and outs of futures trading and the futures market.

Click here to get a free introductory guide to help learn futures trading.

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