Stock Analysis - Know How to Analyse a Stock Effectively

You have just about learnt that equities can generate tremendous profits for you over the long term. But you cannot jump into any stock. You need to take a well thought and calibrated investment decisions. Broadly, you need to consider fundamental factors and technical factors before zeroing in on the stock.

Fundamental factors to examine in a stock

Fundamental factors have got to do with the core business of the company. These factors can be quantitative or qualitative. Here are some key fundamental factors to examine…

Growth is the primary motivation. After all, you want to invest in a company that grows. We are talking about growth in business volumes, growth in revenues and also growth in profits. It is only when these 3 combine that you have an attractive proposition. Higher growth means higher valuations in the market.
Profitability is the key. Eyeballs and footfalls can only take you that far. Your business needs to be profitable. What is the net profit margin and what is the operating margin. This will tell you how good are the business. Check the ROE and the ROCE of the company. That will tell you how well the company deploys its capital.
Efficiency is the binding force. You have up cycles and down cycles in a business. What holds a business together in tough times is the efficiency of operations. How efficiently the company churns its total assets and fixed assets? How well is the working capital of the company managed? All these add up to efficiency.
Brand image is what will give you the advantage in a competitive market. Companies like Hindustan Unilever, Britannia, HDFC Bank and TCS have built a formidable brand in the market. That is why they get premium valuations in the market. Brand image is an intangible factor and cannot be seen or felt, but it can be experienced and monetized.
Management quality separates the wheat from the chaff. A good management can make a success out of a mediocre business but a mediocre management can make a mess of even the best of businesses. Generally, companies with solid managements tend to outperform their peers as well as the index overall.
Business moat is the unique advantage that you have created in the business. It could be a unique product, a special distribution channel, some key entry barrier or a brand that cannot be replicated. The value of the business comes from the moat and it is companies with moat that are better equipped to handle disruptions in the business.

Yes, you will have to examine some technical factors too…

No investment decision is every complete by just looking at the fundamentals of the company. You need to look at the technicals too. Here are a few technical factors to examine…

Price patterns are largely technical factors. You can compare the price chart with the 100-DMA and the 200-DMA to get cues about the stock. You can examine the supports and resistances on the technical chart and also whether there are any double bottoms, double tops or serious breakouts. These are the key to your investment decision.
Volumes can be seen either in terms of number of shares or value. Normally, the number of shares is a better indicator of volumes, especially in smaller stocks. Volumes show whether the interest is building or waning. Volumes are useful in ratifying whether the price trends you see are credible or not.
Spreads and basis risk is a case study on how easily you can enter and exit a stock. Volumes are only one side of the story but these volumes must come with narrow spreads and low basis risk. If an order for 10,000 shares is going to take the stock up by Rs.1 then you are running a huge basis risk on the stock.
Volatility represents the standard deviation or the risk of the stock. Prefer stocks that show movement and sensitivity to news flows but are not too volatile. When stocks are too volatile, they become hard to predict and the stop loss risk becomes too high in them. Such stocks are better avoided.

Even after you consider all these fundamental and technical factors, you must examine whether the valuation offers a margin of safety to you. That is the last test. Only then, a final decision must be taken.

FORM

How to trade options profitably?

A successful self trader – Rule # 30

According to a global study, over 90% of people who buy options lose money. It may appear that selling options is a safer proposition. Not exactly! When you buy options, there are components to that decision. What strike to buy; at what premium to buy; how much time value to pay etc. Unless you understand these finer points of buying options, you will be on the losing side. How to join that other 10%?

HOW TO BUY OPTIONS AND NOT LOSE MONEY

Buying options is not rocket science. But it is not just about determining the direction of the market and deciding to buy a call or a put option. An option is a lot more complicated as compared to plain vanilla futures. There are four unique features of options you need to remember. Understanding their interplay can go a long way in helping you become a smarter player of the options game.

Firstly, an option is a time value game. When you pay a premium for buying an option, you are paying for the price difference and for the expectation of price movement. Secondly, being a time value game, it is a wasting asset. For example an out-of-the-money option will keep losing value consistently in the beginning and rapidly towards the end of the month. Time works against the buyer.

Thirdly, buying options always works best in a volatile market. Both call and put options tend to become more valuable in a volatile market and less valuable in a flat to range-bound market. Lastly, options are primarily hedging instruments and hence they should be predominantly used for counter balancing your risk in other investments. Options as trading choices should always be secondary.

3 QUESTIONS TO ASK BEFORE BUYING OPTIONS-

PROXY FOR PRICE OR PROXY FOR TIME

If you are buying options as a proxy for price, ideally stick to in-the-money options where time value is limited. If you are willing to bet on uncertainty over a period of time, then prefer out-of-the-money options. That is the key.

IS IT A HEDGE, OR IS IT A BET

As mentioned earlier, buying options should primarily be for hedging. But one needs to be clear on the purpose. In a hedge the net cost and the breakeven matters. In case of a bet, the cost and volatility matters. Touché!

WHAT IS MY COST OF TRANSACTING

Options have become cheaper to trade, but read the fine print. Are you paying fixed brokerage per lot or variable brokerage? This matters when you trade in bulk. The statutory costs also add up. When you are trading on wafer-thin margins, costs matter a lot.

“Derivative instruments like futures and options have the potential to become weapons of mass destruction” – Warren Buffett

6 STEPS TO A SOUND OPTION BUYING STRATEGY

Don’t get obsessed with buying out-of-the-money options. It may appear to be a good bet as the downside risk is low. Remember, deep OTM options are cheap because they are actually worthless. You may end up getting upset over the OTM options you keep on buying, that expire worthless. Be careful.

There are investors who say that they are bulls or bears and hence they will only buy calls or puts. This kind of a one-size-fits-all strategy will never work. Buying options is all about being fleet footed to grab opportunities. You must be open to buying calls, puts or even synthetics like strangles. Period!

Check if the option is underpriced before buying it. Your broker trading terminal or even your online interface has a simple algorithm, which identifies which options are underpriced based on the Black Scholes Model. While this may not be a sure-shot money spinner, it definitely gives you a margin of safety.

Do you want to buy index or stock options? It depends on what you are trying to bet on or hedge against. If you are looking at broad macro factors like GDP, fiscal deficit, currency etc, then stick to index or sectoral options. If you are looking at company-specific factors, then focus on stock options.

Beware the liquidity trap. Check the past liquidity of options before jumping into them. This is very true of options on mid-cap stocks. You surely don’t want to end up holding a pile of illiquid options. Check that you can exit in bulk from that option, without disturbing the price too much. That’s critical.

Options buying is all about moderation. Avoid concentrating on just 1-2 options and don’t spread yourself too thin. Set a target for option premium and exit. Avoid waiting till the rapid time-value erosion starts. Avoid the temptation of buying more to reduce your average cost of options. It rarely works.

RISKS TO AVOID WHEN BUYING OPTIONS

There are those eager beaver traders who buy a certain option just because a particular institution or star trader bought it. Perish that thought. You don’t know what is behind their trade. Also don’t buy a call option, the moment you are convinced about the fundamentals of a stock. It may take 3 years for the stock price to fructify. By then your options cost may well and truly finish you. Avoid the bandwagon strategy while buying options.

Remember, a cheap option is not necessarily valuable. It is most likely cheap because that is what it is worth. Averaging is a cardinal sin. An option trader once told me that he had reduced his risk in an option by buying on every dip. That is a myth. While your average cost of holding may have come down, your concentration risk is substantially up. Be cautious of illiquid options for two reasons. Firstly there is a danger of no exit and secondly, it normally attracts regulatory scrutiny.

TAKEAWAYS FROM THE “OPTIONS BUYING” DEBATE

The gist of options was best summed up by the legendary George Soros. “Markets are constantly in a state of uncertainty and flux. Therefore money is made by discounting the obvious and betting on the unexpected.” Buying options provide the best route to bet on the unexpected. For the past many quarters, Infy has been volatile on the day of results. Buying strangles (a call and a put simultaneously) has almost always worked in case of Infosys. Watch out for such mug trades in the market.

Option buying is surely more complicated than buying equities or plain vanilla futures. But then, you at least know your worst case scenario. The aspect of time value surely adds a new dimension to it. There are some basic building blocks to a smart options buying approach. If you focus on options valuation, scientifically decide the strike to buy, monitor your position carefully and avoid the standard pitfall of averaging your position on each dip, you too can be a fairly successful options buyer.

Category: Trading Tips