Wednesday, March 4, 2009

Daydreaming and Buyers Remorse - Using the right metrics

If there is a pet peeve I have when it comes to investing, it's the use of 52 week highs and lows to calculate potential gains or losses. I think it's absolutely absurd that some investment "professionals" will quote 52 week records as potential gains (or losses). Or quote the 52 week high as "proof" of the potential in the stock. If there is one obvious lesson that should be apparent, it's that sky high (as well as rock bottom) prices in the extreme ranges are a function of exuberance and certainly not any rational decision making.

Also understand this. Do you know how many trades were made at the 52 week high (or low)? One. That was the last trade before the price started moving back towards it's equilibrium price.

Let's take a look at the stock chart below. Look familiar? It should. Almost all stocks on the market have exhibited similar behaviour:Generic StockThat heavy drop would have made it's appearance at different parts of last year depending on what industry sector your company was in, but this shape is fairly common (unfortunately). The next graph we add a moving average trend line for technical analysis purposes.Generic Stock with moving averageFinally we highlight our 52 week highs and lows.Generic stock with 52 week highs and lowsI think the next portion is the most important (and the overall lesson), is that aiming to hit the 52 high and low is ridiculous. Even the most advanced traders would probably be happy making a reasonable spread between the upper and lower trading bands shown here. For mathematical purposes, assume that they are only one standard deviation from the mean. And for assumption purposes, assume that the mean is the intrinsic value of the stock (what it *should* be worth)Generic stock with trading bandsAssuming that you trade within the band, your volume will cover 68.2% of all the trades (one standard deviation) and you'll make a hefty profit (especially if the stock's volatility is high).

You can also do a trade off between profit and risk if you narrow your band (to say, half a standard deviation). In the extreme (of small margins and high volumes) the sales and trading technique is known as 'scalping'. Granted that these statements assume that your valuation model can identify these parameters, but even if you can't get exact parameters, the concept still holds (stronger precision and accuracy will provide stronger profits).

A critical observer would also note the following: "But what if the 52 week low we see here isn't the bottom?"

That is the topic of my next post: "Searching for the Bottom"

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