Market Trading Tactics. Guppy Daryl

nightmare. The dedicated fundamental analyst, at this point, throws up his hands in disgust and despair, wipes every chart from the screen display, and returns to the raw balance sheet numbers pitting his estimate of the wallet cash value against the market price.

      The analyst does this by de-constructing the wallet. The process is described in many articles on how to read company reports, and understanding the balance sheet. They are studded with explanations of ‘tricks of the trade’ and warnings that a more comprehensive assessment of the financial position requires an analysis of financial statements. Each step takes the trader further from understanding today’s market price for the security. The final calculated figure of ‘fair value’ is not consistent with the price printed in the stock pages so we turn to another attractively simple explanation to explain the discrepancy. In the simple version the calculated figure is used to decide if today’s market price is under or over valued.

      The further we go down this path, the more subjective the result becomes because vital financial information is hidden, or unavailable, to everyone who wants to attempt these calculations. Many Exchanges now ask for full or continuous disclosure, but this does not apply to commercially confidential material so the analysts must guess at what is concealed. The better analysts often get it right and are paid accordingly.

      Getting it right does not mean picking the current market price. This style of analysis is used by brokerages to ‘price’ an initial public offering (IPO), or ‘float’. They have full access to financial details that under other circumstances they can only guess at, or imply from other public documents. They almost decide what goes in the wallet. Yet, the first trades on listing show some spectacular differences between the brokerage valuation and the market valuation. Even in a bull market where a new IPO seems to list every second day the valuation gap remains. Typically, after 12 months about 30 percent are trading at less than their listing price and 60 percent are trading above, while around 10 percent are going nowhere. It makes little difference if the listing is on the New York Stock Exchange (NYSE), the French Stock Exchange, in Hong Kong or Singapore. We tend to remember the spectacular successes, unless we are unlucky enough to have bought stock in one of the losers.

      This style of analysis has an important place, but we need firmer footings when we approach the market with trading on our mind. I am suggesting that it is less useful from a trading perspective in the same way that the official valuation on your house bears little relationship to the price it brings on the open market. If you use price charts as a measure of the contents of your wallet, then you miss the advantages charts bring to trading.

      Going back to our wallet explains why. If we lose our wallet the insurance value is more than just the cash inside. It includes the credit cards, the sentimental picture, the ticket stub and the PIN card access number ineffectively disguised as a fax contact. It includes some measure of the potential future value of the wallet to the thief, particularly if he uses our credit cards. We readily accept different measures of value and apply them in different circumstances.

      The price chart records the insurance value rather than a daily count of the cash in the wallet. The chart display is a barometer of the market’s feeling about the company and the potential future resale value of shares purchased today.

      THE CHART SAYS SO

      The chart is a graphic representation of the market’s valuation of the security at a particular point in time. Each point on the chart, such as point D, Figure 1.2, captures in the traded exchange the exact market valuation of Ashton Mining. This is not a valuation of fundamental worth reached after a simple addition of its assets and the subtraction of its liabilities. This is not a simple count of the cash in the wallet or diamonds on the shelves. It is an estimate of how much shares in this company are going to be worth sometime in the future.

      When the transaction takes place at D the seller believes Ashton Mining is doomed. He jumps out because he believes prices will go much lower. He takes the loss now before it gets any larger in the future.

      The buyer has exactly the opposite conviction. He believes, for whatever reason, be it fundamental or technical, that the price is going to increase in the future. He is happy to get a bargain entry into an improving price. The seller is pleased because the exit saves him from further loss. Time will tell who will be happy and who will be regretful, but for this very instant each person on either side of the transaction believes he has done the best possible in his circumstances.

      This understanding of market activity – of this trade – tells us nothing about the current status of the company, about its inferred resources, its management, or its audit report. Point D on the chart is never designed to give us this information. This point tells one thing only – how the market of buyers and sellers felt about the value of the security at this precise point in time in relation to its future potential. Such a valuation is a measure of market sentiment.

      When we understand that the bar chart measures market sentiment by using market price, then we have a solution that allows the fundamental trader and the technical trader to make the best use of a chart with a price plot.

      Price is primarily a measure of sentiment, not a measure of worth. If we do use it to measure company worth, such as when it is incorporated into a number of financial ratios including price to earnings, price to net tangible assets, or debt to equity, we still end up with a result reflecting current market sentiment rather than a balance sheet.

      DEFINING THE BALANCE

      Gold fever brings together a rich assortment of prospectors from all walks of life. The portals of the stock exchange building draw crowds in the same way, all impatient to start their expedition. Those determined to survive know at some point they will be called to make, or take, a price in the market. The decision puts the balance of probability with them, or against them. In a landscape shaped by probability, success goes to those who use equipment to make or take this price from within a bulge, rather than those who select a price from more slender territory. Getting behind the price bars offers an advantage.

      ANNEX

CALCULATING ODDS

      Calculating the odds is the first step in calculating the probabilities. The mathematical groundwork distinguishing odds from probability was done in the Renaissance by Girolamo Cardano. Writing in Against the Gods, Peter Bernstein maintains that Leonardo da Vinci was fascinated by the concepts, even though he would fail a Year 3 arithmetic test today. Leonardo spent many hours with Cardano until he finally understood the problem. If he understood the concepts then the following primer discussion should not present too much of a challenge to today’s calculator and spreadsheet-enabled trader.

      Toss two dice, put money on the outcome and we enter the world of odds and probability. And it is not as far from this common wager to trading the financial markets as many people think. The probabilities of any outcome become different from the odds of any outcome in subtle ways.

      Before we calculate the odds, we need first to determine the list of possible results. Each of the pair of dice has six faces giving a total of 11 possible results. Throwing a 0 or a 1 are not possible results. The lowest possible result is a 2 (one dot plus one dot). The highest possible result is a 12 (six dots plus six dots). This gives eleven possible results. All the possible results are shown in Figure A.1 column A – if only life, and trading, were so amenable to a similar process of neat tabulation.

      Calculating the odds of any number between two and 12 appearing after a throw depends on the total number of possible outcomes, or the opportunity set. As our Renaissance scholar Cardano told Leonardo da Vinci, the odds are the ratio of favorable outcomes to unfavorable outcomes. If we want the number 7, a favorable result, then there are 30 other possible combinations in the opportunity set representing unfavorable results. In modern terms the odds of any turning up the number 7 are six (favorable results) to 30 (unfavorable results), or more commonly expressed as 1 to 5 (30 divided by 6).

      Why not 6 to 36 (1 to 6)? We are saying that out of a total of six throws one of them will produce a 7 because there are six combinations out of a possible 36 combinations that give this result. The total of throws needed is six – one favorable outcome plus five unfavorable