Active Investing and Speculation
Speculation and Trading
The Meaning of Speculation
The term speculation is commonly used within the stock market, but the term can be used in a variety of different contexts.
The Meaning of Speculation:
- Speculation can mean buying low priced stocks - usually under $5 which are commonly referred to as Penny stocks.
- Speculation can be used with reference to the market capitalization of a stock. Small-cap and especially Micro-cap stocks are considered Speculative.
- Speculation can refer to the lack of profitability of a company - companies with revenues and generally positive earnings are considered profitable, while companies with years of earnings losses are considered speculation.
- Speculation is also used in reference to the risk of a strategy - low risk strategies are referred to as Investments and high risk strategies are referred to as speculation. Dividend investing is considered investing due to its moderate risk, while trading is considered speculation due to its high risk.
Speculation and Trading
Speculation and trading are two different things but can be used in the same context.
- The term trading refers to the process of buying a stock with the specific intention of re-selling that stock in the immediate future.
- But when used in the context of Speculation, the term trading now refers to the risk of the strategy rather than to the process of trading.
Trading strategies have short time frames which vary significantly between trading strategies. At the short end are day traders who mostly buy and sell their stocks within the same day. Then there are swing traders who buy and sell their stocks within a couple of days to a couple of weeks. At the long end of the trader's short time frame are position traders who buy and sell their stocks within a couple of weeks to a couple of months.
Speculation strategies can have a short time frame as just discussed with trading, but speculation strategies can also have long time frames. Buying small-cap stocks is considered speculation even though the intention might be to hold the stock for ten years.
So not all speculation is trading - but short-term trading is a speculation strategy.
Some investors are under the impression that having the intention to sell a stock means that this constitutes trading. Again trading is the process of selling a stock soon after buying it, whereas with many active investing strategies the intention is to hold the stock into the future but the stock may well be sold when it no longer meets the investor's requirements.
The reason trading is considered high risk is due to its short time frame. The market in the short term is very volatile and quite unpredictable. There are plenty of new traders who find this out the hard way.
With the longer time frames the market shows a distinctive trending nature. These general trends form market cycles which we broadly classify as Bull Markets and Bear Markets. Traders who have had a hard time with the short times frames but do not want to become investors do have another option.
When short-term trading is applied to a long time frame it starts to follow the broad market cycles rather than the random short-term fluctuations. This enables the trader using a long time frame to broadly follow the bull market cycles higher.
While formerly there is no such thing as long-term trading it is still generally considered Speculation. Thus a trader who trades the long time frames would be considered a Speculator.
Some speculators incorporate fundamental information into their strategies while others prefer to rely solely on technical analysis and charting.
Speculators using charts tend to use weekly and/or monthly charts. The same charting patterns found on daily charts are also found on the longer time frame charts. Popular strategies use profit targets and stops.
When speculators include fundamentals a popular strategy used is Earnings Momentum. This is where the investor looks for stocks with increasing earnings and a stock price that is responding to those earnings.
Long-term trading involves less work than short-term trading. This may suit the short-term trader who is finding the time required to be excessive. Also trading over a longer time frame is far more relaxing.
Active Management Strategies
There are two main approaches to managing a portfolio.
Two main approaches to managing a portfolio.
- The first is passive management where the investor buys and mostly holds their investments. There may be some re-balancing between stocks and bonds or they may sell some stocks or even their entire stock portfolio during bearish market conditions. This approach suits investors who do not want to spend a lot of time managing their portfolio.
- The second is active management where the investor takes on a shorter term view; however their time frame is still considerably longer than most traders. They tend to sell their stocks rather than holding them even during a bull market or they use hedging tactics to manage the market's volatility. This approach suits investors who want to spend more time managing their portfolio.
Some of the common active management strategies used by investors are discussed as follows:
Sell Overvalued - Buy Undervalued
This is a common strategy with active investors who want to lock in the profit of a strongly performing stock. They then use the proceeds from the sale to purchase another stock which they hope will do the same.
There are many ways to determine if a stock should be sold. Some investors use a market index such as the S&P 500 and look to sell a stock when it outperforms the index by a certain percentage.
Another approach is to sell when its PEG (price earrings growth ratio) exceeds a certain level. The level is arbitrary but a stock is generally considered to be fairly valued when the PEG ratio is around 1 to 2 and to be overvalued at 3 or more.
Using the PEG ratio investors might buy another stock with a PEG under 1. Some investors will buy with PEGs under 2 with the view of selling when the PEG is over 3 or even 4.
Some investors only use fundamental analysis while others prefer to incorporate technical analysis and charting. The advantage of using charts is that the active investor can more readily locate stocks that are increasing in price.
The active investor might check their portfolio monthly or quarterly, they generally do not check it daily.
The basic idea with this strategy is allow the value of a portfolio to increase while the market is bullish, but to stop the value of a portfolio from dropping when market conditions are bearish. In theory this works well, but in practice it's more difficult to implement.
There are a variety of instruments that can be used for hedging such as futures contracts, index options and short selling ETFs (ExhangeTraded Funds). The main requirement for a suitable hedge is that the value of the instrument increases as the market declines. When the market starts to decline the investor would apply their hedge. As the market drops the investor's portfolio value drops, but the hedge value increases thus offsetting the portfolio's losses. When the market turns bullish again the hedge is removed.
While short selling the S&P 500 Futures contract is a popular and efficient hedge, the downside is that it's a large contract making it way too expensive for a lot of investors. Another popular hedge is an index put Option which the investor buys (no need to short sell). Other popular hedges are Inverse Index ETFs which the investor buys or they can short sell an Index ETF.
Before using a hedge the investor needs to define just what is required for the market to be bearish. The first step is to determine what time frame to use. A popular choice is the intermediate-term trend and a 50-day moving average does a good job of tracking the market for its intermediate-term trends.
The investor now tracks the market and when it has turned bearish the investor applies their hedge. If the market declines the investor's portfolio declines in value but their hedge increases in value. However should the market continue to increase then the portfolio continues to increase in value, but the hedge now declines in value?
The end result is that when a hedge is applied it essentially stops the portfolio value from declining or increasing. Thus since the investor is looking for their portfolio to increase in value, the hedge is only useful while the market is declining and should be removed when the market advances.
This is a very simple tactic that can be combined with other strategies. The basic idea is to sell the stock if it declines by a certain amount. This technique is very useful for investors who fear bear markets. During bear markets stock prices typically decline and the stock is only held while prices remain above their initial stop.
The initial stop tactic is effective in getting investors out of the market early for any new stocks purchased when market conditions turn bearish.
This tactic works well for investors who want to ride the bull market higher but do not want to hold losing stocks in their portfolio. The tactic works best when investors only buy stock during bull markets and sell their stocks when market conditions turn bearish - otherwise the stock price will likely drop all the way back down to the initial stop level.
There are several methods investors can use to determine the price level the initial stop should be placed at.
A simple method is to use a fixed percentage value. This is arbitrary but using a value from 5% to 10% is fairly common. So for example, if the investor buys a stock at $50 with a 10% stop they would sell the stock if it traded below $45.
Some investors prefer to use chart patterns to determine an appropriate stop level. For example, if a stock pulled back and started to rally the investor might place the initial stop just below the relative low of the rally.
A Trailing Stop is simply an initial stop that is raised as the stock price increases. The investor would sell their stock when it trades below the trailing stop.
When an investor first buys their stock, the first price level the stop is placed at is referred to as the initial stop. As stock prices increase the stop is raised so it trails behind the raising stock price. A trailing stop is only ever raised and never lowered.
The investor can use a variety of techniques to trail the stocks price advance.
The simplest technique to use a fixed percentage of 5% to 10%. This is deducted from the stock price whenever the stock price increases.
Using chart based trailing stop techniques is popular. The investor can use a weekly line chart and place the trailing stop under the relative lows as the stock price increases. Other techniques include using monthly bar charts and using chart indicators.
Chart 1.below shows an example using a weekly line chart with a trailing stop placed under the pullback lows.
Chart 1. Pullback Low Trailing Stop
In the above chart example, using a trailing stop takes the investor out of the stock on the fourth raised stop. This is an example where the trailing stop works well - it locked in a good profit.
There are pros and cons with using a trailing stop. There are times when the trailing stop works well. At other times the trailing stop can stop investors out early and the stock then continues to trade higher (without the investor owing any shares as they where sold at the trailing stop).
How to Find Stocks
The active investor looking to buy stocks can use two methods - Fundamental screening and Technical screening.
Some speculative strategies use both fundamental analysis and technical analysis - in this case the active investor can start with one to narrow the list and manually check the other. Another option is to run both screens and look for stocks that are on both screen lists.
Using a fundamental screen the active investor will generally search for profitable companies, but the screen can also be used to find companies with improving financials or even find financially distressed companies.
To find stock candidates the active investor could try using a web-based screener. There are dozens to choose from (both free and paid). The investor could use the free screener from nasdaq.com.
Using the screener is straight forward. All that's required is to enter some criteria and press the screen button.
Let's say for example the active investor is looking for small-cap growth stocks. The first step is to screen for stocks with market capitalizations below $2000 Million (this will exclude the Mid-caps and Large-caps). The next step is to filter for stocks with a 5-year historical earnings growth of say 10% (per year). Entering a higher growth rate will reduce the size of the screen list.
The active investor should now check each stock on the screen list for its five year historical earnings trend and shortlist stocks that show a fairly smooth and consistent increasing trend rather than showing a volatile history (especially with negative earnings years). The investor could use morningstar.com which provides at least 5-years historical data for free.
The active investor can readily determine the financial strength of a company with a few simple calculations using data from the balance sheet. Morningstar does not provide this for free but the investor can obtain this from finance.yahoo.com
The Z-score is a useful calculation which gives the investor an idea of the company's bankruptcy risk level. Companies with a Z-score greater than 2.6 are considered to be low risk and very low risk if above 4.0
Another two useful calculations that determine the financial strength of a company are the Current Ratio (Current Assets divided by Current Liabilities) and the Debt/Asset Ratio (Total Liabilities divided by Total Assets multiplied by 100%).
Generally Current Ratios above 2.0 are preferred but above 1.5 may be acceptable as the company still has more current assets than current liabilities.
Also companies with Debt/Asset Ratios less than 35% are very conservatively financed but a lot of companies have Debt/Asset ratios much high than this. Generally its best to avoid high debt/asset ratios of say above 80% but there are plenty of exceptions.
The active investor can now produce a shortlist of stocks that satisfies their criteria. The above example was looking for small-cap growth stocks.
Active investors who incorporate technical analysis into their strategy can use a technical screener.
The active investor can use a web-based screening service. When using a technical screener it's a good idea to also use a charting service so that the investor can visually examine the stock's price history.
A web-based screener is available from StockCharts.com which also has a decent charting facility. There's a basic free web based screener and charting service and a paid service with long-term charting history up to 30-years.
The free services will suffice for a lot of investors. Active investors and speculators tend to prefer the paid versions as the charting services provide the features that active market participants require. However, the screeners with web-based services tend to be a little basic.
There are charting and screening products that are downloaded and installed onto the investor's computer. These standalone products are generally subscription based but they tend to have a more sophisticated collection of screening tools compared to the web-based services.
Active investors could consider the standalone product from incrediblecharts.com which gives free basic charting. They have a fairly good screener which is available to use via their subscription service.
Another standalone product that is very popular with traders is Metastock which has a decent charting package combined with a good screener. This is the more expensive option and requires more work to setup as the investor has to purchase historical data and install them on their computer. Nevertheless there are plenty of active investors who use Metastock.
Regardless of which screener the active investor uses they should carefully check each stocks charting history. For speculators it's a good idea to check the stock's 10-year chart.
Generally it's a mistake to only look at the three month or six month history when speculating. The short time frames may be OK for short-term trading. but speculation generally involves a longer time frame, so it's a good idea to see where the stock has been in the past.
Understanding the Markets Volatility
The Market's Volatility
In the short-term the stock market is quite volatile and fairly random. From month to month there is a considerable variation in market gains. As the time frame increases, trends start to become more obvious. The stock market starts to become more directional.
Graph 1.below illustrates the stock market's behavior.
Graph 1. The Market's Volatility
Referring to Graph 1. the label RH stands for Relative High and the label RL stands for Relative Low.
The stock market shows two distinct cycles - a bull market and a bear market.
The Bull Market Cycle
- The bull market starts with the first advance higher from label A to the first RH. This is where the market first goes up and is referred to as a Rally.
- This now reverses and the market sells down from the first RH down to the next RL. This is where the market goes down and is referred to as a pullback (but can also be called a correction).
- The next advance begins from the RL and the market rallies up to the next RH.
- The next pullback occurs and the market sells down from the RH down to the next RL.
This alternating rally and pullback action continues for as long as the bull market lasts. This is the basic market behavior of a bull market.
The Bear Market Cycle
- The bear market starts with the first decline lower from label B to the first RL within the bear market. This is where the market first goes down and is referred to as a correction.
- This now reverses and the market rallies up from the RL up to the next RH in the bear market. This is where the market goes up and is referred to as a bear rally.
- The next decline begins from the RH and the market sells down to label C. This is the end of the bear market as shown in Graph 1. but some bear markets show a another correction and bear rally.
This alternating correction and bear rally action continues for as long as the bear market lasts. This is the basic market behavior of a Bear Market. Some bear markets are minor and only show one big decline from label B to C without any RL or RH. A minor bear market is referred to as a market correction and may simply be called a correction.
The top of bull markets are usually higher than the top of the previous bull market. Similarly, the bottom of bear markets are usually higher than the bottom of the previous bear market.
Sometimes a bull market only reaches the top of the previous bull market and sometimes a bear market declines down to the bottom of the previous bear market.
Over the decades the net result of these market cycles is that the stock market works its way higher.
Profitable Market Phases
The market phases that are profitable for speculators and traders are where the market rallies up from a RL to a RH in a bull market. To a lesser extent the market is profitable from a RL to a RH in a bear market. This is based on speculating on the long side. These phases are inversed when short selling.
Chart 1. below shows how the theoretical market behavior from Graph 1. above is applied to the actual market S&P 500 index.
Chart 1. The Volatility of the S&P 500 Index
The labels from Graph 1. are applied to Chart 1. for the S&P 500 index.
As Chart 1. shows, the low of the bear market (label C) actually dropped just below the bottom of the previous bear market (label A). Generally the RH and RL levels increase as the bull market progresses. A lot of bear markets only show one set of RH and RL.
On Chart 1. note that label A is also an RL and label B is also an RH. Similarly label C is an RL and label D is an RH.
During a bull market a rally runs up from an RL to an RH and can last for many months and even a year or two. The pullbacks decline from an RH to an RL and are usually quite short lasting only a few months.
During a bear market the corrections take the market from an RL down to an RH and this can last for many months. The bear rally climbs from an RL to an RH and are usually a bit shorter being a few months long.
Profitable Market Phases:
- Rally (from RL to RH) - Speculating is generally net profitable during this phase. Most stocks rally.
- Pullback/Correction (from RH to RL) - Speculating generally leads to net losses during this phase. Most stocks pullback and decline.
Profitable Market Cycles:
- Bull Market (from label A to B and C to D) - Long-term speculating is generally net profitable during this cycle. Most stocks end up higher by the end of a bull market.
- Bear Market (from label B to C) - Long-term speculating generally leads to net losses during this cycle. Most stocks end up lower by the end of a bear market.
Over the long-term the probability favors the speculator whereas the short-term is quite random. Traders having problems with short-term trading should consider increasing their time frame to a longer time frame. Instead of using daily charts the trader could try using weekly charts or even monthly charts. Speculating over the long-term is generally profitable during bull markets and the trader can always stay out of the market during bear markets. Also trading with a longer time frame involves far less work which makes it less hectic and more relaxing.
The Markets Long-Term Direction
The stock market is biased to the upside over the long-term as shown below in Chart 2.
Chart 2. The Long-Term Direction of the S&P 500 Index
The S&P 500 index began in 1957 and Chart 1. above shows the markets performance since 1945 (The chart data prior to 1957 is back tested data provided by S&P).
As Chart 1. above shows, the stock market works its way higher over the decades with a never ending sequence of bull markets and bear markets each containing a sequence of rallies and pullbacks/corrections.
Investors interested in seeing all of the Market Cycles over the last 100 years can find them in the members section.