My wife Kayla inspired this post with a question she posed to me earlier this week. She asked me if there was a way to determine when a stock’s price will go down. If one truly knew the direction of an individual stock every time they moved they would probably sell the information for a lot of money. This is one in a series of multiple posts attempting to answer the question, “can one know the direction of a stock’s price movement?”. The short answer is yes, however most of the people that can truly predict the direction of a company’s share price cannot actively trade on this information – its called insider trading. To think that such individuals don’t do so is naive, whether they get caught is another question. However, there are some indicators that identify where a company’s stock will go. The biggest problem is that these are much easier to identify after the fact. This post and others on predictive analysis will talk to some of the red flag indications that a stock price may fall.
Insider trading tells everybody at precisely the wrong time that everything is rigged – Preet Bharara
Just a fair warning, insider trading is the dark side of the stock market. If you cannot handle a cynical perspective on the market, stop reading. My perspective is very cynical in this area. I personally believe that it is difficult to think that in a high performance environment to achieve better than average results the temptation to use insider information just to keep one’s job is tremendous.
An interactive Bloomberg article from 2016 talks of the largest insider trading ring bust in US history. The SEC convicted 93 individuals total as part of this crime wave. One can argue that this is a great job by the SEC. However, the alternative perspective could be to think that they only have money and time to prosecute the most egregious deals-just like sports authorities only prosecute Olympians or professionals because the news value of the action has impact to show that the organization is valid.
The average rogue trade according to some professors and New York University was worth about $1.6 Million. Quantifying this information, it was simply a study not the holy grail double blind study that shows the best statistically significant information (who is going to say, “I am an insider trader and would be more than happy to join your study for science…”). However, they did consider over 16 years of data analyzing thousands of merger and acquisition activity as part of the study and claimed that about one in four mergers included insider trading information.
In conclusion, it is possible to get actionable information about the direction of individual stock prices this is why insider trading exists. The individuals that participate in such activity probably can make significant gains from such activity. However, insider trading is illegal and the SEC will prosecute anyone that they find worthy of prosecution.
A few weeks ago, an article in the Wall Street Journal was titled “Stocks are Frothy but there is no Bubble”. What does one do when the market is frothy? In my opinion, frothy means that the market is overpriced, maybe not bubbling, but overpriced. From that article the author identified that the forward looking price to earnings ratio for the S&P 500 rose from 12 times earnings to over 17 in the past five years. I like to think of this simply, the price of the market is approximately 50% more expensive than it was five years ago.
The stock market might not pop, but it can still fall pretty hard. – Justin Lahart
So what does one do when they believe that the market is overpriced? How do they participate in the stock market and preserve capital? What can be done to continue to get returns anticipating a market drop?
My personal method is to sell puts on an Index ETF. Remember from previous posts that selling puts allows you to gain cash on a security by providing an opportunity to another investor to sell their shares of the company at a predetermined price. The other investor uses this as a way to preserve capital. You get the benefit of current cash from the transaction and if things go well for you, the contract expires worthless and you pocket the cash from the transaction. If things do not work out in your favor, you still get the opportunity to purchase the company/security at a lower price than today’s going rate.
Let me share a simple example. IJH, the S&P 400 Index ETF that I wrote about previously is selling at about 171/share, the investor selling puts can sell a contract expiring in about four months setting the transaction price at 153 for about 1.75. Remember that each contract represents the right to buy or sell 100 shares of a security. Therefore, in this example, the seller gets $175 for the transaction and will purchase the underlying security for 153/share if it falls to that level. Basically, you are locking in the opportunity to purchase at a lower rate and being compensated for maintaining the cash for such a transaction.
This strategy does offer some downside, in order to play the entire transaction out, you must maintain the value of the put in cash. Therefore, for the example above, the seller is unable to use the $15,300 in cash for the next four months until the contract expires or is bought back.
This post is more about wit than investing, with yesterday being the April Fool’s holiday in the United States, I thought I would have a little fun.
Why is it that the individual in charge of your money is called a broker when it seems like we are the ones broke?
Why would we call stocks and bonds securities when they are aren’t really that secure?
Why do we measure goodwill as a tangible asset only when a stock gains income but call it an impairment when the company looses money?
Why is a bull market filled with optimism, when more often than not, it is filled with BS?
Why do market leaders fear a bear market, when usually this is a bearer of good profit tidings in the next few years?
Why is debt called margin and not simply debt?
Why do the markets use the term settlements to describe a transaction occurring but don’t require attorneys for settlements?
What is another term you hear in the stock market that seems to mean something different than what it means? Let me know what you find strange.