You’ll find the stock’s volume, as well as its average daily volume over the past 13 weeks, listed on the page. When the day’s volume is consid- erably higher than average, then you can use that insight to analyze the significance of the stock price’s move.
The ABC’s of Beta
Beta, or the beta coefficient, is one of those rare market indicators that both fundamental and technical analysts can agree has value. Beta is a statistical measure of how volatile a stock is relative to the stock market at large. You might recall, from Chapter 11, how beta is used in the capital asset pricing model used to build a discounted cash flow model.
While beta is based on a somewhat complex statistical technique, as an inves- tor, most of what you need is pretty simple. If an individual stock has a beta of 1, that means it is equally volatile as the general stock market. If beta is less than 1, then the stock tends to swing up and down less than the market. And if a stock’s beta is greater than 1, it is less volatile than the market.
A technical analyst might look at beta to provide clues on how wild to expect a stock’s ups and downs to be. Beta is available from nearly all financial Web sites.
The long and short of short interest
It might seem strange, but there may be other investors who are hoping, and betting, that a stock you own will go down. These investors, called short sell- ers, use a series of maneuvers to position themselves to profit if a stock falls.
Investors short a stock by first borrowing shares from another investor who owns them. The short seller, then, turns around and sells the shares imme- diately, pockets the proceeds and waits. The short seller then must buy the shares, hopefully at a lower price, and return them to the investor they bor- rowed from. If the stock falls, the investor makes money by buying the shares back at a lower cost than they sold them for.
You might never decide to bet against a stock yourself. But it may be useful for a fundamental analyst to know just how many people are shorting a stock they do own. There are three things to pay attention to when it comes to short interest:
✓ Short interest: A stock’s short interest is a measurement of how many shares of a company’s stock have been sold short.
Just looking at short interest doesn’t tell you a whole lot. A company with more shares outstanding, or shares in investors’ hands, would natu- rally have more short interest than a company with fewer shares out- standing. You’ll want to compare short interest with another measure to get proper perspective, as I describe below.
✓ Average daily share volume: Remember volume, mentioned above?
This data will be helpful again in interpreting how significant short inter- est is by putting short interest into perspective.
✓ Days to cover: Days to cover tells you how large a company’s short inter- est really is. Days to cover is calculated by dividing a stock’s short inter- est by its average daily volume. This statistic indicates how many days of typical trading it would take for the number of shares being shorted to trade hands.
The higher a stock’s days to cover is, the more heavily shorted it is. Fortunately, all three types of shorting data described above are available at Nasdaq.com.
Just enter a stock’s symbol into the site and a window will pop open. Click on the Short Interest option listed below where it says “Fundamentals.”
Determining what short interest means to a fundamental analyst is bit tricky.
Some fundamental analysts actually like to see a stock that’s heavily shorted.
If you’re completely confident in your fundamental analysis and know what a company is worth, and believe the stock is undervalued, heavy short interest can actually be a good thing. When stocks are heavily shorted, if the com- pany delivers solid earnings, investors who shorted the stock may scurry to buy back the stock.
A rush by nervous short sellers to buy back a stock they wrongly bet against is called a short squeeze. Short squeezes can cause powerful stock rallies.
But fundamental analysts tend to view a heavily shorted stock as a warning sign. After all, an investor who shorts a stock is exposed to a theoretically infinite loss, since there’s no real limit to how high a stock can rise. If inves- tors are that confident a stock is going to fall, you want to make absolutely sure you’ve done a complete job with your fundamental analysis.
Keeping a Close Eye on Options
To be sure, fundamental analysis is all about knowing how to study a com- pany from top to bottom and understand what it’s really worth. A classic fundamental analyst only pays attention to a market price for a stock when deciding whether it’s undervalued and should be bought, or overvalued and should be sold.
And for the most part, looking at the stock’s current price is enough to tell you what the market measures a stock’s value to be. A stock price is the result of a vigorous back-and-forth between buyers and sellers. Through an auction, conducted largely over vast and rapid electronic trading networks, a stock’s price rises and falls until buyers are satisfied with the price they’re paying, and sellers are OK with the price they’re getting.
But there’s an entirely separate layer of trading that takes place beyond the buying and selling of the stock itself in the options market. Options are finan- cial contracts that give investors the right, but not the obligation, to buy or sell stocks at a prearranged price at a set time in the future.
Watching the prices of stock options can give you a better idea of not only what investors are willing to pay for stocks now, but their belief of where a stock might be in the future. You might want to factor in the prices of options in your fundamental analysis.
Understanding the types of options
Options come in two most basic forms, put options and call options. Put options give investors the right, but not the obligation, to sell a stock at a predetermined price at a set time in the future. Call options, on the other hand, give investors the right, but not the obligation, to buy a stock at a pre- determined price at a set time in the future.
Investors may buy and sell both put and call options, driving their prices up and down, just as they would trade stocks. Table 19-2 shows you the four most basic options strategies, which you’ll want to understand in order to know how to interpret prices on options.
Table 19-2 The Four Basic Options Strategies
Calls Puts
Buy A bet the stock
price will rise.
A bet the stock price will fall
Sell A bet the stock
price will fall.
A bet the stock will rise
Paying attention to put and call price levels
If you want to get an idea of what investors are expecting from a stock, you’ll want to take a look at its option chain. An option chain tells you how much investors are paying for both put and call options that expire, or come due, at different times in the future.
Option chains are usually sorted by strike price, or the price at which the option kicks in. For instance, imagine you bought a call option for stock ABC at a strike price of $25 that expires in December. That means you have the right, but not the obligation, to buy the stock at $25 a share in December.
Fast-forward to November. Imagine the stock is now trading at $100 a share.
Suddenly, having the right to buy a $100-a-share stock for just $25 a share is valuable, or in the money. However, if instead of trading for $100 a share, what if the stock is trading for $2.50? Not many people would want the right to buy a $2.50 stock for $25. At that point, your option is considered to be out of the money.
If you start noticing the price of call options with strike prices above the cur- rent market price going up, that’s an indication investors are expecting good things from the stock in the future.
Some technical analysts also pay attention to the volume, or level of trading activity, in options, too. In fact, the amount of trading in put and call options is the basis of another thing technical analysts watch, the put-to-call ratio, dis- cussed below.
Watching the put-to-call ratio
Now that you understand what puts and calls are, you might wonder how you might put the information to use. Again, as a fundamental analyst, you’re
short-term trading noise. But, monitoring the level of puts and calls can tell you how many other investors either agree, or disagree, with your assess- ment of a company’s value.
The put-to-call ratio gives investors a quick look at how bullish or bearish investors are on a stock’s prospects. The ratio is simply the number of puts (which are bearish) divided by the number of calls (which are bullish).
The higher a stock’s put-to-call ratio, the more pessimistic investors are about a stock’s future.
You could calculate a stock’s put-to-call ratio yourself, but it’s easier to use online resources that do it for you. You can get the put-to-call ratio from Schaeffer’s Investment Research at www.schaeffersresearch.com. Enter the stock’s symbol in the upper right-hand corner and click the ‘get quote’
button. Scroll down and click on the Put/Call Open Interest Ratio option, and you’ll see the put-call ratio plotted for you.
Using the market’s fear gauge: The Vix
One of the great strengths of fundamental analysis is that it gives you a frame- work to assess how much a business is worth. That way you can make an intelligent decision on whether the stock’s price is higher or lower than the business’ value. Fundamental analysts, in fact, often get their best deals when other investors are afraid to buy stocks and push stock prices down. Warren Buffett, in his 1986 letter to shareholders, put it this way: “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
One of the biggest reasons why fundamental analysts might choose to pay attention to technical analysis and options is that they may help you see when other investors are feeling greedy and when they’re feeling nervous. And when they’re nervous, you can be greedy.
There are many ways to get an idea of when other investors are fearful, which is valuable information for fundamental analysts. One popular indictor of investors’ fear is based on options trading. This indictor, called the Chicago Board of Options Exchange Volatility Index or Vix, is often looked at as a pretty valuable measure of investors’ fear. When the Vix is rising, that means inves- tors are getting increasingly nervous. And when the Vix is falling, that means investors are getting complacent.
You can obtain current values of the Vix from the CBOE at http://www.
cboe.com/data/mktstat.aspx. Historical values of the Vix are available at http://www.cboe.com/micro/vix/historical.aspx. Most financial Web sites will also let you plot the Vix, if you enter the symbol. For instance,
Applying Technical Analysis Techniques to Fundamental Analysis
As you’ve probably picked up from earlier in the chapter, fundamental ana- lysts and technical analysts take very different approaches when checking out stocks. If you put technical analysts and fundamental analysts in a room, while a fight not break out, there certainly would be some dirty looks being exchanged.
Perhaps you’re reading this book because you disagree with technical analy- sis for the reasons highlighted above. Maybe you’ve tried technical analysis before and gotten burned. Still, even if you’re primarily interested in a com- pany’s fundamentals, don’t assume this chapter doesn’t apply to you. While technical analysis is often a dirty word among fundamental analysts, there are some techniques used by technical analysts that can easily be carried over to fundamental analysis.
In the sections above, you find out how to add technical analysis to your investment style. You may have skipped that section, figuring you want noth- ing to do with technical analysis.
But in this section, I attempt to show you ways to some tricks and techniques used by technical analysts directly to fundamental analysis. This isn’t as strange as it might seem. After all, realize one of the most valuable things technical analysts do is turn mountains of complex numerical data into charts and graphs. Numbers that are indecipherable in huge spreadsheets can suddenly become enlightening when turned into a chart. Suddenly, charts can help investors quickly spot trends in data they might have other- wise of missed.
Even if you’re a die-hard fundamental analyst, there is something to be said about placing investment data on charts that can be closely studied. In fact, the technical analysts are onto something when it comes to a few of their techniques, which can be applied to fundamental analysis.
One of the great drawbacks of fundamental analysis is timing. A cheap stock, based on fundamental analysis, can get even cheaper if it has technical trends working against it. By applying some of the tricks of the technical analysis trade to fundamental analysis, you might spot trends you might have over- looked if you were just focusing on the income statement and balance sheet.
Giving fundamental data the technical analysis treatment
Some technical analysts love charts so much, they might even plot out some data that are traditionally considered to be for fundamental analysts. Even if you’re not onboard with technical analysis, there’s no question that some- times, seeing fundamental data presented graphically may help you spot trends.
Plotting fundamental information, rather than just looking at table stuffed with data, may give you a unique perspective and help you to spot trends you didn’t notice before.
Price-to-earnings ratios, or P-Es, and dividend yields are two of the fundamen- tal pieces of data that technical analysts most often will place on a chart.
Looking at how P-E ratios are rising, or falling, over time can help you deter- mine whether or not investors are getting overly giddy or cautious about a stock. You can read about the P-E ratio in more detail in Chapter 8 and the dividend yield in Chapter 10.
Slapping fundamental information on a chart may bring to light trends your eyes glanced over. And there are online tools that make this pretty easy to do. Nasdaq.com, for instance, provides a free charting service that allows you to plot both P-E ratios and dividend yields. You can do this by following these steps.
1. Log onto Nasdaq’s site at www.nasdaq.com.