Value Wagering

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Gambling On Stocks

Determining the fair short-term (trading) price of a stock can be a very tricky business that it is altogether different than attempting to discern enduring worth or value. Countless volumes have been written about the latter, but very little academic research has been expended on the former. The overriding reason for this, of course, is the perceived futility of such an effort. Indeed, if the “dot com” mania taught us anything it is that current price and long-term value don’t always harmoniously coexist, and that the success of the long-touted “buy and hold” strategy is strongly dependent on what one buys and at what price.
Unfortunately, the buying hysteria that infested the market in the late 90’s (and the subsequent crash in the new millennium) only served to confirm what so many already believed. Mainly, that stock trading is merely a glorified form of gambling and, as such, is doomed to failure. Well, I think it’s certainly true that stock trading is gambling, but I disagree that its pursuit must ultimately end in financial ruin.

To begin with, trading stocks is the only gamble I know of that at least offers a positive expectation. Historically, the Dow Jones Industrial Average, a perennial benchmark of market performance, has increased by slightly more than 10% per annum. Although flat fee structures give an advantage to those with more money to risk (unlike most other forms of gambling), this means that even those relying on nothing more sophisticated than a stock listing and some darts stand a reasonable chance of profiting in the trading game. Compare that to sports gaming where the fee (known as the vigorish) is typically 9-10% per bet, or pari-mutuel wagering, where the fee (or take) can exceed 25%.

Yet, all these “games of chance” can and have been beaten. What ultimately separates the winners from the losers, is the relative level of skill and knowledge that each participant brings to them. Unlike casino games (where players compete against the unyielding “house”), these forms of gambling exist in a competitive environment. Stock prices are established by the relative amounts of buying and selling. The more demand for a particular stock, the higher its price will be. Similarly, sports betting lines and odds are set and adjusted based on the amounts wagered on one team or the other — with the goal of the bookmaker to have equal amounts bet on each. And pari-mutuel wagering directly reflects the proportion bet on every contestant (minus the take). Thus, winning and losing is not left solely to chance.

The fortunes acquired and squandered during the boom/bust cycle of the technology sector was not the inevitable result of gambling but, rather, the inevitable result of poor money management, which is vital to the success of any speculative venture. To illustrate this, a look at two very similar high-flying stocks from that period is instructive.

Online bookseller Amazon.com looked like a stock trader’s answered prayer after posting four consecutive price increases and closing at just a shade over $105* on April 23, 1999, but was it really? A closer look reveals the stock was already quite overextended at that point, with an average (volume-adjusted) closing price of roughly $69 since the beginning of the year. This means that any “reasonable” buy would necessarily occur at a level with a great deal of overhead supply.

In his book, “How To Make Money In Stocks,” William O’ Neil explains the danger of this:

“If a stock advances from $25 to $40, then declines back to $30, most of the people who bought late in the upper $30s and at $40 will have a loss in the stock unless they were quick to sell and cut their loss (which most people don’t do). Therefore, if the stock later increases to the high $30s or $40 area, all the investors that had losses can now get out even… it is normal that a number of these people will sell when they see a chance to get their money back.”

In the case of Amazon, the sell-off would likely be triggered by much smaller advances and be far more severe, as the initial price drop would be considerably greater than that in the example cited by Mr. O’ Neil. The wise gamble would be to wait for a consolidation — marked by a smaller spread between the current and mean price (established during the past 30-60 days of trading). At the height of the rampant buying that characterized the 90’s market boom, this means that one would have surely missed out on a great number of “runaway” stocks, but a successful gambler simply must minimize risk.

So what happened? Well, proving that hindsight is, indeed, 20/20 Amazon did exactly what was feared, dropping below $69 for the first time on May 5th, rallying briefly a week later, and then continuing a pattern of smaller gains and declines for the next two months. Eventually, on July 22, a huge increase in volume started yet another sell-off that culminated with a new yearly low of $41 on August 5. It was at this point, that the situation finally stabilized. During the next month, buyers once again reasserted themselves, as increases in volume led to higher prices a whopping 85% of the time. With most of the previous overhead supply now flushed out, it seemed reasonable to surmise that any subsequent push past $69 would meet only mild resistance. On September 29, that objective was achieved. Amazon opened at 66 1/2, reached a low of 65 3/4, and then stormed past all financial and psychological barriers to close at 80 3/4 on a tremendous upsurge of volume.

Unlike Amazon, Books-A-Million was not confined to the Internet. With headquarters in Birmingham, Alabama, and trading on the NASDQ exchange under the ticker symbol BAMM, Books-A-Million continues to operate a chain of retail bookstores throughout the southeastern United States. In 1999, BAMM was one of several booksellers that went online in an attempt to challenge the Seattle-based Amazon for cyber supremacy.

On February 4 of that year, more than 12 million shares of BAMM were traded — nearly twelve times it’s normal volume — as the price surged from 10 5/8 to 13 7/8. Furthermore, it’s average closing price was a very reasonable $13.35, so greater advancement seemed quite possible. Yet, despite this, a smart gambler wouldn’t have touched it. Since the beginning of the year, BAMM had increased in price just 6 times in 23 trading days. On February 4, the stock actually reached a high of 17, but couldn’t sustain it. These are very negative trends, and whether you’re gambling on sporting events, playing the horses, or trading stocks, going against the prevailing flow is a sure way to financial distress.

In “Winning On Wall Street,” author Martin Zweig sums it up perfectly: “In playing the market, remember you must deal with probabilities, employ sensible strategies to limit risk, and get aggressive only when conditions warrant… I’m a trend follower, not a trend fighter.”

Books-A-Million repeated this pattern of regular decline followed by big volume and mammoth price increases (nine times in excess of 10%) throughout the year. Only towards the end of the calendar, did this begin to change.

Just 394,700 shares of BAMM were traded on October 29, 1999, but that was more than double the 30-day moving average of 182,887, and it resulted in a mild (7%) price increase. Unlike the past, however, this time the overall price trend was decidedly positive, with 15 winning days offset by only 11 losing ones. On days with increased volume, the record was a gaudy 10-5. A buy here, somewhere between $8 and $9 would’ve led to a nice short-term profit as BAMM reached a high of $12 just 18 days later (and traded above $10 from November 12 to December 14).

So, remember: trading stocks is no different in principle than any other type of competitive wagering. To be successful, you’re going to have to work at it. Keep records, test your theories and the theories of others (preferably on paper first), and don’t let your ego dull your senses. There is no such thing as a sure thing. Secretariat lost horse races, Michael Jordan missed big shots, and stalwart companies have lost stature and value.

In the words of Bernard Baruch: “Don’t expect to be right all the time. If you have made a mistake, cut your losses as quickly as possible.”

*All prices referred to have been adjusted for stock splits if applicable.

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October 23, 2010 - Posted by | Uncategorized | , , , , , , , ,

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