Expectational Analysis: When Opposites Attract

By Joseph Hargett

In our feature article titled "The Extra Edge" in the first issue of SENTIMENT, we introduced our unique Expectational Analysis® approach to gaining a trading edge in the market. In this issue, we drill down and focus on fundamental and technical analysis—two of the three major components of Expectational Analysis.

Fundamental and technical analysis are the main pillars of modern security analysis as practiced by Wall Street institutions and investors. The modern incarnation of technical analysis owes much to Robert D. Edwards and John Magee, who first published Technical Analysis of Stock Trends in 1948. Fundamental analysis, meanwhile, came into prominence around 1934 following the release of Benjamin Graham and David Dodd's co-authored book, Security Analysis.

The fundamental and technical approaches each have fierce adherents, and both styles of analysis include useful tools and provide valuable insights. And although many practitioners tend to line up more in one camp than another, in truth, most analysts employ some combination of these disciplines.

That said, there is often a wide gulf separating these two approaches. It's interesting to note that fundamental and technical analysts can look at the same set of data and arrive at completely contradictory conclusions. Consider this paradox: When a stock declines in price, the fundamental analyst who likes the stock will tend to look at it as an even more compelling "buy" because it's "cheaper," while the technical analyst will likely sell his long position and perhaps even short the stock because of its weakening technical outlook.

Keep in mind, while fundamental and technical analysis are crucial to our method, they're still only part of the picture. Let's attempt to break down each to provide a foundation for how they work together in our Expectational Analysis.

Fundamental Analysis

At its core, fundamental analysis examines factors such as earnings, dividends, price to earnings (P/E) ratios, and projections of the strength of the economy to forecast stock prices. For long-term investors, or the buy-and-hold crowd, these indicators carry considerable weight. But for options traders, who are likely looking at considerably shorter time frames—measured in months, weeks, or even days—these factors have considerably less impact. Options traders shouldn't completely write off fundamental analysis, however, as earnings momentum, corporate restructuring, new products or product recalls, management changes, and stock buybacks can have a dramatic and immediate impact on the underlying shares.

Let's examine how one particular fundamental indicator can offer guidance for options traders looking for an edge in judging short-term or intermediate-term moves in the market.

Earnings Reports: Earnings reports are the quarterly filings made by public companies to report their financial performance. Earnings reports are filed at the end of each quarter, with most companies filing in January, April, July, and October. A company's earnings report includes items such as net income, earnings per share, earnings from continuing operations, and net sales. Quarterly earnings reports will also often include a forecast for the coming quarter(s) and sometimes for the rest of the fiscal year.

Think of an earnings report as a "report card" for a company. These quarterly reports let shareholders know exactly how well a company has performed during the past quarter. A company's results will be compared versus the same quarter a year ago, but in today's market environment, this comparison takes a backseat to a comparison with analysts' published estimates of these earnings. Surprises can occur to the upside (stronger than expected results) or the downside (weaker than expected results). The magnitude of a stock's positive or negative earnings surprise can be a major short-term catalyst for the equity's performance. There is also a sentiment angle that we employ when dealing with corporate earnings reactions. For example, everyone is familiar with the example of the "good" quarterly earnings report—i.e., a company that tops its own guidance and Wall Street's forecasts—that meets negative price action. At Schaeffer's, we believe it is important to measure expectations surrounding the report. What are retail investors doing? Are they bidding up the price of the stock or buying call options in anticipation of a positive earnings report? Are analysts overly enthusiastic and setting overly ambitious price and profit targets? If expectations are too high, the bar is raised for what the company must report in order for the earnings to produce a positive price reaction.

Technical analysis

Unlike fundamental analysts, whose main focus is calculating and estimating a company's true worth, technical analysts are less interested in determining a security's intrinsic value. Instead, "technicians" focus on stock charts in an attempt to identify patterns and indicators that will provide an edge in determining the equity's future performance. Furthermore, technicians believe that all relevant fundamental information is reflected in the price action of a stock, that past price action can be used to forecast future price action, and that self-reinforcing "trends" can serve to keep stock prices moving in a particular direction. For options buyers, the strength and validity of a stock's trend can make or break a trade. Therefore, our method tends to favor technical indicators that can help confirm a trend and provide insight into its potential duration. Such an analysis can also be very helpful for the timing of non-directional options strategies such as iron condors and credit spreads. (For more on these strategies, read "Fortified with Iron" [Summer 2009 issue] and "Going Vertical" [Spring 2009].)

Let's take a closer look at a few of these indicators and see how options traders can utilize them to judge market trends.

Moving Averages: One of the most widely used technical tools is a moving average (the average of the closing prices for a stock over a defined number of units of time). This is a trendline that smooths out potentially sharp or erratic price action and helps to visually eliminate "noise" or irregular fluctuations in a security. Moving averages serve as workhorse indicators for many in the industry, and are commonly used to identify trends and their directions. They can also mark levels of support and resistance for a security, making them useful on multiple fronts for options traders.

Time frames for these calculations can range from one minute to several months, with 10-unit and 20-unit time frames among the most common. While there are no hard and fast rules to follow when using moving averages, the short-term nature of daily trendlines makes them particularly ideal for options traders. For example, a stock moving higher above support at its 10-day and 20-day moving averages often has an enhanced probability of continuing its uptrend.

For longer-term options trades, we have found that 50-day and 80-day moving averages can be excellent trend indicators (see Figure 1). Specifically, pullbacks to these trendlines can provide opportunities to enter a long position on a stock that has experienced a short-term decline in a longer-term uptrend. Furthermore, rallies into resistance at these moving averages can mark an opening for a short position.

One of the best examples of utilizing a moving average to help confirm a security's trend is the recent encounter between the S&P 500 Index (SPX) and its 200-day moving average (Figure 2). When the SPX approached this trendline in late May 2009, technical analysts cited the potential for major resistance, positioning it as a make-or-break case for the index's uptrend. Indeed, a rejection at this moving average could have confirmed that the SPX's long-term downtrend was still in place. However, the validity of the SPX's uptrend was confirmed when the index moved past this potential hurdle.

Support and Resistance Levels: Round numbers, "psychological" levels, retracements, Fibonacci levels, century marks, gaps—call them what you will, but they are all ultimately potential areas of support or resistance that can have dramatic effects on a stock's trend. What's more, if these regions have previously altered the course of a security's trend, there is a strong likelihood that they will do so if tested again. For instance, if a stock found support at the $50 level previously, we would expect that area to hold, at least initially, as support on subsequent tests. However, if the region is breached, the $50 level might then switch roles and act as resistance.

More often than not, these levels are also home to heavy concentrations of call or put open interest, creating additional headwinds or tailwinds for a stock when these areas are approached. For example, suppose that shares of XYZ have attracted a considerable buildup in call open interest at the $20 strike. As XYZ approaches $20 per share during expiration week, hedges related to these call options can be unwound, thereby creating selling pressure, or resistance, at the $20 level.

Relative Strength Index (RSI): Oscillators, or technical indicators that give readings within a predefined range, can also help confirm the strength of a stock's trend. Arguably the most popular is J. Welles Wilder's Relative Strength Index (RSI). The RSI is derived from a formula comparing upward and downward moves, and provides readings between 0 and 100. A high reading, typically those above 70, is defined as "overbought," and a low reading, usually near 30, is considered "oversold." (See Figure 1.)

Normally, an overbought reading is interpreted as a sell signal, while an oversold reading is viewed as a buy signal. By monitoring these signals, options traders can get a better idea as to whether a stock's trend may encounter a "speed bump" or a correction due to excessive price movement over a particular time interval. When Wilder first wrote about RSI in the late 1970s, he suggested using 14 periods. Since then, the 9-day RSI has gained some popularity, especially among options traders. The shorter 9-day period is a bit more volatile than the 14-day period, and is considered better for looking at shorter time frames, making it more suited to trading options.

SOMETHING'S MISSING

Fundamental and technical analysis each offer insight to the stock and options trader. But those insights are incomplete—and sometimes contradictory. Even taken in tandem, they go only part of the way toward explaining stock price action. Fundamental and technical analysis each overlook investor psychology. Among technical analysts, the saying is, "The trend is your friend." But we know that the chart of a strong stock can look its most attractive and compelling just ahead of a price peak that occurs because investor enthusiasm reaches such an extreme that buying power is almost completely depleted. In other words, charts often look their most bullish at tops. Likewise, if a company beats earnings expectations and guidance, fundamental analysis dictates that the firm's stock will rise. But we know that stocks often decline on strong earnings due to excessively bullish pre-earnings expectations.

It is here that Expectational Analysis can fill the void. This methodology, pioneered by Bernie Schaeffer, considers fundamental and technical analysis in the context of sentiment analysis. Examining investor sentiment not only helps to fill the gaps, but it can also provide you with an entirely new insight into the market. So, while following the financials and the trend can help improve your trading results, remember that investor psychology is equally important, and the interplay between all three factors is most important of all. Plus, markets and stocks can be irrational, and irrationality doesn't fit neatly in a trend or in an earnings report. We'll examine sentiment analysis more fully in the winter edition of SENTIMENT.

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