Making Profits by Understanding the Market Psychology

I am a big believer that the markets, especially in the short term, aren't moved by company fundamentals or any of the other logical indicators. These indicators certainly play a role, but they don't move share prices in and of themselves. There are certain catalysts that can move a share price (such as an FDA decision for a drug company), but there is another force at play that can move share prices significantly one way or the other without one of these catalysts. To understand this force it is important to understand that the market is very much a human driven entity and thus it can be psychologically studied.

In many of the articles that I have previously written I have used certain wording and talked in generalities, purposely leaving some information out and including some correct but overall purposeless information. I did this because I was trying to provoke a response to these certain elements in order to more closely study the overall market psychology. There are times when people did not respond at all to items that I thought to be very provocative and times when people responded negatively to items that I initially thought to be harmless.

My conclusion from this and from my other close studies of the psychology of the financial markets is that people, perhaps without even knowing it, trade and invest as one "herd". I have found signs of this "herd mentality" in every aspect of the financial markets.

I have collected enough information that I feel comfortable making the following generalizations about the "herds" of the financial markets:

1. No matter how bad things may get, the herd still wants to be long stocks.


2. The herd is very short tempered with people on the short side.


3. If, on the rare occasion, a herd does go "short" something...watch out below for that stock.


4. The herd, as is normal human tendency, will do everything possible to defend their positions even if they are proven wrong time and again.


5. The herd plays favorites with certain companies.


6. The herd will ignore it when the "writing is on the wall" (By this I mean that sometimes things are just blatantly obvious and yet the herd will hold on and go down with the ship...just ask Joe Lewis about this)

I don't think that people trade or invest in herds intentionally, but rather the "herd" is formed when an overwhelming majority of traders and investors make the same decisions based upon the same information. Take for example the bank stocks in 2008 after the write downs had been priced into the shares (the write downs would classify as a catalyst). In many cases, the "herd" decision to continue putting selling pressure on the banks stocks was a result of bad fundamentals, so this would seem to contradict my earlier assertion that stocks don't move on fundamentals in the short term. Though I admit that sometimes a stock can move on short term fundamentals, the existence of the herd mentality is proved when the herd sells off shares of a company that is in the same industry as the one with the poor fundamentals despite the fundamentals of industry competitors being perfectly good still. Back to my example of the bank stocks, once a few stocks were sold off due to poor fundamentals or big write downs, even the healthier banks saw their share prices fall sometimes just as much as the banks with the tremendous write downs.

This is simply a result of a logical human decision process that goes something like this: If bank A and bank B have had these tremendous write downs then bank C probably will sometime in the future. The logic is perfectly sound and I think that it is a very natural human logic. It can be found everywhere in the market, the fact that so many people buy into this very type of logic is what forms the herd mentality. The question now becomes "how do I profit from understanding this market psychology?"

Well, as I said earlier, this "herd mentality" can be found everywhere in the financial markets not just in the stock market. So, the way that I answer the question of how to profit from the herd mentality is that I look to the herd in the options market. Stock options, and in particular LEAPS, are good indicators of what the market players think is going to happen to a stock in the future. The options market has a herd (albeit a much smaller one) just like the stock market does and if you look for just the right indicators, you can make a generalization about the future of certain stock prices based upon where the money of the options market herd is going.

What I look for is levels of high open interest either on the put or call side. If I find an abnormally high open interest level I first search the headlines to see if there is any glaringly obvious reason for why the open interest would be so high. If I find a reason then I usually move on, but if I don't I then apply a set of strict rules which will help to further weed out the options which are unsuitable for this strategy.

Firstly, the option indicators are basically useless if the option is too thinly traded. In the thinly traded options, one person could hold a large position that is skewing the options for that particular equity and it would certainly not be wise to take up a position based upon one other individual's conviction about a stock. There is no definitive rule that I follow here, but do look for consistent daily volumes of 500-2,500 minimum and open interest levels of at least 5,000.

The next rule is that you have to compare apples to apples. By this I mean that if you find an abnormally high open interest for a call or put you have to compare it to it's equivalent put or call. For example, say a stock is trading at 53 and the 60 calls are showing an outrageously high open interest. I have found that many people, in finding abnormal open interest levels, simply will compare these 60 calls to the 60 puts. While I do calculate the same strike ratio, I don't think that this is as important as what I call the "straddle strike" ratio. The straddle strike ratio calculates the ratio of the open interest in the 60 calls against the open interest in the 45 puts. I find this to be important because it calculates how many options are outstanding that are making the exact inverse bet on the share price as the 60 calls. 45 puts are the exact inverse of 60 calls in this situation because they are each two strikes away from the actual price in their own direction. I also calculate the opposite ratio which measures the ratio between the calls with the highest open interest and the puts with the highest open interest, regardless of strike.

While these three ratios are all important in deciding if an open interest level would be classified as abnormally high, perhaps the most important indicator is the total call to total put ratio. This is calculated simply by adding up the open interest on all the calls and dividing that by the total open interest for all of the puts. This total ratio ensures that apples are being compared to apples.

Again there is no definitive rule for what ratios to look for. Some people are more comfortable than others making a generalization about a share based upon lower ratios, but I generally look for all ratios to be at least 2-1 with the exception of the total ratio where I look for 1.5-1.

The next rule that is important to follow is that you have to look at recent share performance to determine if whatever is causing the abnormal options open interest has already been priced into the stock's share price. This will have to be purely a judgement call, but sometimes it is blatantly obvious. The positive note is that you can always wait a little while and then re-evaluate because the LEAPS are not going anywhere.

The last and perhaps most important rule is that you have to continually evaluate your position. It is important to remember that the options market is highly liquid and full of speculators who can change positions at any moment. You must continually monitor the options that you are using as your indicator to ensure that you are still on the same side as the herd.

I have employed this strategy of using the options market for some time now and have seen an astonishing 70% success rate thus far and more often than not, the times that I am wrong are times that I have violated my own rules. My most profitable move yet based on this strategy was taking a short position in Bear Stearns based upon the January 2008 LEAPS.

In taking a close look at the January 2009 LEAPS, two stocks in particular that stand out are Kraft (KFT) and Sears Holdings (SHLD). The ratios for these two companies are as follows:

These ratios all lean toward the bullish side of these two companies and all of the criteria mentioned above is met. It is still important to remember that though the options market can provide a good indicator of future expectations, it is not correct all of the time. The options market "herd" can indeed be incorrect.

There is a further risk that the situation for either Kraft or Sears Holdings could deteriorate and the options indicators could change. With close observation though, this risk can be mitigated.

In the end, market psychology is one more tool to put in your tool box. In my experience, the options market is a good way to use the market psychology to an advantage. I wouldn't recommend changing your entire portfolio based upon this one strategy, but I thinking adding a few stocks based upon it is not an entirely bad idea.

The bottom line is that, though the herd mentality does not always make the correct decision, it does carry a significant amount of money and influence into the marketplace. I think that you can use the herd to piggyback your way to a little profit, but it does take careful study of each individual stock in order to fully understand the psychology at work.

(disclosure: author hold a long position in SHLD and KFT)

Happy Investing

InglefoX

Is the Goldman Sachs Pedestal Real?

One thing I've noticed among college students, academics and business professionals alike is that the name Goldman Sachs (GS) turns heads. People react with a sense of awe toward Goldman and most of these people probably could not even explain the first thing about Goldman outside of the fact that they are an investment bank. (Score one for Goldman's marketing and branding efforts) It had me thinking that if everyone reacted this way to Goldman, are there perhaps boatloads of people that put money into Goldman's stock not based upon a fundamental understanding of Goldman's business but based upon their name.

If you need proof of the blind investments that people often make then look no further than to any episode of Jim Cramer's Mad Money. All you need to do is watch one segment of Cramer's show and watch the live ticker at the bottom of the screen immediately run rampant with trades of whatever stock Cramer has just recommended. If this blind rationale occurs in the after-hours market based upon Cramer's name isn't it just as possible that this type of blind rationale occurs at an even greater pace based upon Goldman Sachs's name?

I don't want to doubt Goldman's ability to make money nor do I want to refute the claim that they are probably the strongest of the investment banks. What I do see though is that investors place Goldman on a pedestal and this pedestal perhaps doesn't allow Goldman's stock to trade at the level that it would be valued at without the pedestal in place.

Let's take a quick look at the numbers. Goldman Sachs has shown phenomenal earnings in some of the toughest market conditions. Their recent second quarter numbers were still down 11% despite their proven risk management abilities which have been heralded as some of the best in the business. The drop in their numbers still shows that they are susceptible to unseen market swings and that it is virtually impossible for them to make every single correct decision. That being said, their numbers are still far superior to anything that their peers are posting. The only number that Goldman posts which may be a turn-off for the more finicky investor is a negative enterprise value 463 billion.

If the Goldman Sachs pedestal is real then how could it come crumbling down and bring Goldman's share price with it? Well, the first thing that would bring them down would be weaker earnings and though it's certainly possible that the market could turn unfavorably, I don't think that would effect Goldman's earnings more than by 10% or so because they operate such a diversified business. Below is a graph provided by Goldman Sachs of their revenue sources by percentage.

Source: Goldman Sachs

The one issue that could hurt Goldman and its pedestal the most would be if somehow the high public opinion of Goldman which props up the pedestal were changed into public disfavor. If this were to happen then it would most likely arise out of the business model which has been Goldman's key to success. By this I mean that this business model, which may be perfect for Goldman to maximize earnings and decrease losses, can lead to a multitude of conflicts of interest many of which Goldman simply brushes aside.

Look to last May for an example of this when Goldman gave a "sell short" recommendation on Washington Mutual's stock (WM). Though a "sell short" recommendation is a fairly rare occurrence on Wall Street, what made this particular one even more rare is that Washington Mutual is a client of Goldman Sachs. It was not long after Goldman had underwritten Washington Mutual's 7 billion dollar recapitalization and earned millions in fees from WaMu on this deal that Goldman was now telling their clients to sell WaMu's stock short.

Goldman Sachs also was dismissed from contention by the government of the city of Chicago for an advisory role on the possible sale of Midway Airport after Chicago's government had learned that Goldman was actively pursuing ownership into UK based airport operating group BAA, which was viewed as one of the potential bidders for Midway. Many might argue Goldman had an ethical responsibility to inform the city of Chicago of this potential conflict rather then letting them find out about if for themselves. Instead Goldman of doing so, Goldman pursued the advising deal without informing the city of this possible conflict of interest.

Goldman's conflicts of interest with their attempted BAA deal goes deeper than their Midway advisory bid. Just after the Spanish group Ferrovial launched a hostile bid for BAA, management at BAA invited Goldman Sachs to do a pitch for an advising role that would advise them about how to fend of Ferrovial's bid. Instead of doing a pitch for the advising role, though, Goldman banker Bill Young recommended to BAA's management that they sell themselves to a special investment vehicle spearheaded by Goldman Sachs. Needless to say, Goldman did not get the advising job and launched their own bid for BAA.

In all of the above cases Goldman Sach's will defend itself by claiming that they are protected by the firm's "Chinese Wall". For those of you not familiar with the Street lingo of the "Chinese Wall", it is the ethical responsibility of members within the various divisions of financial institutions to remain separate from the other divisions of the institution to prevent leaks of information that may lead to conflicts of interest. In the case of Goldman Sachs, a Chinese Wall is said to exist between the corporate advisory business and the mergers & acquisitions business.

The problem with the Chinese Wall in firms as large as Goldman Sachs is that they are never really airtight. The conflicts of interest problem is not solved by the Chinese Wall which leads to the greater question "can a financial institution combine M&A activities and advising/underwriting businesses and truly avoid conflict of interest?"

With the government beginning to play a greater role in oversight of the investment banks, it seems as though it is only a matter of time until the multitude of the conflicts of interest at the investment banks is brought to light and brought under public scrutiny. If this happens then I see the Goldman pedestal crumbling and their share price crumbling with it.

As mentioned earlier in this article part of the reason that Goldman has been so effective at risk management is that they are extremely diversified in their various businesses. The problem with this is that many of the various businesses fall on opposite sides of the Chinese wall. If government oversight increases drastically (and it is already beginning to) it is not outside the realm of possibility that new, radical laws could be enacted along the lines of Glass-Steagall, which in this case would separate M&A from advising. If this were to happen then the diversified business model which has led to superior risk management for Goldman would be in serious jeopardy.

Government scrutiny over the manipulation of short sellers could also be a thorn in the side for Goldman and a potential threat to their pedestal. Though it was Goldman complaining recently that their own shares were being manipulated by short-sellers, they have found themselves on the other side of this table as well. Goldman's executives were confronted by executives from Lehman Brothers (LEH) and Bear Stearns, which is now part of JP Morgan Chase, regarding Goldman's manipulation of their respective stocks. Bear Stearns CEO Alan Schwartz confronted Goldman CEO Lloyd Blankfein to ask if Blankfein had any knowledge as to the rumors that Goldman's London office engaged in manipulation (false rumor spreading) of Bear Stearns's stock just prior to its collapse. Lehman's Richard Fuld contacted Blankfein just recently and told him he was "hearing a lot of noise" that false rumors about Lehman, which was experiencing all time lows in its share price, were coming from the Goldman traders. If these issues are made even more public and the government launches a full scale investigation into them then I would certainly look for investor confidence to put downward pressure on Goldman's share price and deteriorate their pedestal.

A quick look at the price to book value of the company based upon the book value for the most
recent quarter and the price as of July 18, 2008 shows a value of 1.71. If that is compared to the industry peers of Citigroup (C), Lehman Brothers (LEH), Merrill Lynch (MER), Morgan Stanley (MS) and JP Morgan Chase (JPM) the Goldman Sachs value is much higher than any with the above companies reporting .87, .54, 1.18, 1.27 and 1.10 respectively.
With a price to book value that much higher than that of its peers, I am left to wonder just how much of that, if any can be attributed to the Goldman Sachs pedestal. Perhaps part of it is attributable to the Goldman Sachs pedestal, but it is also very possible that part of it is due to investors pulling money out of the stock of Goldman's competitors and putting their money into Goldman, which is viewed as far more stable.

If anything were to happen to the Goldman pedestal I think they would still trade at a price to book value of at least 1.4, which would still be better than all of their peers. At a price to book of 1.4, the stock price would be at $150. This price certainly wouldn't signal an end of the world to Goldman or to Wall Street and would still reflect Goldman's superior capabilities it just wouldn't reflect the pedestal any longer.

When all is said and done I cannot deny that Goldman Sachs is indeed a profitable and well managed company. I do believe that they trade on a pedestal in the minds of investors and that pedestal is working to inflate the stock price somewhat. If it this pedestal were to crumble either from government action or negative public opinion then the stock probably would fall and be a good opportunity for a put option investor to pick up a quick chunk of cash. That trade would certainly carry some risk, but if you're not willing to take any risk then the options market certainly is not where you belong anyway.

Happy Trading

InglefoX

Trouble on the Horizon for the Brokers?

We all know that the brokers play an integral part in both trading and investing. Everyone who trades needs a brokerage account and some people have multiple accounts with various brokers. These brokers make their money based upon the commissions that they receive, generally on a per trade basis. This has been a profitable model for these brokers as the market conditions of years past have been bullish which encourages people to put their money to work in the financial markets. The more money people put to work in the markets the more commissions the brokers can earn. But with thoughts of a recession looming a recent rash of people pulling money out of play in the markets should mean that the brokers' main source of revenue, their commissions, will fall drastically.
This expectation should lead the stocks of these brokers such as Optionsxpress Holdings (OXPS), The Charles Schwab Corporation (SCHW) and Interactive Brokers Group (IBKR) to fall. In fact, the thought of recession has led to recent declines in the prices of all three of these stocks. What is the problem then? The issue is with the market expectations that these companies are still going to make windfall profits. Under the conditions of tough credit and a market that has seen capital fleeing over the past quarter, it is baffling as to how the analysts can still claim that all three of these brokers (OXPS, SCHW, IBKR) are going to exceed their earnings from the same period last quarter. The stocks are falling for a reason right? And a stock price generally shouldn't fall on a company that is making more money every single quarter.
For the quarter ended June 8, 2008, analysts have given OptionXpress a mean earnings estimate of $0.39 a share versus actual earnings of just $0.35 a share for the same period last year. For The Charles Schwab Corporation that estimate is $0.26 per share versus an actual of $0.23 for the same period last year and Interactive Brokers Group has been give a $0.49 a share mean estimate despite just earning $0.33 a share for the same period last year.
It is important to realize that these companies have other sources of income other than just their brokerage commissions. They operate some proprietary trading and collect a significant amount of interest from margin accounts. The margin interest is also likely to suffer from having a lesser amount of capital entry into the markets and even if these companies were able to keep interest and trading income equal to last year's levels, there is still no possibility that they could have brought in the same amount of brokerage commissions.
The bottom line is that it seems as though these companies are set up to disappoint the market when they report for this most recent quarter. OptionsXpress will report on July 15, The Charles Schwab Corporation on July 14 and Interactive Brokers Group on July 21. If one of them reports lower than expected earnings look for the market to then price in lower earnings for the entire group, but until that happens this can be a great opportunity particularly for you traders out there. These look like prime put option opportunities if you can get in before any fall in expectations takes place. In the long run though the market will rebound and that is the time for those of you who are long term investors to swoop in and pick up these companies, which are actually quite well managed companies, at bargain prices.
Happy investing...happy trading

InglefoX
(disclosure: author is short OXPS)