First of all...
My overall goal for having a blog at all is to empower everyday investors with knowledge and confidence to wade into the overwhelming and complex world of investing/trading. Those who make money in these markets want to make it seem that way. It really isn’t in its simplest form. Feel free to message with with any questions, even if it is about other stocks, bonds, mutual funds or options!
What is Risk? Is it important? Do I even care?!
What is risk? Why does it even matter? Is it important to me? I want to answer these questions below and provide two investment picks. This will become my basic format for a regular post. First some fundamental topics (with the goal of each post building on the prior post) and then at least one trading or investment pick analyzed.
What is risk?
Merriam-Webster.com defines risk, as it relates to investing, “the chance that an investment (as a stock or commodity) will lose value”. This definition is concise and brings us directly to the point. The primary purpose of investing/trading is to increase the value of the initial investment. There is no other reason. Period. Some traders will post statements like, “In it for the game”, or “It’s not about the money”. Either these investors have a distorted perception of self or they are merely gamblers. It is always about the money, always. So now we know what defines risk, next we need to establish why it matters.
Why does risk matter? (***Note: To keep things simple, we are not going to bring in the step cousin…Inflation. Inflation does play a part in yield but we are going to consider it a constant across all investment options at any one time, thus negating itself from consideration in our examples.)
Have you ever wondered why a certain investment yields a return of “X” while another investment yields “Y”? The underlying manipulator is risk. Think of yield and risk as a set of twins, one following the others’ lead. Yield always follows the lead of risk. What does that mean exactly A.A., one might ask? It simply means, the higher the level of risk, the higher the expected yield and the lower the level of risk then the lower the expected yield. In other words, the closer the risk is to non-existent the closer the yield will move towards zero. Let’s explore some examples.
A Certificate of Deposit is something most people are familiar with. CDs, as they are commonly called for short, currently provide yields of 1% or less for a one year contract. Why so low you ask? The return is guaranteed and insured in most cases, so the risk to the investor is zero. So, if the risk is zero then why isn't the yield zero? The lender is willing to pay a premium for the right to have the investor’s money on deposit for a specific guaranteed amount of time. This creates a minor inconvenience to the investor and gives the lender the right to lend the money on deposit at a higher rate of return or simply meet certain reserve requirements.
A corporate or municipal bond is another item most people are familiar with. These are debt instruments issued by an entity as an alternative to bank financing or stock issuance. These provide a wide range of yields in the marketplace. Entities carry bond ratings which in turn dictate the amount of yield an investor expects in exchange for purchasing the bond. The lower the bond rating (or the lower the chances an entity can repay the bond interest payments and/or maturity value) the higher the expected yield. Risk directly impacts the cost of the bond in question and the corresponding yield.
To this point we have covered income producing investments and how risk plays a role in their value. In my opinion, it is relatively easy to see the relationship between risk and yield in income producing investments. Individual stock prices can appear more complex and harder to see the underlying correlation between risk and yield.
Stock prices are as infinite as stocks that exist. No two stock prices will be the same at any one given time, and if they are for a time the reasons are never the same, purely coincidence. So, what makes up the driving components of a stock’s market price? There are quite a few things but we will only mention a few here for sake of time. These are listed in my own personal opinion of their importance. Number one: Risk; Number two: Speculation; Number three: Demand. Now, all drivers making up stock price are ultimately related to one another and a lot of times, one driver will be dependent upon another. For example, perceived risk of a stock will drive speculation to an increase or decrease in market price. One could argue that this speculation in turn drives the demand for a stock up or down. However one may look at driving factors in establishment of stock prices in the open market, one has to acknowledge the importance of risk versus yield (or reward). It is the main factor I look for when I decide to take a position in an investment: What are the odds the investment will increase in value as opposed to lose value?
Does risk matter to me (or you in this instance)?
The resounding answer is YES, whether you realize it or accept it. Whether you are choosing allocations in your 401k, deciding on real estate to purchase or taking the extra $5,000 from your tax refund and investing/trading, risk will dictate your actions. The mention of the word risk causes some to have sweaty palms or a racing heart. The fear of risk keeps some out of investing in the market altogether. This does not have to be the case at all. My first blog stated that ALL unknowns create risk. Therefore, if the risk(s) are known then the risk is manageable and can be mitigated. Most risk cannot be entirely eliminated, but it can be greatly reduced through correct entry points, setting a reasonable stop loss and respecting it or hedging with buying or selling of options. I will not get into the topic of options as that requires multiple posts to discuss. However, good entry points and sticking to a well-planned stop loss can bring risks into a manageable area for most investors/traders.
Now on to the analysis!
My previous post discussed entry points, stop loss, resistance and support lines and today’s post discussed risk. I want to present two new investing/trading ideas below. Feel free to refer back to the previous post for help with previously covered topics, or message me any questions you might have. I want to briefly discuss Facebook (FB) and Home Depot (HD) as potential investments. Another term which may be helpful prior to moving on to the analysis is trend channel (price channel). This is when a stock develops an obvious trend (either up or down) and the price range stays within the price channel while it moves up or down overall. FB has a pretty good price channel to look at below. ***Note: When drawing a trend line, it is a good rule of thumb to have at least three closing, opening or intraday price points touch the line drawn to establish it as a line. This is also true of support and resistance lines.
Facebook (FB) for investor or trader
Facebook is an interesting stock to follow. Facebook has tremendous potential in the long-term, a decade down the road. Facebook has one of the highest user counts I know of for any social media entity or any other entity for that matter. Last count was approximately 500,000,000 accounts. Yes, half a billion. The potential to harvest advertising dollars (or any other dollars) from this “free to use” base has yet to be completely tapped. In my opinion, this is why the initial offering of FB started at $45 per share and immediately fell. Facebook may have been the largest hyped public offering in history and when it finally took place the average trader buying on the open market figured it would jump just like Apple. The problem is, Apple’s revenue stream is much easier to follow and predict than Facebook’s. This is a good thing. Why would you say that A.A.? Glad you asked. The market as a whole overreacts a large percentage of the time, especially when average investors can’t put an entity’s business model into an existing mold. Investing/trading is all about predicting present values of future cash flows when considered in the fundamental approach. Facebook proved to be a disappointment when traditional fundamentals were applied to the business activities. Facebook fell into the teens and is now trading around $30.00. Why? Well, it could be the anxiety about the potential for revenue has eased, which reduced downward pressure. Or more importantly in my opinion, investors are realizing the potential of the massive user base. I feel like Facebook will attempt to become a “homepage” little by little, where its users are able to access news, sports, a search engine, their traditional social meeting place and most importantly…shopping. This will be huge. I predict FB will edge from its current price point towards its initial offering price. The initial offering price will offer plenty of resistance. It will fall back and test that resistance line two or three times, passing it and closing above at least once (for a while). Then it will push above and the $45.00 resistance line will become a support line. From there, who can know? It will depend a lot on how Facebook can integrate all these options onto their platform and still retain their account base for social interaction.
My prediction is, FB will test $45 before the end of the year which is roughly a 50% increase. A good entry should be between today’s current price $30.60 and $29.66 with a stop loss at $27.00. This is roughly a 12% stop loss with a potential run towards $45.00. If you look at the chart, there should be resistance at $33.45 on the way up, which would be a 9% gain. A trader could sell as the stock pushes toward this resistance line and buy back again on a price dip. An investor should buy and hold for a test of $45.00, unless of course the stop loss kicks in.
FB Chart
Source: freestockcharts.com
FB Chart Review
The support lines are pretty easy to make out in this chart. They are not exact to the penny, but they are close enough to establish a good stop loss. I have included the price channel using the pinkish lines. It is clear to see the price trend is UPWARD for FB. It appears to me the price could push down below $30.00 per share to test the lower trend line (See blown up chart below for a better view. It has room to fall if the market wants to test the bottom line of the trend). This stock is a good investment and should rise during 2013.
FB Bottom Trend Line Closer View
Source: freestockcharts.com
As we can see in the Orange circle, there is room to test down to the trend line. If the market does test down, don't look for it to fall much below $29.27 as that was the low on 1/18/13 and it looks really close to the bottom edge of the extended trend line. ***Caution: The market may not test this line. If you choose to wait and the stock jumps before you take an entry, take another look at the upside potential versus the stop loss of $27.00. Depending on the jump in price, a stop loss might need to be adjusted up to $29.65 (one tick below the second support line)
Home Depot (HD)
Home Depot (HD) is at its 52 week high today. The chart provided will clearly show a dramatic upward trend. The all time high of HD is $68.92 which occurred in the last week of 1999. This is the first thing I found to be odd. Wouldn't you expect the high of a construction supply company to be its highest during the housing market boom? I sure expected my research to indicate as such. But what I found is that HD didn't break out above $45.00 per share during the entire housing boom. Granted, some may say that Home Depot caters more toward the "Harry Homeowner" than the commercial or residential contractor, but does that explain it peaking NOW and not then? More research reveals that HD purchased RedBeacon in Jan. 2012. This appears to have helped the share price from that period to present. The thing I like about HD is they are trending up during a part of the year when much of their retail territory is experiencing colder weather. This slows construction for do-it-yourselfers and professionals. Home building reports have been strong and I expect next quarter to continue the strong trend. This will do nothing but help HD and add to it that the weather will be warming up and I think sales jump in the second quarter. The charts for this stock are a bit confusing as it appears mini trends are being established inside major trends. The mini trends might be a bit lower currently than the major trend line but all the trends move upwards! Lets take a look at the trends to find some reason...
Approaching All-Time High
Source: freestockcharts.com
30 Month Trend
Source: freestockcharts.com
This 30 month trend is obviously up and up. It appears that recently the stock price has tested the lower trend line and broke through. Does this mean it will continue to fall?
One year trend
Source: freestockcharts.com
One year trend
The one year trend (in Red) is also upward although below the 30 month trend. I don't feel like it means anything other than the lower longer term trend line will probably be the resistance line for upward price movement. A bit of a concern is that the seperating lines of the one year trend are beginning to form a bull horn. This can mean the market is undecided on furture price movement. It could also mean I have not chosen the correct points on the upper line of the trend!! It happens.
Source: freestockcharts.com
Recent Month Trend
Recent month trend in Blue looks good. It is testing the high trend line with three or so days of solid, upward movement. The last picture below for HD will show a blaring resistance line exactly where the stock is stuck at this moment.
Upper Resistance Line and Support Lines
Source: freestockcharts.com
Final Analysis
This is my favorite screen shot. Some things really come together for me here. Take a look at the price movement on 12/3/12. It touched $65.92 and closed right at $65.00. This particular candle is called a DOJI and those who saw it on 12/3/12 knew it could mean a reversal of the previous upward trend and did it ever. From that point it was a downward trend touching $60.20 a share. This $60.20 touched the lower trend line for the year and bounced right back up. I like this stock even though it is at a 52 week high and 5% away from an all time high. All news for this stock and earnings should be good through quarter 3. So, after a rather lengthy analysis here is my take. The stock is trying so hard to push through that $65.92 mark and in fact it pushed above it for a little bit today. If it can close above that mark this week then we will see the price rise to meet the one year extended upper trend line around $67.00. There will be a little resistance there but I think it pushes up to $69.00 and tests the all time high sometime this summer. It should pull back a bit and push right through it to new all time highs. I predict $70+ by end of summer with good housing reports, warmer weather and increased sales. A good entry point is around $65.10 if it pulls back from its current test. A stop loss should be set at $63.50. This a 3.5% downside with about a 7% upside. Longer term this stock could be a monster if the economy continues to heal.
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