Tuesday, January 15, 2013

PEP, BKD, LAMR: Tough Choices

First the numbers: I tracked precisely 1,000 stocks and exchange-traded funds in my analysis of Monday's market action.

Sixteen of them broke beyond their 20-day price channels to give a trading signal, 14 to the bull side and two to the bear side.

Of those 16, eight were excluded under my rules because they have earnings announcements coming within a month.

Of the remaining eight, five dropped back into their price channels in today's trading and so failed the confirmation test.

That leaves three, all to the bull side, and as it turns out, each is flawed in some way that makes the trading decision less than straightforward.

In the grafs that follow, I'll walking through my decision process using the historical data, back to January 2009, that I've added to my analytical mix. The data allows me to calculate success rates and average returns on each stock's winning trades. Put more simply, the data gives me what I need to calculate the odds of success.

The most liquid of the three stocks is PepsiCo Inc. (PEP), the giant soft-drink maker. It trades 5 million shares a day and so has an excellent selection of options with high open interest and narrow spreads. It has return on equity of 30%.

Most important, PEP has success rate of 53% in breakouts to the upside. That's sufficient edge if the successful breakouts are productive -- if they produce sufficient profit.

But in the case of PEP, the average return on successful bullish trades is only 3.4%, which works out to 1.8% when adjusted for the success rate. That's not enough return in my book to make the trade worthwhile. Generally, I'm looking for 5% or greater.

Brookdale Senior Living Inc. (BKD), a national assisted living chain headquartered in Brentwood, Tennessee, that operates more than 550 living facilities for seniors with 52,000 residents.

BKD is is less liquid than PEP, trading 883,000 shares a day, and that shows in the options grid, which has a limited selection of strike prices.

The bid/ask spreads aren't awful, but the open interest is. In order to create my preferred vertical options spread for the opening position, I would have a choice of two put strike prices having open interest, one in the low double digits and one in the singles. I can't trade something that illiquid.

Moreover, BKD has a negative return on equity, -3%, with debt that is nearly double equity. It's not a firm rule, but I have a strong prejudice against opening bull positions on companies that have a negative return.

Also, BKD has an upside success rate of 47.1%; its bullish breakouts lose money more often than they make it, which is a deal-killer under the methods I use for trading now. Even so, the return on those successful trades is 26.1% on average, giving BKD the highest adjusted yield of the three, at 12.3%.

The third prospect is Lamar Advertising Inc. (LAMR), a Baton Rouge, Louisiana outdoor advertising company with 143,000 billboard displays in 44 states, Canada and Puerto Rico. Lamar trades 632,000 shares a day. Counter intuitively, it has a broader options strike selection than BKD, but the open interest picture is quite similar. It's not liquid enough for options trading.

Unlike BKD, LAMR has a positive return on equity, although not a very impressive one, at 3%, with a huge load of debt amount to 237% of equity.

It has the best success rate of the three, at 73.3%, with average return of 16%. That gives an excellent adjusted yield of 11.7%.

So, based on the numbers, LAMR is the top choice. PEP gets bumped from consideration because of its low adjusted yield, and BKD because of its negative return on equity.

But the only way to trade LAMR, given the low open interest of its options, to to buy shares. And buying shares means that I'm giving up a huge amount of leverage that multiplies my returns (and my losses, if things head south).

Take PEP as an example. It is selling at $7,171 for a round lot, 100 shares. Under my rules, today I'm trading April long options with strike prices as close to 70 as I can manage. In the case of PEP, that's the April $70 strike with a delta of 63, with an ask price of $257 per lot.

Now, with options, of course, a delta of 63 means that a dollar move in the price of the stock just means a 63 cent move in the price of the option. So, actually, the comparable price of a lot is $407.94, or the lot price, $257, divided by the delta, 0.63.

To get the lever, I simply divide the price of a stock lot by the adjusted options price, and I come up with my leverage, which in this case is about 18:1 (17.578565:1, if you're into precision).

That puts a whole different spin on the adjusted return. The best I can expect from LAMR stock is an adjusted return of 11.7%. With leverage, PEP will give me a return of 32.2%.

PEP, then, becomes the top choice...

Decision for my account: ... but a poor choice indeed. Remember, the success rate is only 53%. That's not much better than break-even. I'm really happier with something closer to 60% or better. Also, while 32% yield sounds a like a good deal, I'm normally look for adjusted returns of 5% or better, which is a 60% yield with the leverage options provide.

So based on the odds, I'm rejecting PEP as well. This is will be a no new trade day at Private Trader. 


My trading rules can be read here. (They don't talk about the trend score because I'm still developing the tool.) A discussion of recent modifications to my trading methods, which haven't yet been incorporated in the original write-up, can be found here.

And the classic Turtle Trading rules on which my rules are based can be read here.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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