Avoid This Simple Error for Big Profits

Asad Dossani

The error is this: Assuming that a simple trading strategy will always work.

You probably expected to read the opposite. After all, there is beauty in simplicity. A simple trading strategy is appealing. It's easy to understand. And easy to implement. But does that mean it will be profitable?

The push for a simple strategy is usually a successful backtest. Backtesting is when we test out a trading strategy on historical data. We see how it would have performed, had we implemented it in the past. Here's an example of a simple strategy: Buy the stock when the 5-day moving average crosses above the 20-day moving average. Sell the stock when the 5-day moving average crosses below the 20-day moving average.

If you test this out on the data, you'll probably find it to be quite profitable historically. But unfortunately, this does not mean it will be profitable in the future. In fact, the simpler the strategy, the less likely it is to remain profitable. Here's why:

Traders react to past prices. When they observe a pattern that works, they exploit it for profit. Suppose traders observed that the simple strategy we discussed has been profitable historically. What would happen next? Traders would implement the strategy.

Once enough traders have implemented the strategy, the profits disappear. If the stock was underpriced when the 5-day moving average crossed above the 20-day moving average, that will no longer be the case if enough traders buy the stock. The logic is similar to enough investors buying an undervalued stock, so that it is no longer undervalued.

The simpler the strategy, the easier it is for others to implement it. And the more people implement it, the less profitable it becomes. On the other hand, a complex strategy is less likely to be discovered by others. The profits from a complex strategy can persist for much longer.

Successful traders are ones that maintain an edge. An edge is some type of advantage over other market participants. And this requires continuous innovation.

Does this mean the average retail trader is doomed to failure? Far from it. Edge comes from many different places. And retail traders have edges that professionals can only dream of.

One place you can exploit this edge is the derivatives market. More on that next time.


Market Notes

TCS to Buyback at Rs 2,850, Will the Price Catch Up?

As a grad student, my friend and I were very much involved in stock markets. We were learning about everything related to stocks and always observing the price action. At that time, we were closely tracking the price of FMCG giant Hindustan Unilever's (HULs).

On 12 June 2010, HUL announced a share buyback amounting to Rs 630 crore. The stock was trading at Rs 250 and the buyback price was Rs 280. The company offered an 11% premium to buy its own share. The stock shot up to Rs 280 in no time. In fact, the stock made a high of Rs 325 on 4 January 2011.

We studied the whole concept of share buybacks at length and observed that share prices usually rise when a company announces a buyback at a price higher than the current market price.

That's because a company usually buys its shares back when it believes they're undervalued. This indicates the management has confidence in their business prospects. This creates a positive outlook towards the company and the share price shoots up.

Further, a share buyback reduces the number of outstanding shares in the market. This improves the valuation parameters. The price to earnings ratio (PE) and the return on equity (ROE) become favourable ex-buyback, which increases demand for the stock.

FY17 was a year of buybacks. Forty-five companies launched buyback programs amounting to more than Rs 345 billion. That's more than the buybacks of the past seven years combined.

TCS Reaction to Share Buyback

Power Grid Hits New 52-Week High  

Recently, TCS announced a Rs 16,000 crore buyback, the biggest in India, at a fixed price of Rs 2,850. The share price hit a high of Rs 2,555 on the day of the announcement. But now it is trading at Rs 2,300, 10% down.

Wipro too announced a Rs 2,500 crore buyback at Rs 625 on 20 April 2016. The share price was trading near Rs 600 on the day of the announcement. That was the 52-week high for the stock. The share plunged 27% after that and it is still trading below 600.

Similar price declines were observed in major buybacks from Sun Pharma, Dr Reddy's, Bharti Infratel and Bharti Airtel during the past one year.

Why are prices declining after these premium buyback announcements?

Companies with excess cash usually reward their shareholders with either dividends or share buybacks. And nowadays, cash-rich companies are opting for buybacks over dividends because of the Additional Dividend Tax (ADT) introduced from 1 April 2016.

Any dividend received in excess of Rs 1 million will be taxable at a rate of 10% in the hands of the recipient. This is in addition to the Dividend Distribution Tax (DDT) already levied on the company.

The measure - aimed at those receiving significant amounts of dividends - did not go down well with India Inc. Rather than pay dividends, many companies opted to use their surplus cash on share buybacks, which carry no such levy.

So now the motive for the buyback has changed. Managements aren't buying their shares because they believe they're undervalued. They want to save tax. Buybacks are now an attractive alternative to dividends. And this is well understood by smart investors, who are behind the downward share price action.

Many cash-rich companies like TCS, Infosys and HCL Tech are lined up to buy back their shares. But the intentions are now different. Investors looking for a quick buck from buybacks need to keep this in mind. Share buybacks are not always a good thing. Consider them on a case-by-case basis.

From The Market Wizards...

"In trading it's not about how much you make, but how much you don't lose" - Bernard Baruch

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2 Responses to "Avoid This Simple Error for Big Profits"
06 May, 2017
The moral of story is that innovation in different methods of trading will be useful for retail traders to remain in this field otherwise to give up the trading after making huge losses in trading. Please advise how to innovate different trading strategies on ongoing basis for doing regular profitable trading with minimum losses as far as possible. Thanks with regards RAJKUMAR S DLike 
21 Apr, 2017
Very interesting analysis. out of the boxLike (1)
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