Introduction to Trading

Introducing Trading with Some Notation

  • In trading, the price of a stock represents the value of a company

    • ptp_{t} is an observed stock price at a given point in time tt
    • p˙t\dot{p}_{t} is the true, unknown stock price at a given point in time tt

  • Thus, ptp_{t} represents the perceived value of a company

    • Obviously, the perceived value is influenced by:

      • Current earnings
      • Speculation

    • Whereas, the true and inherent value is influenced by:

      • Current earnings

Describing Influences of Stock Prices

  • Roughly, trading assumes the observed stock price ptp_{t} is nearly equal to its true and inherent valuation p˙t\dot{p}_{t}

    • Meaning, the amount of speculation is assumed to be negligible
    • Realistically, this assumption rarely holds true
  • In other words, the stock price p˙t\dot{p}_{t} equals the earnings per share
price=EPS\text{price} = \text{EPS}

  • And, ptp_{t} should equal p˙t\dot{p}_{t}

    • Again, this assumption is rarely true

    • Due to a combination of cognitive biases such as the following:

      • Overconfidence
      • Overreaction
      • Representative bias
      • Information bias
      • Other human errors

Defining the Goal of Trading

  • The goal of trading is to buy stocks with a lower price ptp_{t} than:

    • Its true current price p˙t\dot{p}_{t}
    • Or its true future price p˙t+i\dot{p}_{t+i}
  • The first method is known as value investing
  • The second method is known as growth investing

  • To effectively achieve growth investing, we must accurately predict the future earnings without any amount of speculation

    • Thus, growth investing involves paying a higher price now if the company will have higher future earnings
    • Usually, current prices are overvalued at a given moment due to expected higher prices in the future
    • A decent range is up to 5−75-7 years into the future

Defining Investing Strategies

  • As stated previously, value investing involves buying stocks with a lower current price than its current intrinsic value
  • Whereas, growth investing involves buying stocks with a lower current price than its future intrinsic value
  • Another investing strategy is momentum investing

  • Momentum involves buying stocks with high returns over the past 3−123-12 months, and selling stocks with poor returns over the same period

    • Generally, momentum is used in high-frequency trading
    • Many of these trades operate over small time scales
    • Often, executing dozens or hundreds of trades per second

Describing Stock Valuation Methods

  • The most popular method for stock valuation is discounted cash flow
  • DCF is a method using concepts of the time value of money

  • DCF is widely used in the following other sectors:

    • Investment finance
    • Real estate development
    • Corporate financial management
    • Patent valuation

References

Next

Stock Valuation

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