Determining Undervalue/Overvalue

Discussion in 'Strategy Development' started by Fraze14, Aug 19, 2003.

  1. Fraze14

    Fraze14

    I work for a small proprietary trading firm that had luck trading correlated pairs. With decimalization the spreads faded and we were forced to speculate on stocks by position trading. We have had some luck comparing a stock to its correlating competitors in a basket to determine whether it is under or over valued. We employ moving averages and volume analysis in conjunction with the baskets to predict the movement of a stock. These "intuitive" indicators coupled with some basic fundamental analysis has been fruitful, but need at least one or two more useful indicators to stay ahead of the curve.

    In the last couple of years we have dabbled unsuccessfully with technical indicators like MACD, RSI, and % offset bands. Our philosophy on technical indicators is that since they are available to the masses there isn't a disctinct edge unless you've spent years mastering the nuances of the indicator. (I personally respect those successfully making money trading by emphasizing such technical indicators.)

    We have a couple of ideas to spark some dialogue about more "intuitive" indicators. We thought that looking at the corporate bond yields and directly comparing them to the stock price chart might give some indication as to the possible movement of a stock. The idea here is that as bond yields tank the cost of borrowing money would also decrease essentially boosting a company's margin. If we could chart these roughly on the same axis there may be a direct relationship which helps predict the movement of a stock. We looked at INTC and found a rough inverse relationship between the yield and price charts.(Bear with us these are rough ideas)

    Another thought would be to look at the open interest in the options of a stock to determine where the big money is betting. (I am not the expert in the office on options, so forgive my ignorance.) If we could chart the open interest of the puts and calls, we may again find a useful relationship to indicate possible stock movement. Also the volume of the puts and calls may also provide some indication of stock movement.

    These are some very rough ideas that may not have any validity or usefulness as predictive indicators, but further research may provide some new insight.

    Our basic question is: What makes a stock cheap or expensive to the market?

    Thanks for the dialogue - Mike