Anatomy of a Trade: How to Play Apple

This is a true story.  It illustrates an important and little-understood point about markets.  Let us start with the popular and incorrect idea.

The stock market is a zero-sum game.  Therefore, when a trade takes place there will always be a winner and a loser.

The first statement is true, but the second is not.  A stock trade can benefit both sides.  How so?

An investment in a stock seeks a risk-adjusted expected return, with a specific time horizon.

This means that depending upon your time horizon and risk tolerance, your mileage may vary.  Take a look at the chart below, the interesting example of Apple Computer, Inc.  (AAPL).  In particular, please note that the stock recently dropped below the 50-day moving average (the red line).  The green line is the 200-day moving average. These reflect different investor and trader time horizons.

Aapl dec 09 

Same Situation, Differing Participants

Let us look at this stock from three different perspectives:

  1. The long-term holder
  2. A potential long-term investor — think of this as one of my new accounts
  3. The trader

By way of background, let me say that my own price target for Apple is 260, based upon backing out cash, adjusting earnings for the earlier realization of revenue from the iPhone service plans, and applying a P/E ratio for one of the few true growth stocks.  I think that the increasing market share for computers is a big kicker.  I basically ignore the many rumors around the stock as a source of noise.  I have written more on Apple in the past, but the fundamental analysis, merely summarized here, explains my perspective.  (Another firm initiated coverage with the same target today.  Another cited 240 last week.  Jim Cramer has also been bullish with a recent price target of 300.

So let us consider the participants.

The long-term holder (most of my accounts, including my own) occasionally rebalance their holdings.  We lightened up on positions after big gains.  We were kicking ourselves as the stock moved higher, but that did not mean the decision was incorrect.  Periodic rebalancing is a key to long-term risk-adjusted returns.  The rebalance timing is an educated guess.

The new accounts have been waiting for a good buying opportunity in one of the best growth stocks.  These investors should be hopeful for a "dip."  So I bought for the new accounts.  Perhaps I acted too soon, since the technical traders are driving the stock lower.  The decision of when to buy is an educated guess.  (A digression — I once had a client who canceled her account when I bought a stock and it immediately moved lower.  The stock later tripled, and other holdings also would have done well.  People need to take a longer view in evaluating managers.)

The trader is trying to time the stock, buying and selling based upon technical indicators.  A colleague in the investment management business, someone for whom I have great respect, was reducing positions because the stock dipped below the 50-day moving average.  This may be a winning decision for my friend, assuming that he moves quickly to get back in on a bounce.  My own experience in Apple is that there are many news-driven gaps.  It is often psychologically difficult to "chase" the stock after such a move, so you might miss a big rally.  This does not mean that my friend is wrong.  It means that he must be both aggressive and disciplined.  He is a pro, and knows how to react.

To summarize, we have three different players.  Some are selling on the way up, and selling too soon.  Some are buying on the way down, and perhaps too soon.  Some are selling on the way down, trying to make a profitable trade, and needing to buy back quickly if the situation changes.

The Surprising Conclusion

All three may be correct!  And all three may be winners on their decisions.

The correct and winning investment decision depends upon risk tolerance and time frame.

I study and implement many winning trading strategies.  Sometimes one strategy says "sell" and the other says "buy" on the very same day!  Both strategies have long-term records of success.

Briefly put, one trader can sell to another and both can be correct in terms of their proven and successful strategies.

In my experience, this situation is completely typical.  I face it every week.

The Individual Investor Mistake

There is one definite losing strategy.  It happens when you chase a winning stock (buying high) and sell it on a decline (selling low) and fail to get back in when things change.  Unfortunately, this is the psychology of many individual investors.  It helps to explain why most investors trail the market averages, while many pros are consistent winners.

Television ads perpetuate this myth, encouraging trading (their own source of revenue) and excessive confidence in the customer's  "feel" for the market.

[long AAPL in personal and client accounts]

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  • Studiophototrope December 9, 2009  

    Good read, thanks.
    Just curious, do you see the “how to trade” similarity in both the fundamental/technical view between Goldman and Apple?

  • Mike C December 9, 2009  

    Excellent note on a topic that seems to present conceptual difficulty for many. My experience is the typical novice or amateur individual investor finds it very difficult to grasp that both a buy or sell decision can be the “right” decision depending on the strategy and the anticipated holding time frame for the investment or “trade”. This was a great nuts and bolts explain that I’ll probably borrow at some point.
    That said, in the aggregate, for the overall market, the stock-market can be a zero-sum game if the time frame isn’t long enough. Over the very long-term, let’s say 20-30+ year time frames the overall total market capitalization of the U.S. stock market persistently trends up so the stock market creates wealth and is a positive sum game for buy and holders. Over shorter time frames, even 5-10 years (look at the last 5-10 years) there has been little to no net increase in market capitalization. One person’s cumulative dollar gains had to come at the expense of someone else’s cumulative dollar losses (the bagholders on Enron, Worldcom, Bear Stearns, Lehman, Countrywide, etc.)
    You hit the nail on the head with the definite losing strategy and unfortunately that seems to be the strategy we humans are psychologically hardwired to follow.

  • Mike C December 9, 2009  

    I would add that the price performance of gold over the last 10 years, and then carved out by year by year and even month by month would provide a field day for this type of breakdown where depending on what your time frame and strategy was there were many price points where both a buy and sell was the right decision.

  • Jeff Miller December 9, 2009  

    Studio — There are many applications, as you note. I agree that Goldman is another good case, and regular readers know that we are long GS.
    The trading gaps to the upside are sometimes not as dramatic as in Apple, but the concept is similar.
    Thanks for the good point.

  • Jeff Miller December 9, 2009  

    Mike — I am trying to focus on an individual stock, partly to get away from the idea of a market opinion. So many people believe (usually unwisely) that they have a “feel for the market.” It makes it difficult to help.
    Many investors need to find some good choices so that they can participate, and that is my current focus.
    Perhaps I’ll get around to index investors, but not right now.

  • Adam December 10, 2009  

    Great stuff as always. In options you can really have both sides win (or lose), even in the same time frame. One guy buys long gamma from the other and the stock chops and he flips well. The short gamma guy holds tight and if the stock ultimately ends near where it started, they both win.