Seven Major Mistakes done by Traders

Seven Major Mistakes done by Traders

1. Lack of Knowledge and No Plan
It is surprising that some people expect to trade the stock market effectively without any effort. However, if they want to take up golf, for instance, they will happily take several lessons or at least read a book before heading out onto the course.

The stock market is not the place for the poorly informed. Although learning what you need is easy, you just need someone to show you the way. The contradictory extreme of this is those traders who spend their life looking for the Holy Grail of trading. The fact is that there is no Holy Grail. But the excellent news is that you don't require it. Indian trading system is highly successful, easy to learn and low risk.

2. Unrealistic Expectations
Many beginner traders expect to make huge money over a trading week. The stock market can be an enormous way to restore your current income and for creating wealth but it does need time. Not a lot, but of course some time is required.

Other beginners think that trading can be 100% accurate all the time. Certainly this is unrealistic. But the best thing is that with different methods you only need to get 50-60% of your trades "right" to be successful and highly profitable.

3. Listening to Others
When traders first start out they repeatedly feel like they know nothing and that everyone else have the answers. So they pay attention to all the news reports and so called "experts" and get totally confused and they take "tips" from their friends, who got it from some cab driver.

We will show you how you can get to be acquainted with everything you need to know and so never have to listen to anyone else.

4. Getting in the Way
When you first start to trade it is very hard to control your emotions. Fear and greed can be overpowering. Lack of discipline; lack of patience and over confidence are only some of the other problems that we all face. It is important you understand how to control this side of trading.

5. Poor Money Management
It never stops to astonish us that how many traders don't understand the significant nature of money management and the related area of risk management. This is an important aspect of trading. If you don't understand this right you not only won't be successful, you won't survive. Luckily, it is not complex to address and the simple steps we can show you will ensure that you don't "blow up" and that you get to keep your profits.

6. Only Trading Market in One Direction
Most new traders only learn how to trade a growing market. And very few traders know really good strategies for trading in a diminishing market. If you don't learn to trade "both" kind of ends of the market, you are significantly limiting the number of trades you can take. And this restricts the amount of money you can make.

7. Overtrading
Most traders, those who are new to trading feel that they have to be in the market all the time to make any real money. And they see trading opportunities when they are not even there. You should think before investing that how much money you can afford to invest.

Source: www.theindianmoney.com

Private Equity - An Analyisis

Private equity players say they are all weather players. They admittedly look for growth stories and value multiplication of investments. Most PE investors say their investments are not valuation-specific, and they do not mind paying higher valuations if there is growth potential. But the actual PE investment trend, over time, throws up an opposite picture. An analysis of PE investments made in India between 1998 and 2008 shows that PE investors remained silent during the bear period barring some one-off deals, and they aggressively invested during the bull-run even at higher valuations.
To successfully execute a PE investment, a fund manager needs to identify and access an investment opportunity, finance the company through a properly structured instrument, create new shareholder value and realise it via an advantageously structured and executed ‘exit’ transaction. Superior investment return is not the only reason why more and more investors are turning to PE. A sophisticated investor holding a typical portfolio of publicly traded stocks, bonds, or real estate could improve the portfolio’s risk profile by investing some assets in PE.

Studies have shown that the returns on PE are directly correlated to the equity markets, resulting in even stronger benefit of diversification during boom times. The same studies indicate that a portfolio weighting of up to 10% in PE provides investors with significant risk reduction as a result of diversification during a bearish trend.

The complexity of this investment cycle explains why fund managers’ domain expertise is of crucial importance for achieving superior returns on PE investments. To illustrate what return could be achieved by PE expert investors, consider this example. Over the course of more than 40 years of the history of the American venture capital industry, there have been several hundred cases in which fund managers were able to increase investor capital by 10 to 100 times in just four to six years by investing in innovative new companies in the fields of information technology and telecommunications.

Though valuations in India at present look attractive in clear numerical terms when compared to peak-time valuations, the inability of any fund manager to assess and arrive at how long the gloom time will prevail is a billion-dollar question. This may not find any right answer in terms of periodicity, and that is why PE players say, "Let us get knowledge during the boom time, and when the overall signals of a come-back trend surfaces, start taking aggressive investment positions."

The logic behind PE players’ aggressive investment posture during bull-runs can be attributed to many factors: (i) PE funds pool in funds from companies, pension funds, and high net worth individuals who tend to subscribe to these funds only when they see a turnaround in markets and global economy (ii) The performance of PE funds becomes visible only during a boom time, which in turn helps them raise any number of follow-ons. (iii) The evolution of venture capital in large-size is PE fund, and so valuations and associated returns and turn-around time too count a lot (iv) Recapitalisation happens quickly during boom times.(v) Leveraged investment possibilities are ample during boom time.

Currently, the Sensex is quoting at a price-earning multiple of about 15.23, when compared to peak-time multiple of 22.45 a year ago. PE funds aggressively invested during the boom time. The present PE investments may purely be driven on the basis of valuations, turn-around time and may happen very selectively and rarely for the following reasons: (i) Funds have become scarce and investors have become fussy due to the negative returns at this point of time. (ii) When it comes to diversified investments vs focussed investments, given a chance, investors are now looking for future stories and sectors that can emerge after this downtrend.(iii) Most of the fund managers are facing flak from investors as some of them could not use the boom time for good exits on behalf of the investors. (iv) Bottomed-out valuations and levels have become a big question mark. (v) PEs look at attractive annualised returns upon exits, so they are no charity houses to ignore the downtrend in global economy. When the global economy is not doing well they look at stories wherein promoters desperately look for funds at lower valuations with good growth potential.

Though the right time for investments by PE funds is, in general, the time at which valuations look attractive, investments rarely take place except for strategic reasons. Though PE funds talk a lot on growth story and value-based investments, they do get into the quick-return bandwagon and invest aggressively during boom times. And bear times seldom attract investments irrespective of a great profitable proposition.

(Source:Financial Express)

Equity Valuation - Gordon Model

Gordon Model (Constant Growth rate)
The Gordon model assumes a constant growth rate for infinity.

The value of the stock is given by:
V = D1 / (Re - g)
Where,
D1 = Expected dividend at the end of the year
Re = Required rate of return on equity
g = Expected growth rate for a long period of time (mathematically, infinite period)

For example, A Ltd. Reported earnings per share (EPS) of Rs 15 last year and paid out 52% of its earnings as dividend. The earnings and dividends are expected to grow at the rate of 8% in the long term as in the past. If the required rate of return on equity shares of A Ltd. is 12%, the value of the security is calculated as follows;

EPS = Rs 15
The Current dividend per share is given by the payout ratio times the EPS. Dividend per share (D0) = 15 x 0.52 = Rs. 7.8
So the expected dividend would be given by multiplying the current dividend with the expected growth rate.
Dividend per share (D1) = 7.8 x 1.08 = Rs. 8.42
Expected growth rate = 8%
Required rate of return = 12%

V = 8.42 / (0.12 - 0.08) = 210.50

There are two major limitations of this model
a) This model is used only when the growth rate is constant.
b) This model does not function when the growth rate is equal to or exceeds the required rate of return. Try and calculate the value of the security in the above example assuming the growth rate is 13%! The price would be negative Rs. 842. Equity shares cannot have negative value. More so, if the growth rate is equal to the required rate of return, the value of the security approaches infinity.

Dividend Decision - Walter Model

The term dividend refers to that part of after-tax profit which is distributed to the owners (shareholders) of the company. The undistributed part of the profit is known as Retained earnings. Higher the dividend payout, lower will be retained earnings.

The dividend policy of a company refers to the views and policies of the management with respect of distribution of dividends. The dividend policy of a company should aim at shareholder-wealth maximization.

The essence of dividend policy is:
If the company is confident of generating more than market returns then only it should retain higher profits and pay less as dividends (or pay no dividends at all), as the shareholders can expect higher share prices based on higher RoI of the company. However, if the company is not confident of generating more than market returns, it should pay out more dividends (or 100% dividends). This is done for two reasons. One, the shareholders prefer early receipt of cash (liquidity preference theory) and second, the shareholders can invest this cash to generate more returns (since market returns are expected to be higher than returns generated by the company).

Over the years, various models have been developed that establish the relationship between dividends and stock prices. The most important of them is Walter Model:

Walter Model
Prof James E. Walter devised an easy and simple formula to show how dividend can be used to maximize the wealth position of shareholders. He considers dividend as one of the important factors determining the market valuation. According to Walter, in the long run, share prices reflect the present value of future stream of dividends. Retained earnings influence stock prices only through their effect on further dividends.
Assumptions:
The company is a going concern with perpetual life span.
The only source of finance is retained earnings. i.e. no other alternative means of financing.
The cost of capital and return on investment are constant throughout the life of the company.
According to Walter Model,
P = [D + (E - D) x ROI / Kc] / Kc

P= Market price per share E= Earnings per share
D = Dividend per share Kc= Cost of Capital (Capitalisation rate)
ROI = Return on Investment (also called return on internal retention)

The model considers internal rate of return (IRR), market Capitalisation rate (Kc) and dividend payout ratio in determination of share prices. However, it ignores various other factors determining the share prices. It fails to appropriately calculate prices of companies that resort to external sources of finance. Further, the assumption of constant cost of capital and constant return are unrealistic.
If the internal rate of return from retained earnings (RoI) is higher than the market capitalization rate, the value of ordinary shares would be high even if the dividends are low. However, if the RoI within the business is lower than what market expects, the value of shares would be low. In such cases, the shareholders would expect a higher dividend.
If RoI > Kc, Price would be high even if Dividends are low

Walter model explains why market prices of shares of growth companies are high even if dividend payout is low. It also explains why the market prices of shares of certain companies which pay higher dividend and retain low profits are high.
Example:
A Ltd. paid a dividend of Rs 5 per share for 2009-10. the company follows a fixed dividend payout ratio of 30% and earns a return of 18% on its investments. Cost of capital is 12%. The expected price of the shares of A Ltd. using Walter Model would be calculated as follows

EPS = Dividend / payout Ratio = 5 / 0.30 = Rs.16.67
According to Walter Model,

P = [D + (E - D) x ROI / Kc] / Kc

P = [5 + 16.67 - 5.00) x 0.18 / 0.12] / 0.12

P = 187.50

Black Scholes Model

The Black and Scholes Model:
The Black and Scholes Option Pricing Model didn't appear overnight, in fact, Fisher Black started out working to create a valuation model for stock warrants. This work involved calculating a derivative to measure how the discount rate of a warrant varies with time and stock price. The result of this calculation held a striking resemblance to a well-known heat transfer equation. Soon after this discovery, Myron Scholes joined Black and the result of their work is a startlingly accurate option pricing model. Black and Scholes can't take all credit for their work, in fact their model is actually an improved version of a previous model developed by A. James Boness in his Ph.D. dissertation at the University of Chicago. Black and Scholes' improvements on the Boness model come in the form of a proof that the risk-free interest rate is the correct discount factor, and with the absence of assumptions regarding investor's risk preferences.

The Model

In order to understand the model itself, we divide it into two parts. The first part, SN(d1), derives the expected benefit from acquiring a stock outright. This is found by multiplying stock price [S] by the change in the call premium with respect to a change in the underlying stock price [N(d1)]. The second part of the model, Ke(-rt)N(d2), gives the present value of paying the exercise price on the expiration day. The fair market value of the call option is then calculated by taking the difference between these two parts. [2]

ASSUMPTIONS OF THE BLACK AND SCHOLES MODEL:

The stock pays no dividends during the option's life
Most companies pay dividends to their share holders, so this might seem a serious limitation to the model considering the observation that higher dividend yields elicit lower call premiums. A common way of adjusting the model for this situation is to subtract the discounted value of a future dividend from the stock price.

European exercise terms are used

European exercise terms dictate that the option can only be exercised on the expiration date. American exercise term allow the option to be exercised at any time during the life of the option, making american options more valuable due to their greater flexibility. This limitation is not a major concern because very few calls are ever exercised before the last few days of their life. This is true because when you exercise a call early, you forfeit the remaining time value on the call and collect the intrinsic value. Towards the end of the life of a call, the remaining time value is very small, but the intrinsic value is the same.

Markets are efficient

This assumption suggests that people cannot consistently predict the direction of the market or an individual stock. The market operates continuously with share prices following a continuous Itô process. To understand what a continuous Itô process is, you must first know that a Markov process is "one where the observation in time period t depends only on the preceding observation." An Itô process is simply a Markov process in continuous time. If you were to draw a continuous process you would do so without picking the pen up from the piece of paper.

No commissions are charged

Usually market participants do have to pay a commission to buy or sell options. Even floor traders pay some kind of fee, but it is usually very small. The fees that Individual investor's pay is more substantial and can often distort the output of the model.

Interest rates remain constant and known

The Black and Scholes model uses the risk-free rate to represent this constant and known rate. In reality there is no such thing as the risk-free rate, but the discount rate on U.S. Government Treasury Bills with 30 days left until maturity is usually used to represent it. During periods of rapidly changing interest rates, these 30 day rates are often subject to change, thereby violating one of the assumptions of the model.

Returns are log normally distributed

This assumption suggests, returns on the underlying stock are normally distributed, which is reasonable for most assets that offer options.