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Market Indicator for the Week Ahead
October 31, 2011
Leading and Lagging Stocks



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Leading & Lagging Stocks Noticeable in Big Market Gains



The market’s leading and lagging stocks, which might be poised to outperform during the near term!

Last Thursday, the S&P 500 Index (SPX) had its third-biggest day of the year, rising 3.4%. These are the type of days where the bulls become excited and look to their portfolios for assurance. However, there's nothing more demoralizing than being heavily exposed to a stock (or group of stocks) that does not participate in such a strong rally.

SPX -2011



Comparison of Participating to Non-participating Stocks

Why did some stocks participate in this market surge whilst other did not?

Is this a signal that non-participating stocks are weak, and should be sold -- or is the opposite true?

However, the answer lies with the many recent studies conducted, showing that stocks have a strong tendency to mean-revert, where equities that are weak over a certain time frame will generally tend to outperform going forward.

Mean-reversion Philosophy

The underlying principle of mean-reversion trading is that when stocks rapidly move away from their mean price they will revert back to that mean in the short term. If a stock falls rapidly in price then it is likely to rally in the short term and if a stock rises rapidly in price then it is likely to fall in the short term.

Leading and Lagging Stocks

To analyze this phenomenon, we need to observe days when the SPX gained 3% or more going back to 2010. This time frame includes six prior returns of 3% or more (actually, seven -- but one just occurred on Oct. 10, for which we do not yet have a one-month return). By organizing the stocks into three groups based on their relative strength to the market an observance of leading and lagging stocks is unveiled. The stocks that underperformed (relative strength of less than 0.97) are listed as "laggards," and those that outperformed (relative strength above 1.04) are the "leaders."

The lagging indicators are the ones which go after the price pattern of the stock, security, or commodity -- follows an event. The information is then created from a past assortment of data and therefore is effective in denoting if a new trend is currently developing or whether or not the stocks are inside trading ranges. Moreover, the lagging indicators don’t succeed in predicting pullbacks or rallies in the future.

On the other hand, the leading indicators will be able to predict what may happen later on -- signals future events. Crashes, pullbacks, or price rallies are often determined since they calculate the movement of the prices momentum. These tools can also define prices which have gone way too high or too low thereby providing the words overbought and oversold.

The table below shows mean reversion ruling the day, as the leading stocks on big up days significantly underperformed the laggards and middle-of-the-road stocks. Meanwhile, the laggards were the strongest performers going forward.

1month returns



Strategy Involved for Leading and Lagging Stock

When deciding on a strategy to enter a trade, it is essential to realize that about half of the trading in a stock is due to the fundamentals of the company and the other half due to the conditions of the market. The market overreacts for a variety of factors; "hot money" jumps on news, investors will dump at a sign of adverse developments, money managers do not like holding losing positions portfolios. These fluctuations, having nothing to do with the fundamental value of the stock, are opportunities.

Studies show that over the long term, the market is efficient. Prices will reflect the fair value of the stock based on all available information. Basically, all of the information that is out there will be accounted for and factored into the price of the stock. That is the basis of the efficient market hypothesis.

But, over the short term, the market is very inefficient. That is why stocks such as NewLead Holdings (NASDAQ: NEWL) and NeuorgesX (NASDAQ: NGSX) will be among the top gainers and top losers in a short period of time as both were recommended as mean-reversion trades. Both were among the top gainers and top losers in short periods of time. The loss days had nothing to do with the fundamentals of the stock, rather the market. Last week, NewLead was a top gainer one day; and then a top loser the next. There was no material news to impact the share price of the company, just "hot money" leaving the stock on the search for another short term opportunity.

Laggard Stock

Finally, below is a list of 25 of the most liquid stocks that qualified as "laggards" during Thursday's big market rally. According to the research above, these names could have a tendency to outperform other stocks during the short term. The list is sorted from the worst-performing stocks on Thursday to the best.

laggard stock

For a complete list of leading and lagging industries go to Dow Jones Total Stock Market - U.S. Leading and Lagging Industries

Leading and Lagging Stock Effects on the Options Market

Due to tension building there could lead to some outsized returns for option buyers as the market enters the second half of earnings season. Over the past 15 years, stocks that were laggards in the two weeks ahead of their earnings period tended to outperform by more during their earnings than stocks that performed well in this prior period.

By buying calls on the under-performers ahead of earnings was more profitable than buying calls on stocks that outperformed in the two weeks ahead of the earnings period.

This is defined as the earnings event period starting five days before the results are announced.

Options prices were high ahead of those companies that reported early, but small earnings moves, thus far, have resulted in lower option implied moves ahead of the event. This quarter, strangle selling, five days before each earnings event, and closing one day after, has led to an average 16 percent return on premium.

The CBOE Market Volatility Index (VIX) started October at 45 and declined to 25, and options prices on stocks fell sharply as well. Thus, according to strategists, the stocks that they targeted, have significantly performed well or lagged where their analysts' fundamental views are counter to recent stock movement.

VIX-2011

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