What is fundamental analysis and why is it important to option traders?
Fundamental analysis is the study of a company’s financial health, which will directly affect the stock price of company. Very often, the act of fundamental analysis involves the performance analysis of:
- Asset utilisation
- Debt analysis
- Cash flow analysis
In general, if a company is undervalued, investors will buy the stock. If the company is overvalued, investors will sell the stock causing the stock price to decrease.
Poor fundamentals in a company will cause a stock price to drop. The stock market is always forward looking. When a company announces that it has difficulty paying its interest on debt, the stock market would devalue the company’s stock price because of its prospects.
On the other hand, if a company’s prospect is getting better and its earnings are projected to accelerate, then the company can use the increased free cash flow to pay down its debt, increase dividends or even do a share buyback that will cause stock prices to go up.
If a stock is trading at a price to earnings ratio of 2 and it is expected to sell off some of its real estate assets to distribute any gains as a one off dividend, the company’s share price would most likely rise over time to the point that it distributes the dividend.
A Jigsaw Puzzle
Fundamental analysis and the reading financial statements should be done holistically. One should not only look at the income statement of the company, but also the balance sheet and the cash flow statement.
It is like a jigsaw puzzle being pieced together bit by bit.
Why option traders can use fundamental analysis?
Fundamental analysis is the study of the company’s financial health. By studying the company’s financial health, the management, its business model, its cash flow and debt to equity structure, one is able to arrive at a conclusion as to whether the company’s price will increase over the medium to long term.
The Importance Of Price Versus Value
Fundamental analysis allows an option trader to determine the price- value gap. For example, the price to earnings ratio of stock A is 5 times. Typically, stocks within this industry trade at 10 times earnings. You get a scenario where the security in question is likely to be undervalued, assuming that there is nothing absolutely wrong with the security. By that, we mean, there are no accounting shenanigans, no fraudulent accounting and such. Also, a fundamental analyst may want to look out for a catalyst when purchasing options. The faster the price of an underlying security moves, the price of the option moves alongside with it. Usually, the earnings of a company can be a real catalyst to price movement.
Of course, the earnings are connected to cash flows, to the balance sheet, to other factors and hence, a fundamental analyst will need to look at the financials of the underlying security or the company in totality.
Case in point: Options traders can use fundamental analysis as a tool to determine the prevailing direction of a security.
What You Should Look Out For With Fundamental Analysis
- Rising profits and revenues can lead to higher stock prices
- The divergence of price and value. Look out for undervaluation and a depressed price relative to intrinsic value.
Read: Income Statement