FXP Stock Trading

EXAMPLE 41 Profiting from Inconsistent Probabilities

• Understanding Chart Pattern Book For Traders
• How To Follow Mutual Fund Trends For Profit
• How You Can Finally Be a Profitable Swing Trader

You are examining the common stock of two companies in the same industry in which an important antitrust decision will be announced next week. The first company, SmithCo Corporation, will benefit from a governmental decision that there is no antitrust obstacle related to a merger in which it is involved. You believe that SmithCo's share price reflects a 0.85 probability of such a decision. A second company, Selbert Corporation, will equally benefit from a "go ahead" ruling. Surprisingly, you believe Selbert stock reflects only a 0.50 probability of a favorable decision. Assuming your analysis is correct, what investment strategy would profit from this pricing discrepancy?

Consider the logical possibilities. One is that the probability of 0.50 reflected in Selbert's share price is accurate. In that case. Selbert is fairly valued hut SmithCo is over-valued, as its current share price overestimates the probability of a "go ahead" decision. The second possibility is that the probability of 0.85 is accurate. In that case, SmithCo shares are fairly valued, but Selbert shares, which build in a lower probability of a favorable decision, are undervalued. You diagram the situation as shown in Table 4-1.