And not just picking "good" stocks and avoiding "bad" stocks. Your task, as a trader, is to pick stocks whose prices, in the future, will move as you think they will move.
In other words, tarot cards gripped tightly in your left hand and horoscope in your right, as a trader you're in the crystal ball business, and don't let anyone tell you different.
Some people, born theorists, approach their stock picking by trying to understand what moves the markets, and then finding a method that matches their conclusions. Others give up any attempt to understand why prices move as they do, declare the markets to be a random walk, and pull out their dice or dart board. Bored already? Click here for a short cheatsheet. And then there's people like me. I have no idea why markets move as they do, and I don't think things are random -- at least they don't look that way to me. In my heart of hearts, I think stocks move in patterns for two reasons. One reason is expectations. The art of trading is held up by a superbly complex structure of analytical techniques that people use to guide their trading. They become, through long use, a self-fulfilling prophecy. For example, if a stock moves into a head and shoulders pattern, and if enough traders believe that the H&S indicates a top, then they will sell at the appropriate moment, putting more shares on the market than buyers can handle at a higher price, and the price will go down until the sellers lose interest, thereby proving, yet again, that a head and shoulders pattern does indeed indicate a top. And strengthening that belief among traders. | "Technical analysis does not deal in certainties, only probabilities. Yet those probabilities improve dramatically when traders understand the psychology of price patterns and how that psychology influences traders' behavior and the movement of prices themselves." --back cover of Price Patterns, by Martin Pring |
The second reason is history. The past movements of a stock's price determine levels of support (where the price will pause in descent, or even reverse) and levels of resistance (where the price will pause in an ascent, or reverse).
Support and resistance, by definition, are levels where the price has reversed before.
What happened in the past when that reversal happened? Some people were left holding the bag.
When price rose to $25 (for example) on high volume, and then reversed, dropping to $21, a lot of traders who had bought shares at $24.95 didn't sell in time. And human nature being what it is, they don't want to take the loss. So they wait, sitting on their shares, and when the stock again rises to $25, they cheer, "A 5-cent profit! Hoorah!!", and sell their shares, causing another reversal.
So expectations count, and history counts, and I look at both in selecting stocks. Some traders also look at the underlying fundamentals of a company -- earnings, revenue, debt, analysts' opinions, on the theory that if a company's business is bad or about to turn sour, then the stock's price will go down to reflect that lessened ability to turn a profit.
People that write books about stock picking, for some reason, focus on nothing but the fundamentals. Go figure.
Here's how I pick stocks.
First, I want companies that are very liquid. They trade many shares every day. That means when it comes time for me to trade, there'll be a lot of sellers and buyers for me to trade with. My trades will execute faster. There will be a narrower spread between the bid (the proposed buying price) and ask (the proposed selling price), so it will be cheaper for me to play.
My rule of thumb is 5 million shares or more a day for stocks whose options I plan to trade, or 1 million or more for stocks that I plan to own outright as shares.
That's the universe I scan.
Although I've narrowed my choice considerably already, there are still a lot of different stocks left to evaluate. So I look for a way to narrow further.
Remember, I'm scanning during the trading day. I don't have a lot of time to spend on research. I need to evaluate quickly. To trade is to act in the now.
My next step is to look at one or more technical indicators, those that give unambiguous signals. Presently I use the Macd -- which stands for moving average convergence-divergence -- and the money flow index.
The Macd is a signal that measures the distance between two moving averages, usually the 26-day and the 12-day. The 26-day is subtracted from the 12-day. When they're identical, the Macd is on the it's zero line. When the 12-day moving average is above the 26-day, then the Macd is above the zero line. This is a bullish signal. When the 26-day is on top, the Macd is below the zero line, a bear signal.
For my signal, I'm looking for those days when the Macd crosses the zero line in one direction or another -- crossing up for a bull signal, down for a bear signal.
The money flow index uses price and volume to measure the flow of money into and out of a stock. When the Mfi is above the 80-line, then that means the stock is overbought, a bear signal. When the Mfi is below the 20-line, then the stock is oversold, a bull signal.
When I scan, either one of those signals will cause me to look more closely.
It's important to note that any signal or group of signals will fulfill this winnowing purpose. I'm not making a decision based on the technical signals. They only tell me, "Some is happening here. Let's check it out."
My next step is to look at the price pattern. I am a trend trader. I like to go with the flow. I'll trade bullish in an uptrend, bearish in a downtrend and use some sort of sideways options strategy in a sideways trend. By my rules, I don't go against a trend.
When the price each period is making a series of higher highs and higher lows, that's an uptrend. When the price makes a series of lower lows and lower highs, that's a downtrend. And when it bounces repeatedly between the same resistance level on the upside and support level on the downside, that's a sideways trend.
It's easy to overthink this. Most stocks will reverse every third or fourth day, just a little bit. Is that a new trend? Well, maybe, but it's so microscopic as to not be useful.
The way I do it, I look at a daily chart covering three months. And I look for the big movements that are obvious within that period, squinting my eyes if I have to in order to blur the smaller movements. It may not be mathematically defensible, but trends seen that way are something that I can grasp in a second. I don't find deeper complexity to be useful.
If I have a bull signal on the technical, and the stock is in an uptrend, and the volume meets my guidelines, then I have a potential bull trade. Likewise, bear signal, downtrend, volume, a potential bear trade.
I've found each day that there's usually fewer than half a dozen potential trades, and some days none. And that's OK. I want strict rules for picking, because the only time I know for sure that I'm not losing money in the market is when I haven't yet placed the trade yet.
How do the fundamentals play into this? Most of my positions are structured to last 20 or 30 days, far too short a time for the fundamentals to matter. The date of the next earnings announcement is far more important for assessing those trades (since earnings announcements can carry surprises that produce huge, unexpected movements in the price).
If there's a chance that I may be left owning a stock, such as when I buy shares outright or do a covered call, then I want to know that the fundamentals look pretty good. I don't have any firm guidelines on what "pretty good" means. It's generally clear: Making money, increasing earnings, moderately happy talk from the analysts.
And that's all there is to it. In many ways, it's mind-numbing in its simplicity. But when my money is at stake, simple is good. It's harder to mess it up.
New to private trading? Here's a look at How to Become a Private Trader.
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