Trading in any stock market is fraught with potential for error, especially for investors who don’t have a cohesive strategy or an eye for analysis. Succeeding in the market means having a strategy, closely following indicators, and knowing how to analyze what goes on during an average trading day to give you every edge possible.
Here, I’ll help you formulate strategy, analyze stocks, and use key indicators and metrics to make more sense of the chaotic world that is the market.
Creating a Strategy
If you fail to plan, plan to fail – in stocks, in your career, and in life.
Each trader should have a strategy, or a roadmap to what he or she will do, when he or she will do it, and how he or she will do anything from cut losses to lock in profits. This strategy is primarily formed based off your goals and your risk tolerance. If you want to make as much money as possible, your strategy will probably be more aggressive than someone who wants to conserve the buying power of their money, or turn in a steady stream of income from dividend-paying stocks.
We’ll assume that you want to stick to stocks as your asset of choice. One way to begin your strategy is to ask yourself these questions:
- How much money do I want to make?
- How quickly do I want to make this money?
- Am I okay with the high risk that comes with an aggressive approach?
- What’s my timeline? I.e. Do I care to hold onto stocks for at least a year to avoid a higher tax rate? Or, do I not care about the tax implications and would rather trade daily?
Once you have these questions answered, you can look into specific strategies to get you where you need to go. Growth investing targets stocks that grow quickly, bring in loads of cash and income, and generally outperform their peers and the market. These carry more risk and many growth stocks do not pay dividends.
Value investing chooses good companies at reasonable prices. This approach focuses on stocks that are undervalued by the market, with low P/E ratios, a strong asset-to-liabilities ratio, and strong financial fundamentals.
A mixture of the two, what some call a hybrid investment strategy, gives you a balanced approach that may be to your liking.
Analyzing the Market
Once you have a strategy in place, you’ll need to analyze each stock that is a prospect. Using a stock screener is a great way to select the criteria you want (i.e. a specific P/E ratio, dividend yield, earnings per share number, market cap, etc.) and find all the stocks in an exchange that meet that criteria.
With each individual stock, there are a few metrics you should examine. (Note: I prefer using both fundamental analysis and technical analysis to get a full, well-rounded picture of a company.) Some key metrics include:
– Operations cash flow per share: The amount of cash that your company brings in, divided by the number of outstanding shares. Then, take this figure and divide it into the current stock price. You’re looking for single-digit numbers. Cash flow is a sign of financial strength that is less easily manipulated than earnings. Use operational cash flow for a better analysis of performance.
– Dividend yield: If you want a steady stream of income, use dividend yield to find stocks with strong dividends. The higher, the better.
– Price-to-book ratio: Take the stock’s price per share and divide by the company’s book value of equity. This gives you an approximation of the stock’s true value. A low P/B ratio could signify that the stock is undervalued – but it can also signify that there are problems with the company.
– Return on equity (ROE): The company’s net income for a year divided by the total amount of shareholder’s equity. This gives you an idea of how well a company is using its reinvested earnings to turn out additional earnings. Using ROE with P/B ratio is a good combination; when the two are in sync, that is a strong sign of value. A high ROE and low P/B ratio – one at or below 3.0 – could reveal that the company is undervalued but a good performer.
– Price-to-sales ratio: The P/S ratio takes the company’s market cap and divides it by the company’s most recent annual revenue. You can also divided the stock’s price per share by revenue per share. Smaller ratios, like those less than 1.0, are preferable, especially when paired with rising earnings and stock prices.
– Price/earnings to growth ratio: The PEG ratio helps you figure out how fairly valued a company is. It is calculated by taking the stock’s price and dividing it by a company’s earnings. Then, take that figure and divide by annual EPS growth. A PEG of 1 suggests that the stock is fairly valued; lower suggests a cheaper stock and higher suggests a more expensive one. This is best used with growth stocks.
– Earnings per share: EPS is a common metric that measures the profit of a company. To calculate EPS, take the company’s profit and subtract dividends from that figure. Then, take this number and divide it by the number of outstanding shares. EPS tells you how much money the company is earning per share of stock issued.
Useful Indicators and Tools
In addition to the metrics described above, you can use a few well-known indicators and tools to help you.
With technical analysis, you have many tools available to you to help you strictly analyze the price of a stock and its volume to identify trends, turning points, and other opportune times to trade. We’ll look at a few essentials:
On-Balance Volume (OBV)
This indicator helps you measure how volume fluctuates with a particular stock, relative to its price over a certain timeframe. The theory is that a rise in volume precedes a movement in price. OBV that goes up, then, could be a signal that the price is moving up. When OBV changes, a trend reversal could be at hand.
Moving Average Convergence Divergence (MACD)
This feature helps you determine momentum and trends in a stock’s price. MACD measures how far apart (or how close) two moving averages are. A moving average is just the average of a stock’s price over a certain period of trading days. A 10-day MA, for example, is the average price of the last 10 trading days. When the two MAs converge and cross, it typically signals a trend reversal.
This indicator helps you determine momentum. It has a range from zero to 100; when the signal is above 80, it is a sign that the stock is overbought (or overvalued) and due for a pullback. When the signal is above 20, it is a sign that the stock could be oversold and due for a rise.
Relative Strength Index (RSI)
Along with an oscillator, the RSI can be used to clarify when a stock is overbought or oversold. Any rating above 70 suggests that the stock is overbought; anything below 30 suggests that the stock is oversold.
All of these indicators and more can be accessed via most online trading platforms or charting programs. Some features are only available if you subscribe to a program, so keep that in mind.
Above all, take time and make smart, informed choices. Have a method to the madness before moving forward with any trade. Using analysis can help you separate the winners from the also-rans and money losers.