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Stock Selection: The Top-Down and Bottom-Up Approaches

Search for stocks that fit your trading needs with a top-down or bottom-up approach.

So, you want to trade a stock. Well, you’re not going to trade any stock, of course. So the question is: what stock are you going to trade? There are a lot of stocks out there and you’re going to need a way to narrow down your search. For this, there are two approaches you could take: bottom-up, or top-down.

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TOP-DOWN 

In the top-down approach, you go from big to small. First, you take a look at the prevailing market trends in terms of what industries are experiencing favorable trends. Within those industries, you take a look at the sectors that are trending well. And finally, within those favorable sectors, you look at the specific stocks that are performing well.

Some of the reasons that stock traders prefer this method of stock selection is because it allows them to approach the market with an open mind. Rather than trying to formulate a trading plan on the basis of liking a particular stock, it starts traders out on a path that lets them discover a stock that may work for them. Also, the practice of identifying strong sectors in and of itself can be useful for traders looking to get a good sense of the overall market. Some traders also favor this approach because it may help them discover opportunities for diversification. Again, instead of you saying, “I know lots of things about tech, so I’ll focus on tech,” it allows you to consider all sectors, as long as they’re favorably trending.

On the other hand, some traders feel the top-down approach is not the best way of selecting stocks. This method forces the trader to be aware of the entire market, which can be challenging and requires a greater amount of research. But also, by ruling out entire sectors, some traders feel that they are missing out on many trading opportunities.  

BOTTOM-UP

As you might have guessed, the bottom-up process is pretty much the opposite of the top-down approach. Here, you consider particular stocks that you believe are poised for growth, and then confirm that the sectors they are in are trending favorably, and that the industries that those sectors are in are also trending well.

Some traders like this, as it allows them to investigate stocks one-by-one, rather than having to research the market as a whole. It may also allow traders to select stocks that they might have otherwise passed up in a bear market, when the top-down approach could make most sectors look unattractive. But mostly, it’s a stylistic choice: some traders are interested in a certain set of stocks, and it allows them to use those stocks as starting points.

Of course, some traders eschew this method, as it may play too well into pre-conceived notions (if you’re already “rooting for” a stock, you may only find good things when you’re researching it). And, of course, by focusing on the individual stock, a trader could miss larger, macroeconomic trends and shifts, which could impact their trade down the line.

Ultimately, no particular way is better than the other. But what both of these approaches allow you to do is be thoughtful and prepared as you formulate your trading plan. And that thoughtfulness and preparedness should not only give you an idea about what stocks to buy, but also at what point you should sell the stock. In other words, as you look at trends and the viability of a stock, don’t just think about buying stock; think about when the time comes to sell it, and what level you expect that will be at. After all, it’s all part of the plan.

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