Experienced traders have a method for picking stocks. They arrive at their selections using a form of planned, consistent approach that allows them to efficiently and objectively identify opportunities in the markets. While this article will focus on stocks, the approach you choose can be used for other securities.
Many traders employ a top-down or bottom-up stock selection approach. The top-down approach begins with a review of the market as a whole, then drills down through a variety of details until a potential stock candidate is identified and selected. The bottom-up approach begins with a particular stock and then looks at sector and macro data to support the selection.
The top-down approach consists of starting with a broad economic outlook; moving to a country’s or region’s outlook; then into sectors and; finally, various individual stocks. By doing this, you get a sense for how markets, regions, and segments are performing generally. And, while a trader should not assume that current performance will continue, it is an indicator of current sentiment. The stock market has institutionalized this type of thinking with such sayings as, “The trend is your friend,” and “Don’t fight the tape.” The steps involved in a top-down search are as follows:
- Develop a point of view on the direction of the overall market. Potential indicators that may help formulate that view are employment figures, business and consumer spending, inflation, and governments’ monetary policies.
- Identify the sectors that are leading the broad market higher or lower.
- Use technical and/or fundamental analysis to identify the stronger/weaker stocks within the sector.
The second method is the bottom-up method, whereby the trader starts with a particular stock that he or she likes and then looks to industry, sector, and macro measures to support the selection. If any of these measures are behaving counter to your point of view on the stock, consider your trade carefully.
- Look at the fundamentals and technical actions of the firm. Assess those against comparable firms.
- Determine how the sector is behaving.
- Determine the prevailing trend of the broad market.
- Determine the shape of the general economy.
Instead of starting with the trend and then looking for stocks that are following it, you are taking a given stock and seeing how it compares against the prevailing trend. This has the advantage of giving the trader an immediate focus, as you are only looking at what may be happening to a given stock and its industry, rather than searching the entire universe of stocks. Just be cautious to not cherry pick the data to support the trade. Objectivity is what keeps emotions in check.
The top-down and bottom-up approaches provide ways to identify and evaluate trade candidates. While the steps in each are the same, the order in which you go through them is different. You may use the bottom-up approach to vet out a ‘hot tip’ or something heard in the financial news. Or, you may use the top-down approach, following a strong overall market trend and drilling down to specific opportunities. With time and practice, you will find the best combination suitable for your trading objectives and trading style.