There are many ways to pick stocks. Traditionally, longer-term investors have relied on fundamental analysis, which examines a company’s management structure, competitors, industry position, growth rate, growth potential, income, and revenues to try to determine if it is a good value. Many metrics such as earnings per share, price-to-earnings ratio, price-to-earnings growth, and dividend yield have been developed to compare two companies with different share prices, a different number of shares outstanding, or just different corporate structures, side by side.
Shorter-term traders often rely on technical analysis, which focuses on patterns within stock charts to forecast future pricing and volume trends. Technical analysis assumes that future patterns and movement will often be similar to previous patterns and movement. Followers of technical analysis typically believe that charts reflect all the information that is publicly known about a particular company, by those who are trading it, and their activities are directly reflected in how chart patterns emerge.
Which type of analysis is right for you?
Typically, the type of analysis you choose depends on your overall trade strategy. Essentially, it’s believed that the longer-term the strategy, the greater the emphasis should be on fundamentals; the shorter-term the strategy, the greater the emphasis should be on technicals. However, both forms of analysis are important, and ignoring either potentially overlooks valuable information. And since the intended duration of a trade may change, employing both forms of analysis might be your best approach.
Both longer-term investors and shorter-term traders may be able to improve their chances of success by using fundamental factors to select the candidate, and technical factors to dictate the ideal entry or exit price.
First, focus on fundamentals
Investors who use fundamental analysis are often broken into two categories:
- Growth investors, who place a higher priority on the future prospects of a particular company.
- Value investors, who place a higher priority on whether the current stock price is aligned with the health of a particular company.
Growth investor’s strategy
The sole purpose of corporations is to grow, so that they can eventually turn a profit and return some of that profit to the shareholders. Very few new companies are immediately profitable. But if they are able to show strong revenue growth initially, even while losing money, growth investors will invest in them with the hope that profits will eventually materialize. When enough investors are motivated in this manner, possibly because a company has an innovative product or a competitive advantage, the share prices of these companies will be driven higher by buyers; the more buyers, the higher the prices will rise. As a result, historical and projected growth rates are typically the most important factors for investors buying shares of relatively new companies.
Value investor’s strategy
Value investors seek out larger, more established companies that appear to be priced below the level that would be expected based on their revenues or earnings per share. Value investors often focus on companies that are leaders in their industry, even though their growth rates have slowed down, because they often pay steady dividends. Value stocks often have low price-to-earnings ratios and pay above average dividends, but trade at a price that is very low or below their book value (total tangible assets minus total liabilities). Sometimes value investing is described as investing in great companies at a good price, not simply buying cheap stocks.
Screening stocks using fundamental analysis
Once you’ve identified whether you are looking for growth or value stocks, you can use the stock screening tool on Schwab.com to create a stock screener, which will help you narrow down the choices to a manageable list of quality candidates.
When screening for fundamental factors, consider limiting your analysis to only those stocks that have a Schwab Equity Rating (SER) of “A” or “B,” as these are considered “buy” candidates. In the example below, using this criteria narrows down the universe of choices from about 2800 candidates to about 824 candidates.
Since Schwab Equity Ratings already takes many fundamental factors into account, to keep things simple, investors searching for growth stocks should consider stocks that have a history of strong revenue growth, as well as projected strong revenue growth and projected strong earnings. In the example below, selecting these three additional criteria further narrows down the choices from 824 candidates to just six candidates. And again, you can further narrow down your choices through value screening, which I explain below.
Although there are several metrics you may use when searching for value stocks, a simple approach is to consider stocks that have an above-average dividend yield (but not too high), as well as a low price-to-earnings ratio and a price that is less than its book value. (As you search, keep in mind that high dividends are often candidates for elimination, and a stock may appear to be cheap due to outdated products, bad management, expired patents, pending lawsuits, etc.).
In the example below, selecting these three additional criteria reduces the choices down from 824 to just five.
After continuing your research on the five matches from this screener, you can follow the Technical Analysis process to narrow down your choices even further.
Next, focus on technicals
There are three main steps to stock selection based on technical analysis: stock screening, chart scanning, and the trade setup. With stock screening, your goal is to procure a list of 20 or 25 candidates by quickly sorting through thousands of stocks using a set of technical criteria. You will then try to narrow that list down to three or four candidates by scanning the charts for possible entries. Finally, you will perform a more detailed chart analysis and choose the one you’ll trade.
To illustrate this process, let’s assume you’re a swing trader that tends to hold a stock for a few days to a few weeks.
Screen stocks using technical analysis
To set up a screen, consider the following items:
- Price and market capitalization. This can be a good place to start as it allows you to eliminate a lot of stocks right away. For example, if you’re not interested in stocks priced over $100, you could exclude them in the screen.
- Sectors and industries. Using the StreetSmart Edge® sector tool, look for strong sector and industry groups if you want to go long and weak ones if you want to go short. Momentum. The technical trader usually wants to identify strong, uptrending stocks for potential buys and weak downtrending stocks for shorts. To find stocks that fit these patterns, consider moving average analysis. Moving averages are trend-following indicators that smooth out the day-to-day price movements to give you a sense of the trend. They can also act as support and resistance levels. A simple moving average is calculated by averaging the closing prices over a period of time by giving equal weight to each close.
For the longs, you might consider the stock be above its 20-day moving average, and that its 20-day moving average be above its 50-day moving average. For the shorts, you might consider the stock be below its 20-day moving average, and that its 20-day moving average be below its 50-day moving average. For liquidity, you might look for stocks that trade at least 200,000 shares a day. These values are used by many traders, but you might want to adjust them for your own needs.
Now, scan the charts of the candidates generated from your screen and look for stocks with good entry points. Among various considerations, there are two common entry strategies for swing trading: breakouts in the direction of the trend (new highs or lows) and pullbacks.
For breakouts on longs, consider entering on the first new high, or maybe the second, after the stock has traded sideways for a few days. For breakouts on shorts, consider entering on the first or second new low after a few days of sideways movement. With the pullback strategy, you’ll want to see the stock correct for a few days in the direction opposite the trend. You might then consider buying into that short-term weakness on the longs, and selling into that short-term strength on the shorts.
Next, examine the charts of the stocks that passed step two and pick the stock to trade the next day. We’ll assume for sake of discussion that you prefer pullback entries and have narrowed your choices down to two buy candidates, stock A, (figure 1) and stock B (figure 2). To help you decide, use price patterns, volume, moving averages and one additional tool, the stochastic oscillator.
Use the stochastic indicator
The stochastic indicator compares where a security’s price is relative to its price range over a given time period. One version consists of two lines, %K (fast line) and %D (slow line). Values can range from 0 to 100, with a reading of over 75 indicating that the stock may be “overbought” and possibly overextended on the upside. Readings under 25 indicate that the stock is “oversold” and possibly overextended on the downside.
When a stock is in a trading range and the stochastics values move into the overbought or oversold, look for a price reversal. This is especially true when the fast line is crossing from below to above the slow line for an upward reversal, and from above to below for a downward reversal. However, it doesn’t quite work this way in trends. For example, in an uptrending market, the oscillator can reach overbought and stay there for extended periods as the stock works its way higher.
When evaluating pullbacks, look for signs that the pullback is simply a pullback and not a reversal. Although you cannot be certain, chances of a reversal are diminished if the stock has pulled back to a support level, such as a moving average or an old low. Also, if the stock can exceed the high of the previous day, it can be a sign that the pullback is ending and that it’s ready to resume its uptrend. Looking at Figure 1 and Figure 2, we can see that both stocks A and B have pulled back and held their 20-day moving averages. So far, so good.
Now, look at the last trading day for each stock. Stock A was unable to trade above its previous day high, either on an intraday or closing basis. Also, it closed about where it opened and did so in the middle of a narrow range, all signs that buyers lacked conviction.
Looking closer, the %D line indicates that the stock isn’t oversold, which is very good and typical of an uptrend. However, the stochastics lines haven’t crossed; as you can see, %K is still below %D. If %K had crossed %D, that would show a little more upside strength.
On a positive note, the volume was relatively light: heavy volume can a danger sign when the stock moves in the opposite direction of the trend.
The last trading day on stock B tells a different story. The stock not only was able to trade intraday through the previous day’s high, it also managed to close above it. Also, it had a wide-range day with a close near the top. These are all signs that the buyers have gained control and that the pullback could be over, especially since this price action was achieved on higher than average volume. Also, stochastics show that neither %K nor %D are oversold, indicating strength. In addition, %K has crossed %D, which is another bullish sign.
Stock B, then looks like the stronger candidate for the next day.
Figure 1: Source: StreetSmart Edge®
Figure 2: Source: StreetSmart Edge®
Simplify your stock selection
Stock selection doesn’t have to be difficult, but you do need to be flexible. Look for markets that are moving, and be willing not to trade or to go short, as well as long. Finally, and perhaps most importantly, you need to be disciplined. Don’t let the inevitable bad trades turn into disasters. Keep your losses small and live to trade another day.