One of the major hurdles that traders face is the proper selection of stocks to trade. People with no trade plan would rely on "gurus" or investment forums to get a tip on the next big thing. After many painful losses, they quit and blame stock trading for being a scam.
The truth in trading is that a stock can move in various unexpected ways. To minimize the risk of losing, we employ a strategy to eliminate most of the noise and concentrate on stocks that show the best potential for profit. To do this, we'll need a systematic approach to check the fundamentals, technicals, market sentiment, and risk before we pull the trigger.
Proper stock selection is no rocket science. Once you get the rhythm of discipline and timing going, you'll find yourself hitting that buy and sell button at the right time. Here's our basic template on proper stock qualification:
A. Define first the overall market trend
As a general rule, stock qualification starts by identifying first the general market trend. This will determine what kind of play to do and will tell you the amount of position in your portfolio that is worth risking. There is always a time to be aggressive and defensive in trading and the overall market trend will determine which stance you should take.
1. Uptrend
An uptrending market means that there are more people buying than selling in a particular timeframe. To take advantage of this market condition, a trader has to position near the dynamic support to be able to profit from the rally. Waiting for stocks to hit their key support will cause you to miss out on major moves since stocks will continue to move up as buying pressure gains momentum.
2. Downtrend
A downtrending market is generally frustrating to navigate. Many traders get faked as breakout setups rarely happen in this market climate. To ensure profitability, a trader must always position at the key support level and set a cutloss point if it does breakdown further. Sell immediately at its key resistance and wait for a pullback.
3. Sideways
A sideways market is distinguished by a contracted trading channel which is defined by key supports and resistances. This can be a profitable market condition for seasoned traders as multiple swings allow for constant buying and selling to take place.
A swing trade approach is very effective during a sideways market. Since key supports and resistances are clearly defined, a trader can forecast the move of each swing. Always sell at resistance during this market condition as selling pressure quickly takes place near the resistance level.
B. Look for stocks with good volume
If there is no trading activity in the stock then it will not move. Volume in the context of trading refers to the number of shares traded in a particular time period. It is the fuel of price action so you must be looking to enter at stocks with enough demand to generate volatility.
Check the most actively traded stocks in your online broker platform. Start scanning the list for potential plays. This will be a good starting point to narrow down potential stocks for further analysis.
C. Check if the company is profitable
Positive company earnings will likely attract institutional buying. Check the earnings for the past few years and see if the company is generating profit.
D. Check company news and updates
Actively traded stocks have a news driven component to them. One bad news can send a stock tumbling down and a single good one can send it soaring to new highs. Make sure you browse news for potential speculative plays that can lead to a very profitable trade. Of course technicals have to check out as well for this to be valid.
E. Analyze the technicals of the stock
Once you narrowed down your list to a handful of stocks, it is time to check the price charts. This is the time when Technical Analysis will be fully utilized. It will help you interpret the proper stock entries and exits for you to generate a profit. Among all the steps, this will prove to be the most complex since flawless chart analysis requires a certain level of skill to be executed properly.
As you refine your skill in interpreting the charts, remember that technical indicators are merely guides to navigate volatility. A lot of traders fall to the trap of relying too much on specific technical indicators. Indicators are only a derivative of price action. The bottom line here is interpreting the price action against the volume. Certain questions will eventually be asked. Are there more buyers than sellers at the current price level? Is the price near a multi-year support level or at the peak of a multi-year resistance? Is there heavy institutional buying for a period of time? All of these questions are mandatory before any decision can be made.
Remember that you should be buying when buying pressure is the greatest and selling when selling pressure rejects the price. Technical analysis will allow you to determine these levels.
F. Determine the Risk-Reward Ratio
Before you place your hard earned money, you have to ask how much you are willing to risk depending on the amount that could be lost if the stock moves against your bias. If the play only shows a potential 5% upside and a support breakdown shows a potential -15% free fall from the entry price, will you still take the trade? Of course not!
Risk management is always the key to remain in the game. Always determine the potential loss that a trade could incur if it goes sour. This way you can easily set a cutloss level and get out immediately if the stock turns against you. Remember, stock trading is always about maximizing profits and minimizing losses. Manage your risk in every trade!
We hope this post has helped you. To read more stock trade strategies and tips, check out the online learning module in this website. We are constantly updating content to better serve you. Happy investing!
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