"How do I pick a good stock” is one of the biggest challenges facing beginning traders. It’s a bit of an innocent question, but it’s a revealing question as well!
The question is revealing because it reflects the borderline hopelessness that so many traders feel. As a teacher, I’m always looking for the question within the question; the question a person needs to be asking but doesn’t know how to voice.
When I see this question about picking a stock, it tells me the person asking it is feeling a bit hopeless. Many times, the person who asks this question is saying, “I don’t even know where to start.”
Every trader has faced this question at some point. The good news is a lot of us have found the answer! The bad news is we all have different ways of picking a stock!
Some traders like to trade certain trade setups such as a Bollinger Squeeze play, or perhaps a moving average cross. For example, our local day trading expert Alphonso only likes to play opening morning gaps. Great - that’s his preferred trade setup.
The best way to find this kind of a setup is to use a scanner. Most quality charting software provide a scan function which allows you to scan for certain criteria. Trade Navigator, Motive Wave, and TradeStation are all examples of software that allow you to scan for a specific trade setup.
The more traditional way long term investors look for great stocks is to spend the time to do a solid fundamental analysis on the company. We call it Value Based Trading. This method takes a good bit of time and is typically not for the statistical faint of heart. It involves looking at potentially hundreds of companies, doing a fundamental analysis on them, and finding the ones that are not trading at their estimated fair market value. When you find one that is trading for less than the estimated value, you buy that company with the expectation that it will rise to your estimated target.
This method is very popular among fund managers and long-term investors. There are some built-in challenges to this form of stock picking. One challenge is the reality that you’re basing your trade based on the theory of what you believe it should be worth. But who’s to say what the best fundamentals are? Who’s to say there’s not another one you’re missing somewhere?
Moreover, if the stock is worth that estimated value, why is the market trading below that price? This is the one that gets me the most. Markets tend to be very efficient at revaluing a stock and moving it to the fair price very quickly. Anything beyond that is left to speculation, and it is a component which fundamental analysis cannot predict.
I have a good friend who manages a large amount of money for a well-known firm. He has a certain criteria that he follows when picking stocks.
What is the overall market doing? Is the overall market strong? Is there weakness which needs to be considered? Are there any larger fundamental announcements that need to be considered?
He considers the following criteria as it relates to each stock he is looking at:
He ranks them in order of highest probability based on his research above. His theory is that portfolio management is a lot like building a book of racehorses, you take some off and put some on, all based on performance. If one is performing better, you swap it out for one that is not performing as well. The ranking helps organize who is performing better.
He looks for technical strength. Even though my friend is primarily a fundamental investor, he admits his history picking winning stocks based on fundamentals alone has not been stellar. He includes a technical view as added confirmation.
When a trade sets up that looks like it has better upside than one currently on the books, he makes the switch and buys the new winner while cutting the older one that isn’t performing as well.
This strategy has worked well for this friend many years. His career has been over 25 years in top-level portfolio management, and he has only had a couple of years where he did not beat the S&P as a whole.
For me, I preferred a bit of a different approach. I don’t like scanning, and I don’t like looking at hundreds of companies. I have a life, and I like to live it! So, my method is one where I prefer to put together a watch list, keep up with the stocks on that watch list, and wait for a great trade setup. When it appears, BOOM! I like to pounce and place the trade.
This method annoys a lot of people because it feels boring. I like it because it’s boring! I also like it because I become very familiar with the trading behavior of the stocks I’m trading.
In our Power Trader Live class, we have a watchlist of 10 stocks that we watch every week. Probably 90% of my trades are placed off of this list. You can get enrolled today with our Premier Trader's Club Membership!
Now, this method requires something a lot of traders aren’t willing to develop - actual trading skill. But if you’re willing to develop the skill, I believe this method to be superior.
I do not care if the stock is going up or down; I want it to move. So I put stocks on the list that tend to move a lot. Every year we tend to get one on there that doesn’t move, but as a whole, they all tend to have pretty decent volatility and movement.
Since I don’t care which way the trade goes, all I need to do is track the trade. When a bullish trade sets up, I place the bullish trade (for me that usually involves buying a call option). When a bearish trade sets up, I place a bearish trade (for me that usually involves buying a put option).
I like this method because it takes a somewhat ambiguous question and changes it from “how do I pick a good stock” to “How do I know when a stock is about to move and which direction?” In truth, regardless of your stock-picking method, you still have to answer the second question. So I find it better to get a watch list and spend my energy answering the second question rather than searching for the answer to the first.
So how do I answer the second question? I use all of the techniques I teach in Foundations of Stocks and Options, and you see us demonstrate in our Power Trader Live every week. I use the five steps of trade confirmation that we teach. I trade primarily on the break out of a pattern. I prefer to trade to a target and take the profit. I prefer to have a defined risk-reward.
As you can see, this method takes basic question and turns it into more of an action list that is focused not on picking, but on executing great trades.
What if the question we woke up built-in to ask was, “how do I execute great trades?” That would be a question that would lead us down a more productive and profitable road. That’s why I like this method of picking trades.
It doesn’t matter which stock-picking method you choose. In reality you have to choose a method that works for your personality and provides trades that fit your style of trading. Regardless of the method you still have to answer that final most important question of “how do I execute great trades.” That’s the question that should be front and center in the mind of every trader.
My suggestion is that maybe you try all three. I expect at the end of the day you’ll come to the same conclusion have which says the 3rd method is best. Build a good watch list of stocks that move a lot. Learn to be a great trader. And lay in wait for the trade to come along. I promise there’s plenty of great trades. You have to recognize them when they show up!