"How do I pick a good stock?!" This is one of the biggest challenges facing beginning traders, and it is a great question.
It’s a bit of an innocent question. And it’s a revealing question!
It’s revealing because the question itself reflects the borderline hopelessness that so many traders feel. As a teacher I’m always looking for the question within the question. The question that the person needs to be asking but doesn’t know how to voice.
When I see this question about picking a stock it tells me that the person asking it is feeling a bit hopeless. Many times the person who asks this question is really saying “I don’t even know where to start”.
I have great news! YOU’RE NOT ALONE!
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 only trade certain trade setups. Maybe they like a Bollinger Squeeze play, or perhaps a moving average cross. Our local day trading expert Alphonso for example, he only likes to play opening morning gaps. Great - that’s his trade setup he’s looking for.
The best way to find this kind of a setup is to use a scanner. Most quality charting softwares provide a scan function that allow you to scan for certain criteria. Trade Navigator, Motive Wave, and TradeStation - these 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 to look at? Who’s to say there’s not another one you’re missing somewhere?
Moreover, if the stock is really worth that estimated value, why is the market trading below that price? This is the one that really 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 that is a component that fundamental analysis simply can not 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 that needs to be considered? Are there any larger fundamental announcements (fed meetings etc) 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 race horses, 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 just 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 just 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 really like this method because 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 on a weekly basis. I use the 5 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 everyday 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 simply 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.
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