This Week’s Trading Lesson
It is sometimes difficult to know where to begin when deciding whether a stock is worth purchasing or not. Here are 7 questions that I think everyone should ask before buying a stock, as well as what to look for when answering the questions in the most basic form.
1. Is The Market In An Uptrend?
Stocks go up because investors are optimistic about the future. This is shown on a stock chart in a number of ways. The most important and easiest way is to look for whether the bottoms of the stock chart are rising and if the market is in a general uptrend (moving from the lower left to the lower right). If it is, that means that the buyers are in control of the market, making the stock more likely to go higher rather than lower.
However, it can also happen that conditions become just right for a stock to go up if the tops are falling. This is due to if investors are motivated by fear. When investors are afraid of prices going lower, they will sell with emotion – always an unwise practice – and accept too low of a price. When stocks in this situation find a catalyst for emotional change, they often bounce back quickly.
2. Do Investors perceive significant fundamental change may be likely in the future?
It is important to realize that stocks do not go up because of what happened in the past. They go up because of what will happen in the future. We also need to accept that the stock market is not fair and that some people use information better than others. These investors will create abnormal trading activity in a stock when they expect significant fundamental change in the future. To beat the market, we have to leverage this break down in market efficiency and focus on stocks that are showing abnormal trading activity in both price and volume. Remember perception is reality and the market always knows best.
3. Is the probability of the stock going higher strong enough to justify the trade?
While the market may be showing optimism, as evidenced by rising bottoms on the stock chart, we also need to know that the probability that the optimism will continue is good enough to justify entering the stock. The best way to determine this is by using chart pattern recognition. Patterns like ascending triangles, pennants, flags and cup and handles are very helpful (because human nature doesn’t change) so it is essential to learn how to recognize them. Often, investors will buy a stock that is well in to an upward trend because the stock is showing a lot of optimism. However, because stocks that have been trending higher don’t usually have good chart patterns any longer, they may not be worth entering. We want to find stocks that are starting upward trends so that we can maximize the probability of success.
4. Does the reward potential of the trade justify the risk?
All signs may indicate that the stock is likely to go up but if there is a limit to how high it can go then we should evaluate whether the reward potential is significant enough to justify the trade. Stocks will often stall at historic ceiling prices which chart readers call resistance. We should exit a trade if the stock falls below its historic floor price, which chart readers call support. If resistance is not twice as far away from your entry price as support is, the trade is probably not worth taking.
5. How Much Will I Risk? Can you, the investor, handle the risk of the trade?
Always know exactly how much you want to lose if you are wrong an where you are going to exit – if the trade moves against you. The greatest enemy of any trader is emotion. Emotion causes us to avoid taking losses when the market tells us the stock is likely to go lower. It causes us to sell our strong stocks too early. Emotion is at the root of almost every break down in our trading discipline and it is the reason most people fail to beat the stock market. If you take more risk than you are comfortable with on any trade you will likely make emotional mistakes. Therefore, it is essential that you are comfortable with the risk of every trade you make. To be successful, you must not care about the money.
6. Is the overall market condition right for your trade?
Every stock has some correlation to the overall market. No matter how good your analysis or disciplined your trading, you will do better if you go with that thing that is out of your control. Trade with the mood of the overall market and buy stocks aggressively when the overall market is going up. For long-only investors, being conservatively when the overall market is down tends to be a highly rewarding proposition. Remember, 3 out of 4 stocks follow the major averages and if the market is falling trying to find a stock that will buck the trend is not ideal.
7. Does the stock have enough liquidity to justify the trade?
The public listing of a stock does not mean it will be easy to buy and sell. A stock needs buyers and sellers to create the liquidity of the investment. Stocks that trade with little volume or not on a regular basis are best avoided simply because the costs of entry and exit are too high.