Lesson 9: Picking Stocks & Analyzing Economic Data
When it comes to personal finance and the accumulation of wealth, few subjects are
more talked about than stocks. It's easy to understand why: playing the stock market
is thrilling. But on this financial roller-coaster ride, we all want to experience the ups
without the downs.
There are nearly 6,000 publicly traded companies in the U.S. While this represents a
37% decline in the number of U.S.-listed companies since its 1997 high, it’s still a lot
of companies. How’s an investor to choose?
In this tutorial, we examine some of the most popular time-tested strategies for
finding good stocks (or at least avoiding bad ones). In other words, we'll explore the
art of stock-picking – selecting stocks based on a certain set of criteria, with the aim
of achieving a rate of return that is greater than the market's overall average.
#Intra-day Trading
Intraday trading involves buying and selling of stocks within the same trading day.
Here stocks are purchased, not with an intention to invest, but for the purpose of
earning profits by harnessing the movement of stock indices. Thus, the fluctuations
in the prices of the stocks are harnessed to earn profits from the trading of stocks.
An online trading account is used for the purpose of intraday trading. While doing
intraday trading, you need to specify that the orders are specific to intraday trading.
As the orders are squared off before the end of the trading day, it is also called as
Intraday Trading.
Intraday trading deals with buying and selling of stocks on the same day, during the
trading hours that are stipulated by the exchange. Stocks are bought and sold in
large numbers strategically with the intention of booking profits in a day.
Let’s explain Intraday trading with an example:
Suppose that you have bought 100 stocks of ABC limited during the open market
hours, then you have to sell the same no. of stocks of ABC limited before market
closure. Same is the case if you have sold the stocks, you have to buy the same
quantity of the stock you have sold earlier.
Advantage of intra-day trading
1. No overnight risk
The greatest benefit of day trading is that you have zero overnight risk. You close
your position prior to the end of trading day because of which your profitability is not
affected by good or bad news and events that happens during the non-trading hours.
A positional traders profit can disappear overnight because of any bad overnight
event. No overnight crises or tragedies of local or global markets can affect your
income for that day.
2. Day traders can make profit in any direction
Day traders can take benefit of both rising and falling market. This is not the case
with long term investors who hold their stocks for long duration to make profit from
bull run. Day traders can do short selling to make profit from falling stocks. Positional
traders can do short selling only in futures which requires high margin.
3. Increased Leverage more buying power
Day trading requires low margin and provides greater leverage on your trading
capital. Most brokers provide up to 100% leverage. That means you can trade with
more amount than you actually have in your account. If you have 1 lakh in your
account then you can trade with up to 2 lakh in a intraday (this varies from broker to
broker) This increased leverage can multiply your profits. Positional traders don’t
have this advantage and they have to have high level of investment to make
substantial profit.
4. High Returns
If proper day trading strategy is implemented with discipline good profit can be made.
To get good returns you have to learn to handle the intraday fluctuations of the
market to keep up.
5. Low brokerage commission
Brokerage commissions are 1/10th for day trading comparing to that of taking the
delivery of stocks. Other charges like service tax, stamp charges, stock transaction
tax etc. are applied over brokerage only, therefore for day trading you have to pay
very less commission. Taking delivery of stocks involves extra procedure of
transferring stock from company to your demat account which increases the cost that
you pay through brokerage. With day trading you can trade with more amount by
paying the least commission which is not possible with positional and long-term
trading.
6. You are in cash at the beginning and end of day
In intraday you square off all your position before the close of market. You start your
day with cash and end it with same cash (adjusting profit/loss) It’s easy to sleep well
at night when you’re in 100% cash. There is also a big advantage of this and that is
you can withdraw your cash any time in case of any emergency. Positional traders
don’t have this advantage they can’t withdraw their money immediately. They have to
sell the stocks first and then only can cash it.
7. Less Risky
As you are not vulnerable to overnight risk, with proper money management and
discipline you are less exposed to risk comparing to other form of trading. Loses can
be too much in positional trading as anything can happen overnight and your stock
can crash next morning on the opening of market. You may not even get suitable exit
levels. Imagine you are holding a fundamentally sound company stocks. After the
close of market CBI raids company office and arrests in CEO. The next morning the
stock will plunge down and you may not even get opportunity to exit. Your loses are
limited in day trading.
8. You can do more trades
Day trading gives you more opportunities. In positional trade you have to wait for
days, weeks or months for your targets or stop loss levels to trigger so that you can
make exit. But in day trading you have more leverage and can do more trades. You
can make quick exit on profit or loss in case of stop outs and can take entry into
another good stock. You have more buying power in day trade and can use more
opportunities than positional or long-term trade.
9. Better learning opportunities
Intraday trading gives you more opportunity to learn, test and apply various trading
techniques in the relatively short time span. You can test yourself which strategies
works good for you, which chart patterns gives better results. This can make you
more efficient and profitable.
10. Don’t have to do much study
If you prefer to buy stocks for short or long-time period you have to do more study to
select the right stock. You have to study its fundamentals and technical thoroughly.
You don’t have to do too much serious study of stocks in case of day trade. Most of
the traders only trade in few selected high-volume stocks every day and make good
profit without doing any intense technical or fundamental study of that stock.
#Full time trading
Both day trading and more conventional career paths have their benefits. A
conventional job guarantees you a salary (and, sometimes, benefits), whereas day
trading has higher theoretical scalability and allows you to be your own boss. For
most full-time day-traders, the biggest benefit is that you get to do what you love at a
job that consistently challenges you. Sound appealing? Take the following into
account:
As a full-time day-trader, you will have less stability, especially as you start out. You
will have good months, bad months, great months, and mentally exhausting months.
While this roller coaster of emotions is part of what makes day trading exciting, it can
also be stressful if approached improperly.
There are plenty of day traders and swing traders out there, many of them engaging
in the stock market at different levels. Some people utilize day trading for a living,
while others just trade for a few hours a day to bring in some extra income. One of
the questions I get asked a lot is, “when is the right time to make the leap to full-time
day trading?”
Of course, there is no universal answer to this question, however there are a few
considerations that come into play. It should be noted that day trading is not as
glamorous as it is often portrayed to be. Trading stocks is not about “making bank” or
living an exotic lifestyle. For full-time day-traders, trading stocks is a career. This
means it requires work – work that entails sitting by the computer for hours a day
staring at screens. You are not guaranteed to make millions of dollars. Heck, you’re
not even guaranteed to get paid. Day trading is one of the few career choices where
you are not guaranteed a paycheck, and you may even lose money after investing
hours of your time.
Discouraged yet? Don’t be. This is not intended to critique day trading as a career. I
trade every day and I love it. This post is intended to be a reality check that allows
you to set realistic expectations that will help you take the necessary steps to
achieve your goals. It’s also important to note that this post is targeted towards
people who want to know how to start day trading full-time (meaning you are leaving
your other job to pursue day trading full-time). Some of these points will not be
relevant to those who trade as an extracurricular activity.
Training – Before you even consider taking the leap towards becoming a full-time
stock trader, you should make sure you are properly equipped. You wouldn’t quit
your job to become an engineer without any proper training, right? What are your
chances of succeeding? The same logic applies to trading. Start developing the
proper expertise before even considering a career in day trading. We have a variety
of free and paid resources to get you started on your journey.
Experience – You can read 1000 books on trading theory and still get crushed by
the markets. Theory and practice are two different skill sets. Most traders need to
spend some time actually trading before they can get a real feel for the markets.
Consistency – If you are even considering becoming a full-time trader, make sure
you are trading consistently. This will allow you to set realistic expectations for the
future. Consistency is proof that you have actually developed an applicable skillset.
For a new trader, there’s more long-term value in making $5,000/month for 12
months than making $200,000 your first month and $0 the rest of the year. Sure, one
provides a higher short-term monetary value, however, it is less sustainable in the
long run.
#Identifying Stocks
In order to identify trading opportunities, we need to filter stocks for suitability define
the criteria and identify trading ideas for long and short trades.
A few caveats before we get started: Many investors new to the stock-picking scene
believe that there is some infallible strategy that, once followed, will guarantee
success. There is no foolproof system for picking stocks! This doesn't mean you
can't expand your wealth through the stock market. It's just better to think of
stock-picking as an art rather than a science. There are a few reasons for this:
1. So many factors affect a company's health that it is nearly impossible to construct
a formula that will predict success. It is one thing to assemble data that you can work
with, but quite another to determine which numbers are relevant.
2. A lot of information is intangible and cannot be measured. The quantifiable
aspects of a company, such as profits, are easy enough to find. But how do you
measure the qualitative factors, such as the company's staff, its competitive
advantages, its reputation and so on? This combination of tangible and intangible
aspects makes picking stocks a highly subjective, even intuitive process.
3. Because of the human (often irrational) element inherent in the forces that move
the stock market, stocks do not always do what you anticipate they'll do. Emotions
can change quickly and unpredictably. And unfortunately, when confidence turns into
fear, the stock market can be a dangerous place.
4. his should go without saying, but too many investors buy shares of companies
without really knowing how they make their money or having a grasp on the overall
business dynamics of the industry. As a rule, when searching for undervalued
companies, I highly recommend narrowing your search for undervalued stocks to the
types of businesses you understand.
For example, I have a strong understanding of the banking industry, as well as real
estate, energy, and consumer goods, so stocks in those industries make up the
majority of my portfolio. On the other hand, I really don't have a good grasp on the
biotech industry so I simply won't invest in it. Don't get me wrong -- I'm sure there are
a lot of great companies in biotech, and many could indeed be undervalued right
now, but it's just not my area of expertise.
5. Know the metrics. There are dozens of metrics you can use to evaluate a stock,
but the following are some of the best for locating undervalued stocks:
Price-to-earnings (P/E) ratio: By dividing a stock's current share price by its annual
earnings, you can calculate this metric, which is useful for comparing companies in
the same business. A lower P/E means a stock is "cheaper," but this is just one
variable to consider.
Price-to-book (P/B) ratio: Calculated by dividing a stock's price by its equity per
share. A book value of less than one implies that the stock is trading for less than the
value of a business's assets. Value investors use P/B multiples to find stocks with a
margin of safety.
Price-to-earnings to growth (PEG): Found by dividing a stock's P/E ratio by its
projected earnings growth rate over a certain time period -- typically the next five
years. This can be effective for assessing the valuation of a company with a
seemingly high P/E, but whose earnings are growing rapidly.
Return on equity (ROE): A company's annualized net income as a percentage of
shareholders' equity. This is a measure of how efficiently a company is using
invested capital to generate profits.
Debt-to-equity ratio: As the name implies, this is calculated by dividing a company's
total debt by its shareholders' equity.
Current ratio: A liquidity metric calculated by dividing a company's current assets by
its current liabilities. This tells investors how easily a company can pay its short-term
obligations.
Once you start evaluating stocks and getting a feel for these metrics, it's a good idea
to develop your own criteria for identifying a stock as undervalued. For example,
when I'm hunting for a good value, I like to see a below-average P/E for the stock's
peer group, a debt-to-equity ratio of 0.5 or less, and ROE of 15% or higher. Note that
these aren't set-in-stone guidelines. Rather, they are one piece of the puzzle that
should be taken into consideration.
The bottom line is that there is no one way to pick stocks. Better to think of every
stock strategy as nothing more than an application of a theory – a "best guess" of
how to invest. And sometimes two seemingly opposed theories can be successful at
the same time. Perhaps just as important as considering theory, is determining how
well an investment strategy fits your personal outlook, time frame, risk tolerance and
the amount of time you want to devote to investing and picking stocks.
At this point, you may be asking yourself why stock-picking is so important. Why
spend hours doing it? The answer is simple: wealth. If you become a good
stock-picker, you can increase your personal wealth exponentially. Take Microsoft,
for example. Had you invested in Bill Gates' brainchild at its IPO back in 1986 and
simply held that investment, your return would have been somewhere in the
neighborhood of 35,000% by spring of 2004. In other words, over an 18-year period,
a $10,000 investment would have turned itself into a cool $3.5 million! (In fact, had
you had this foresight in the bull market of the late '90s, your return could have been
even greater.) With returns like this, it's no wonder that investors continue to hunt for
"the next Microsoft".
Let's start by delving into one of the most basic and crucial aspects of stock-picking:
fundamental analysis, the theory that underlies all of the strategies we explore in this
tutorial (with the exception of the last section on technical analysis). Although there
are many differences among strategies, they all come down to finding the worth of a
company. Keep this in mind as we move forward.
The following can help in identifying stocks: Stock Screener -Finviz and another,
different site, maybe google finance, yahoo finance.
#Stock Market Announcements
Stock market announcement is an official public statement of a company's
profitability for a specific time period, typically a quarter or a year. Stock market
announcement typically occurs on a specific date during earnings season and is
preceded by earnings estimates that equity analysts issue. If a company has been
profitable leading up to the announcement, its share price will usually increase up to
and slightly after the information is released.
Because stock market announcement is the official statement of a company's
profitability, the days leading up to the announcement are often filled with speculation
among investors. Analyst estimates can be notoriously off-the-mark and can rapidly
adjust up or down in the days leading up to the announcement, artificially inflating
the share price alongside speculative trading.
Earnings Announcement and Analyst Estimates
For analysts valuing a firm future earnings per share (EPS) estimates are arguably
the most important input. Analysts use forecasting models, management guidance
and other fundamental information on the company to derive an EPS estimate. For
example, they might use a discounted cash flows model or DCF.
DCF analyses use future free cash flow projections and discount them. This is done
using a required annual rate to arrive at present value estimates, which in turn is
used to evaluate the potential for investment. If the value arrived at through DCF
analysis is higher than the current cost of the investment, the opportunity could be a
good one.
Calculated as:
DCF = [CF1/(1+r)1] + [CF2/(1+r)2] + ... + [CFn/(1+r)n]
CF = Cash Flow
r= discount rate (WACC)
Analysts may also rely on fundamental factors outlined in the management
discussion and analysis (MD&A) section of a company’s financial reports. This
section provides an overview of the previous year or quarter’s operations and how
the company performed financially. It digs into the reasons behind certain aspects of
growth or decline on the company’s income statement, balance sheet, and statement
of cash flows. It discusses growth drivers, risks, even pending litigation.
Management also often uses this section to discusses the upcoming year by
outlining future goals and approaches to new projects, along with any changes in the
executive suite and/or key hires.
Finally, analysts may take into account external factors, such as industry trends (e.g.
large mergers, acquisitions, bankruptcies, etc.), the macro economic climate,
pending U.S Federal Reserve meetings and potential interest rate hikes.
Stock market announcement can be obtained from the following:
- Market Announcements
- Company Announcements
- Economic News and Market Announcements
- Economic News
- Company Releases
- Interest Rate Announcement
- Employment
- Consumer Confidence