Even if you are disciplined and well-organized, you will lose your money if you can't find a way to trade better than the other traders. In this article, I talk about some parts of my trading edge and how I use them.
Fundamental Analysis
Fundamental analysis is a way to figure out how a company is doing financially by looking at its financial reports, price/earnings ratios, revenues, market share, sales and growth, etc. This kind of analysis can take a lot of time, so I just look at IBD ratings instead of reading through pages of financial reports.
Investor's Business Daily (IBD, found at investors.com) is a good way for me to get a quick overview of a stock. The IBD score looks at:
1: The Earnings Per Share (EPS) rating tells me the average short-term (last three quarters) and long-term (last three years) growth rate of a stock's earnings. When I look at the number, I can see how the company stacks up against all other companies. On this scale, 1 is the worst and 99 is the best.
2 - Relative Price Strength (RS) Rating: This shows how a stock's price has changed relative to all other stocks in the last 12 months. On this scale, 1 is the worst and 99 is the best.
3 - Industry Relative Price Rating: Compares the price movement of a stock's industry over the last six months to the price movements of the other 196 industries on IBD's list of industries. From A to E, the scale goes, with A being the best.
4: Sales + Profit Margin + Return on Equity (Return on Equity) Rating: Turns a company's sales growth rate over the last three quarters, before and after profit margins and return on equity, into a single letter. From A to E, the scale goes, with A being the best.
5 - Accumulation/Distribution rating: Uses a formula based on price and volume changes in the last 13 weeks to figure out if it is being accumulated or distributed. A means a lot of people are buying, C means no one is buying or selling, and E means a lot of people are selling.
If you like the idea of using fundamental analysis in your trading plan, you might want to trade only stocks that meet some minimum requirements, such as an A or B rating, a score of 70 or higher, etc.
For longer-term trades, like the ones I plan on weekly charts, I like to use fundamental ratings. If you trade intraday, it is not very useful.
Look at the numbers
Fundamental analysis is great for making a list of good stocks or getting rid of bad ones, but that's about it. It doesn't give you a clear way to know when to enter and leave a trade. Technical analysis is what I use to decide when to buy, sell, and set stops.
The prices are what are looked at in technical analysis. Price action makes patterns on charts, and because people's actions can be repeated, so can the patterns.
You can pick from different kinds of charts. By far, the best charts are the Japanese candlestick charts, and that's the only kind you need. There are whole books about studying candlestick patterns. If you want to learn more about candlestick charts, look at books by Steve Nison and Gregory L. Morris.
Support and Resistance: Support and Resistance is the most important idea in technical analysis. It's the basis for all trading decisions, and I could write many pages about it, but I'll just give a few simple definitions and examples.
Support level: A price level that a falling stock or market didn't break through.
For example, the low of the previous day is often used as a stop loss because it is a support area.
Resistance level: A price level that a rising market or stock couldn't break through
For example, a previous high in an uptrend can be used as a point of resistance and a minimum goal to take some profits.
Some technical indicators, like moving averages, may also offer support and resistance. This may be because so many traders expect it.
- Oscillators
An oscillator is a type of technical indicator that shows at a glance whether a market or stock is "overbought" or "oversold." Some traders use oscillators to try to guess when the market will change direction. The RSI, the Stochastic Oscillator, and the MACD are all examples.
There are many oscillators and technical indicators out there. I look at them to narrow down my choices when there are too many good stocks. I have never used them to open or close a trade.
- Public Sentiment
I look for support and resistance on the daily chart of the VIX (Volatility Index) to predict when prices will change direction.
On the daily chart, I look at the Put/Call Ratio (5 MA and 10 MA) to see if traders are too pessimistic (MAs > 0.8) or too optimistic (MAs 0.5).
(MA = Moving Average)
- Market internals to find out if the market is overbought or oversold
I look at the daily chart to see if the TRIN (5 MA and 10 MA) is overbought (MAs 0.8) or oversold (MAs > 1.2).
I look at the McClellan Oscillator. If it goes above +70, it means the market is overbought. If it goes below -70, it means the market is oversold. If it goes down to the oversold area (-70 to -100) and then goes up, that's a buy signal. If it goes up to the overbought area (+70 to +100) and then goes down, that's a sell signal. If it goes past the -100/+100 levels, it could mean that the current trend will keep going.
- The Market and Business
I like to buy stocks in industries that are going up strongly and sell shares in industries that are going down. I also think about where the business is going at the moment (positive or negative).
How it all fits together
This article won't teach you how to get an edge, but it should show you that there are a lot of different ways to improve your chances. It takes time to find the right combination for you. Finding what works for you takes time.
