A Traders Edge In The Stock Market
Unless you are able to develop a considerable trading edge over the other traders, you will end up losing your money, even if you are disciplined and organized. In this article, I discuss some elements that I use in my trading edge.
Fundamental analysis is the process of evaluating the financial condition of a company using financial reports, price/earning ratios, revenues, market share, sales and growth, etc. This type of analysis can be time consuming so instead of going through pages of financial reports, I simply look at IBD ratings.
I like to use Investor’s Business Daily (IBD found at investors.com) to get a quick overview of a stock. The IBD rating covers:
1 – Earnings Per Share (EPS) rating: tells me a stock’s average short term (recent quarters) and long term (last three years) earning growth rate. The number I see is how the company compares to all other companies. The scale runs from 1 to 99, 99 being the best.
2 – Relative Price Strength (RS) Rating: Measures a stock’s relative price change in the last 12 months in comparison to all other equities. The scale runs from 1 to 99, 99 being the best.
3 – Industry Relative Price Rating: Compares a stock’s industry price action in the last 6 months to the other 196 industries in IBD’s industry list. The scale is from A to E, A being the best.
4 – Sales + Profit Margins + ROE (Return on Equity) Rating: Crunches a firm’s sales growth rate during the last 3 quarters, before and after profit margins and return on equity into one letter. The scale is from A to E, A being the best.
5 – Accumulation/Distribution rating: Applies a formula of price and volume changes in the last 13 weeks to determine if it is being accumulated or distributed. A = heavy buying, C = Neutral, E = heavy selling.
If you like the idea of including fundamental analysis into your trading plan, consider trading only stocks that meet some minimum requirements – for example A or B, > 70, etc.
I like to use fundamental ratings for longer term trades such as the ones I plan on weekly charts. It is not really useful if you trade intraday.
Fundamental analysis is great to build a list of strong stocks, or as a way to filter out weak stocks, but that’s about it. It does not provide you with an objective method to enter and exit trades. All my trading decisions (entry, exit, and stops) are based on technical analysis.
Technical analysis is the study of prices. The price action draws patterns on charts and because human behavior can be repetitive, the price patterns can also be repetitive.
You can choose from a variety of chart types. The Japanese candlestick charts are by far the best and it is the only form you need. There are entire books dedicated to the study of candlestick patterns – if you are serious about studying candlestick charts, look at books written by Steve Nison and and Gregory L. Morris.
– Support and Resistance: The most important concept in technical analysis is Support and Resistance. It forms the foundation for every trading decision and could cover many pages but I will limit myself to simplified definitions and a couple examples:
Support level: A price level that a declining market or stock failed to penetrate
Example: the low of the previous day forms an area of support and is often used as a stop loss.
Resistance level: A price level that a rising market or stock failed to break through
Example: a prior high in an uptrend forms an area of resistance and can be used as a minimum objective to take some profits.
Some technical indicators may also provide some support and resistance, for example moving averages, in part maybe because so many traders expect it.
An oscillator is a technical indicator that tells you at a glance whether a market or a stock currently trades in an “overbought” or “oversold” condition. Some traders use oscillators to forecast a change of direction. Some examples include the RSI, Stochastic Oscillator, and MACD.
There are hundreds of oscillators and technical indicators. I personally look at them to filter out some stocks if I have too many good ones to choose from. I never use them as a signal to open or close a trade.
– Public Sentiment
I look for support and resistance on the VIX (Volatility Index) daily chart to anticipate reversals.
I look at the Put/Call Ratio (5 MA and 10 MA) on the daily chart to see if traders are too bearish (MAs > 0.8) or too bullish (MAs < 0.5).
(MA = Moving Average)
– Market internals to see if the market is overbought or oversold
I look at the TRIN (5 MA and 10 MA) on the daily chart – overbought (MAs < 0.8) or oversold (MAs > 1.2).
I look at the McClellan Oscillator – the market is overbought if it rises above +70 and oversold if drops below -70. A buy signal is generated if it falls into the oversold area (-70 to -100) and then turns up – a sell signal is generated if it rises into the overbought area (+70 to +100) and then turns down. If it goes beyond the -100/+100 levels then it may be a sign of continuation of the current trend.
– Market and Industries
I like to buy stocks from industries in a strong uptrend and short stocks from industries in a downtrend. I also consider the direction of the industry for the day (positive or negative).
Putting it all together
This article is not about teaching you how to develop an edge but hopefully it shows you that there are many different tools that can be used to improve your odds. It takes time to find a combination that fits your personality. It takes time to find what works for you.