Minimize Research; Maximize Potential for Profit
In my over 20 years of trading, I have learned the following:
1. The pundits are right that one must not trade by emotion. Wow, hard to break but this is a must.
2. Getting from point A to point B is best done with a map…not the Garmin type, I may add, when trading stocks.
3. The investor is awash with information - Again, wow! I re live my early trading days when this resource was scarce and what one got was mostly at least a quarter year old.
4. Time is valuable - Again, wow! There are new breeds of tennis racquets and golf clubs waiting for us to try out. Yes, life should not be all about trading securities.
5. I cannot always be right - humbling, but a mantra that has kept me on track and hedge my losses.
I like keeping things simple so I will limit discussions below for trading in common stocks only.
Why is emotion so hard to take out from our trading equation? The desire to make a profit has a dose of emotion to start with easily laying the foundation for including emotion in trading. The lack of knowledge and trading skill contributes to depending upon views we hear from others, making us a captive of emotion laced trades. Newsletters are aplenty but most of them are old news by the time one gets them and many are written to promote a stock. I have heard traders bought stocks because their daughter or someone they know work for this company. I have seen traders held back buying a stock, watch it go up for a few days and feel remorse so they jump in and buy it and watch the price go down sooner than later.
In my case, I wean out emotion as much as I can (honestly, I do not know if anyone can really ignore it 100%) by relying on myself using metrics that I found meaningful running businesses and living through the impacts of such metrics. I set a system consists of a few but select Fundamental and Technical metrics and go with my assessments objectively tempered by current NEWS specific to the stock of interest.
Mapping Out My Trades:
I am systematic when trading. I might add that my map is focused on individual common stocks and not the sector or market in general. There are individual gems to be found in either bull or bear market. My map starts with stocks in my check list. I update my check list every two weeks using a preset screen in 2 or 3 sources at the most. My list is finalized with those stocks passing my three Fundamental metrics. This list clears what stocks I plan to trade. When to trade is another piece of the map. I use a select few Technical metrics to tell me when to trade, i.e. buy, hold, sell.
Today there are still many who believe in not timing the market. Long term investors believe that they can jump in anytime as their chosen "good" stock will eventually go up in price. Well, just like using a GPS when traveling, one can use different routes be it "FAST, SHORTEST, or ECO". I need to have my route chosen as part of my map. Day, swing and technical traders are my version of FAST and I belong to this group for personal reasons. I used to be a buy and hold investor in my younger days. Now that I am retired, I do not feel like waiting for years to realize gain. In addition, the current relatively higher stock price volatilities is more challenging to predict the longer one owns a stock. Who would think that the automobile industry, banking, etc. fell from their lofty perches as fast as they did? I subconsciously adapted and became a technical trader timing the market, with entry at lows and exits at highs based on my technical criteria. I do time the stock (not the market/sector) and find this more profitable. The one glaring factor in my age group is protection of capital over high gains and how much capital to put at risk is of personal tolerance. One thing for sure, at our senior age, to protect capital and significantly improve profiting from trades, one must have an above average skill in trading.
Summarizing, my stock trading map starts with a check list of stocks that passed my Fundamental and Technical metrics. Current News influence my trade when it falls in a value range when I quantify my interpretation of my Fundamental and Technical metrics.
Information at Hand:
Of course, the traders today must be comfortable navigating the stock marketplace in front of his/her computer to take advantage of what is out there that can be used for trading. The challenge is to emerge from the flood of information weaning out the real and relevant ones. I look at newsletters but do not take everything there as gospel truths as the preachers most of the time have other motives rather than giving me a tip to make money for myself. However, newsletters are handy when corroborated with other sources of information. Neither am I advertising for the following entities nor endorsing them… I am mentioning them as examples of corroborative sources of information…Morningstar, Yahoo Finance, Scottrade, Fidelity, etc.
I quantified the impact of my Fundamental and Technical metrics when trading. This means that I assign values to where the stock price fits in my criteria and buy, hold or sell decisions are made depending upon the sum of all values. News is difficult to quantify so I treat is as a bonus. When I trade, news does not come into play when the sum of my values is overwhelmingly either to the left or to the right. News does influence my trading decision when I am near the thresholds of buys or sells. News can make me swing one way or the other.
Time is Super Valuable:
"One would rather do something else rather than sit in front of the computer all day!" Sounds familiar? My take on this is it is a scapegoat mainly caused by not knowing how to efficiently map out trading. I average 1 hour daily to review my check list and trade. Once every two weeks, I spend more like 3 or so hours updating my check list and investigating deeper into market related developments. The time spent is well worth it when one makes money at the end. The key to time management is developing a strategy based on metrics and follow one's road map leaving behind bags of emotions. I mean no second guessing. Trade guided by your system. Of course one must take the time to understand and use a system that works. The system I developed for myself and teach my club in the community I live has worked well for me over the years. One needs to reach a comfort and confidence level that he/she is on the right track, not 100% of the time but at least 65% of the time. I value my time as each second that ticks is gone but this does not mean that I rush through my analyses. A systematic observance of my road map has resulted in an efficient use of time. You can do the same.
Be Realistic. You Cannot Be Right All the Time:
The system I developed evolved in time to what works for me in an efficiently manageable time. My accuracy is highest within a week to two weeks and it tapers off from there caused by factors driving volatilities. So I hedge. My main manner of hedging is putting stop loss orders. The stop loss is set depending upon where the price is relative to my Technical metrics. My stop setting changes depending upon its function in the life cycle that I hold the stock. The first setting is to protect my new investment from sudden unforeseen drops in price. The tightest setting is to protect my gains and the price of the stock is at the top of its current volatility curve.
There are other ways of hedging including options. I my case, I forego this method in part due to time management. I find myself with 80-100 stocks most of the time and I concentrate on what I do best, i.e. efficiently getting in at lows and getting out at highs. I probably hold more stocks compared to other small investors and it can be said that the number of stocks offer me some degree of diversification. It does not as I trade on a stock on its own merit not considering how it fits in a diversification strategy. I also do not believe in the classic concept of diversification and balancing the portfolio selling good earners just to maintain the proportion. Thus, I stick to managing a simple hedge - stops (and less frequently, limits when applicable).
Choice Fundamental Metrics:
For brevity and keeping things focused, allow me to share my Fundamental metrics this time.
Over the years of running businesses and trading, I have focused on what makes a business not only survive but grow. Many today still use PE ratio as a main criterion of value. I do not. I find PE ratio relevant only when compared among peers. It loses its value when comparison is applied across its sector and the general in general. How many of us can make this distinction readily without spending hours researching one stock? There are over 5000 domestic stocks out there plus many more internationally. Looking at all the financial and other fundamentals is daunting and will create more confusion than help.
My Fundamental metrics are limited to three, conditionally. The condition is that it does not apply well to penny stocks and average daily volumes below 80,000. Having said this, my Fundamental metrics are Morningstar Rating, Free Cash Flow and Debt-to-Equity Ratio.
The Morningstar Rating is my valuation and I consider going long on stocks with 4 - 5 stars. The rating is specific to the stock. Morningstar adjusts the gap between its "fair value estimate" and "consider buying" values according to other factors like risks specific to the stock of interest. This rating gives me a position and a reasonably accurate interpretation of "Buying low and selling high". I find this rating superior to PE ratio.
My second Fundamental criterion is best related to working capital although free cash flow has connotations over and beyond the classic function of working capital. My purpose for choosing free cash flow is to assure myself that the business behind the stock I am looking into has enough cash to finance itself and survive negative sudden conditions in the market that it is in. I go long on stocks with positive free cash flow and give a higher number of valuation when it is higher than the previous reporting period. The caveat in analyzing free cash flow by itself is that it can be affected by infusions from debts. This is not a good thing and this is where my third and final metric comes in.
The debt-to-equity ratio is my metric of the degree of leverage. This metric can be compared to other companies in its niche or sector but I ignore this also. I focus on the company and limit my exposure to those with no higher than 0.3 debt-to-equity.
The three Fundamentals above must be used as a system and I eliminate any stock that does not meet all three benchmarks. These metrics are more important for long term investors than for technical traders like me. Right or wrong for others, these metrics are benchmarks in my trading road map and have worked for me. It makes me trade efficiently and with a significant edge toward profitability having started with a good valuation and stable company. I hope you will find the same observation.
If there is enough interest, I plan to cover my Technical metrics, and News, in another article.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.