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The 5 Keys to Identifying a Fundamental Day Trade - Part I

|Includes: BKC, GPS, JCG, MCD, Torchmark Corporation (TMK), WEN
David Ristau, premier stock trader at Phil's Stock World, presents daily stock trades for readers based on what he calls his "fundamental day-trade system." He has an excellent track record, which is posted in the Oxen Group section and updated every few weeks.

Introduction to The 5 Keys to Identifying a Fundamental Day Trade

By Ilene

day trading, quotesIn PSW's Oxen Group section, David recommends a couple day-trades each morning, often a stock or ETF to buy and a stock or ETF to sell short. David selects his trading candidates based on his fundamental analysis and his analysis of the technical condition of the market. He attempts to choose stocks and ETFs that are likely to move 3-5% during the day, and also to open and close the positions at optimal times. He does this by first examining five key sources of information to help him find high probability trades. After selecting his trades, he applies several basic trading rules.

In this introductory article, David discusses the first two of his five keys to identifying a fundamental or high probability day trade. The signals David examines are easy to understand and the techniques he shares may help transform your day-trading into a more disciplined method.

The 5 Keys to Identifying a Fundamental Day Trade

By David at Phil's Stock World

Identifying the Fundamentals

Stocks do not move on their own. There are a number of fundamentally bullish or bearish factors that we can use to identify stocks that are likely to move 3-5% in a single day. Even the best technicals seldom give you 5% upward (or downward) movements intraday alone.

To begin to seek that perfect stock or ETF, we first need to look for something that can propel a stock or, in the case ETFs, the represented sector. This 3-5% movement is not from the previous day's close, but between the market's open and close. We want to identify a stock that can be bought sometime in the morning to give us that significant movement by the end of the day. The first type of information that is prone to easily move a stock is its earnings.

1. Earnings

There are multiple ways to play a company's earnings. One of the most effective ways to invest based on earnings is after a company has already announced their earnings. We are looking for earnings that were surprising, especially ones that say something about a sector.

For example, if one company announces positive earnings because it had a large profit from a lawsuit, this information does not tell us much about the earnings potential of the sector in general. However, if an important company in a sector has positive earnings due to an increase in sales or because it saw higher demand than anticipated, this information is more telling of its sector as a whole, and the news may move many similarly situated stocks.

We like the sector-telling earnings because it suggests something about the sector is most likely bullish (or bearish). For example, if Burger King Holdings Inc. (BKC) reported earnings and noted that they were seeing increased demand for fast food because customers were cutting back on more expensive restaurants, this would suggest a general transferring of food money from high-end restaurants to fast food. This information should propel not only BKC, but also McDonald's (NYSE:MCD) and Wendys/Arbys Group (NYSE:WEN). The positive earnings may benefit companies that are closely related to the reporting company. Typically, we do not want to invest for a single day-trade in the specific company that reported the earnings. The reporting company is likely to gap up the next morning and have less room to run due to the large jump up from the closing price.

Instead, we look for competitors that will profit from the good news. Take for example, J. Crew Group Inc. (JCG) and Gap Inc. (NYSE:GPS). On May 28, 2009, J. Crew, in after hours, announced earnings that significantly exceeded estimates when it reported an earnings per share at 0.34 EPS. The street was estimating 0.11 EPS. This was seriously bullish news for JCG. The next day the stock jumped 26.4%. The stock gapped up so heavily that traders jumping on in the morning missed most of that movement. So, in the morning, the Oxen Group recommended Gap Inc., a close competitor of JCG, especially with their Banana Republic line. On the same day, GPS moved up almost 5%. The Oxen Group was able to get in at the beginning of the day while the stock was still at a low price, and then ride the wave upwards.

We find that earnings releases can be used to make gains on competitor companies because the competitors' stock often reacts slower than that of the company releasing the earnings. We look for competitors that have similar product lines. The same is true in the reverse direction. If a company bombs estimates, many similar companies will be pulled down with it, providing us with a good shorting opportunity.

Additionally, extremely good earnings in an important company within a particular sector may suggest a day-trade with an ETF that models the sector. In the case of JCG, retail ETFs are sparse and have low volume, not the best vehicle for trading. But with an energy or financial company, sector ETFs are heavily traded, and playing an ETF the same way we played Gap could be very profitable.

In summary, earnings can be a very solid fundamental bull or bear signals for a single day-trade. However, earnings do not come out everyday. Where else can one look when trying to identify a bullish or bearish fundamental trade for the next day?

2. Upgrades/Downgrades

Upgrades and downgrades are extremely powerful mechanisms that can propel a stock up or down significantly. Ratings can move a stock up or down anywhere from 1% to 10% depending on the rating company's significance, the ratings change, and the company being rated. Moody's, S&P, Credit Suisse, Goldman Sachs, Morgan Stanley, and Fitch are rating companies that are particularly significant. Smaller equity firms tend to have less impact on a stock's next day movement. Upgrades and downgrades typically come in the morning or intraday. However, when they do come in the evening, they work in the same way as earnings - an upgrade can give rise to a sizable stock movement.

An upgrade or downgrade will have a strong effect on an entire sector if it has something to do with the broader picture. If a company gets downgraded because of risky investments or bad credit, it is not likely to bring down its competitors. However, if the downgrade is due to lower sales expectations, it's competitors are more likely to trade down in sympathy. 

For example, on Saturday, June 6, 2009, Torchmark Corp. (NYSE:TMK), an insurance company, was downgraded by Fitch Ratings for bad investments as well as a sector wide decline in the ability for insurance companies to be profitable in this market. All the insurers ended in the red, most likely due to the questioning of insurance companies' profitability in general. Obviously, a multitude of factors go into companies within a sector, but upgrades and downgrades can be very significant in predicting the movement of single stocks and sectors.


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Disclosure: none