Knowing how to trade is only part of the battle. When tackling the equity markets, we also need to figure out what to trade. There are a lot of stocks available on the NYSE and the Nasdaq, so how do you choose the right stocks? Traders need a set of rules to filter out dangerous stocks and find stocks that will offer the highest probability for success.
In our Core Strategy and Stock Trading Course, we set out a detailed set of guidelines for finding stocks that are acceptable for trading and those that should be avoided due to factors such as: low volume, extremely volatile price swings, non-correlation with the broad market, etc.
Once we narrow down the list of tradable stocks, we need to identify the ones that will offer us the best chance for success during our chosen trading timeframe. There are two ways of doing this: the first way to find the right stock is a top down approach to and the second is bottom up.
One thing that both methods have in common is that we want to identify the trend of the broad market. Which, in our case, is the S&P 500 Index and/or the Nasdaq Index. Trying to trade against the larger market trend is likely to spell disaster. Even if we are able to make a profit, it is likely to be extremely small in relation to the profits we could have made by trading in the same direction as the markets.
How to Choose Stocks Using the Top Down Approach
Starting with the top down approach to finding the right stock, you will want to identify the broad market’s trend and its probable future direction. This is done by viewing the charts of your intended intermediate time frame and the Curve. These are concepts discussed in the Core Strategy Course to increase your probability of success. You want to properly recognize the trend direction and then identify the supply and demand zones that are likely to cause a pause or reversal of the trend.
Once you know the broad market’s likely direction, you can then look to the sectors that are likely to outperform the others in that market environment. Not all sectors perform as well in bullish markets or bearish markets. Some are seen as risky and excel in overall bullish moves while others are defensive and may do well when the bears take hold. Knowing the characteristics of the sectors themselves offers an advantage to the stock trader.
Many traders will stop there and invest and trade in the Exchange Traded Funds (ETFs) that track the markets or sectors. This is a good idea for many investors as ETFs are baskets of many stocks in a sector and your investment in these securities automatically diversifies your portfolio, unlike buying individual stocks. Owning a basket of many stocks can be less risky that owning one or two stocks. If there is bad news on one company, owning just that company could prove disastrous. If that company is one part of an ETF, the entire portfolio may not suffer as much if the price of that one stock drops.
Working our way down from the sector, we are now ready to select individual stocks in those sectors. There are many market maps that will allow you to search stocks for free, or you can look at the lists available on your software. You want to find strong stocks in strong sectors to buy at demand zones when the markets are bullish. Conversely, you want to find weak stocks at supply in weak sectors when the markets are bearish.
How to Choose Stocks Using the Bottom Up Approach
The bottom up approach works well too. Using a stock screener or even just looking at a small group of individual stocks you like to trade, you would identify both long and short trading opportunities. Creating a list of long and short trading opportunities may be better for the intraday trader since the markets can often swing both directions and you will be ready to trade wherever the market tells you to go. Once you have your stocks chosen from the scanner, you would simply wait for direction from the broad markets to tell you the trend for the day and then execute your plan.
For more information on how to select the right stocks to trade, come join us in one of our Professional Trader courses and online in the Extended Learning Track. We teach you how strategies to combine the knowledge of how to trade with the skill of finding the right trade.